Greenspan on risk premiums

Greenspan's Remarks
August 26, 2005

Reflections on central banking
At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2005.

* * *

In the spirit of this conference, I asked myself what developments in the past eighteen years -- both in the economy and in the economics profession--were most important in changing the way we at the Federal Reserve have approached and implemented monetary policy.

The Federal Reserve System was created in 1913 to counter the recurrent credit stringencies that had so frequently been experienced in earlier decades. As lender of last resort, we had a mandate that, at least viewed from today's perspective, was limited. We did not engage in Systemwide open market operations until the 1920s. And as recently as the 1950s, the framework within which those open market operations were formulated was still being developed. Credit was eased when the economy weakened and tightened when inflation threatened, but largely in an ad hoc manner. As a consequence, the Federal Reserve was perceived by some as often accentuating, rather than damping, cycles in prices and activity. Importantly, however, the surge in prices that followed the removal of wage and price controls after World War II and again after the Korean War kept monetary policymakers wary of the threat of inflation.

But concern that the monetary restraint of the 1950s had led to unnecessarily high unemployment persuaded the Federal Open Market Committee to adopt a more stimulative policy stance in the mid-1960s. Those actions appear to have been predicated, in part, on an acceptance of the then-prevalent view that a long-term tradeoff existed between inflation and unemployment.

Subsequently, however, the experience of stagflation in the 1970s and intellectual advances in understanding the importance of expectations--which built on the earlier work of Friedman and Phelps--undermined the notion of a long-run tradeoff. Inflation again became widely viewed as being detrimental to financial stability and macroeconomic performance. And as the decade progressed, a keener appreciation for the monetary roots of inflation emerged both in the profession at large and at central banks. Indeed, the insights from the work of Friedman and Schwartz a decade earlier gained greater prominence in the realm of practical policy.

These events, both economic and intellectual, significantly influenced the tool kits employed by macroeconomists inside and outside policymaking institutions. The large-scale macromodels that had been the focus of so much work in the 1960s came under attack on two fronts.

Most prominently, greater recognition of the importance of expectations suggested that those models, which for the most part incorporated autoregressive expectations, were excessively reduced-form and backward-looking in nature and thus insensitive to changes in economic structure and the policy process. In addition, some researchers observed that simple time-series models often produced better forecasts than the large macromodels of that period.

One prescription was to focus on uncovering, at a more fundamental level, the structural parameters of the economy. Needless to say, this task has proven to be a very tall order that has yet to be filled. Partly in response to these difficulties, a substantial body of research focused on improvements in empirical modeling, such as vector autoregressions for forecasting, and in some cases, for policy analysis.

Each one of these approaches has proven useful, and their descendants are currently employed in various forms in central banks throughout the world. But as yet, none of these approaches is capable of addressing the full range of policymakers' needs.

At various points in time, some analysts have held out hope that a single indicator variable -- such as commodity prices, the yield curve, nominal income, and of course, the monetary aggregates -- could be used to reliably guide the conduct of monetary policy. If it were the case that an indicator variable or a relatively simple equation could extract the essence of key economic relationships from an exceedingly complex and dynamic real world, then broader issues of economic causality could be set aside, and the tools of policy could be directed at fostering a path for this variable consistent with the attainment of the ultimate policy objective.

M1 was the focus of policy for a brief period in the late 1970s and early 1980s. That episode proved key to breaking the inflation spiral that had developed over the 1970s, but policymakers soon came to question the viability over the longer haul of targeting the monetary aggregates. The relationships of the monetary aggregates to income and prices were eroded significantly over the course of the 1980s and into the early 1990s by financial deregulation, innovation, and globalization. For example, the previously stable relationship of M2 to nominal gross domestic product and the opportunity cost of holding M2 deposits underwent a major structural shift in the early 1990s because of the increasing prevalence of competing forms of intermediation and financial instruments.

In the absence of a single variable, or at most a few, that can serve as a reliable guide, policymakers have been forced to fall back on an approach that entails the interpretation of the full range of economic and financial data. Policy is implemented through nominal and, implicitly, real short-term interest rates. However, reflecting the progress in economic understanding, our actions are now better informed about the pitfalls associated with relying on nominal interest rates to set policy and the important role played by inflation expectations in gauging the stance of monetary policy.

Our appreciation of the importance of expectations has also shaped our increasing transparency about policy actions and their rationale. We have moved toward greater transparency at a "measured pace" in part because we were concerned about potential feedback on the policy process and about being misinterpreted -- as indeed we were from time to time. I do not intend this brief and necessarily incomplete review of events to illustrate how far we have come or to despair of how far we have to go. Rather, I believe it demonstrates the inevitable and ongoing uncertainty faced by policymakers.

Despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many critical linkages is far from complete and, in all likelihood, will remain so. Every model, no matter how detailed or how well conceived, designed, and implemented, is a vastly simplified representation of the world, with all of the intricacies we experience on a day-to-day basis.

Formal models are a necessary, but not sufficient, system of analysis. To be sure, models discipline forecasts by requiring, among many restraints, that identities are indeed equal, inventories non-negative, and marginal propensities to consume positive. But we all temper the outputs of our models and test their results against the ongoing evaluations of a whole array of observations that we do not capture in either the data input or the structure of our models. We are particularly sensitive to observations that appear inconsistent with the causal relationships of our formal models. Tentative revisions of that structure are reflected in our add factors.

Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy.

The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. Forecasts of change in the global economic structure -- for that is what we are now required to construct -- can usefully be described only in probabalistic terms. In other words, point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them.

In effect, we strive to construct a spectrum of forecasts from which, at least conceptually, specific policy action is determined through the tradeoffs implied by a loss-function. In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates.

The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. Moreover, the risk of a sizable jump in inflation seemed limited at the time, largely because increased productivity growth was resulting in only modest advances in unit labor costs and because heightened competition, driven by globalization, was limiting employers' ability to pass through those cost increases into prices. Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs.

* * *

The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.

The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.

Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

The lowered risk premiums -- the apparent consequence of a long period of economic stability -- coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

* * *

Broad economic forces are continuously at work, shaping the environment in which the Federal Reserve makes monetary policy. In recent years, the U.S. economy has prospered notably from the increase in productivity growth that began in the mid-1990s and the enhanced competition engendered by globalization. Innovation, spurred by competition, has nurtured the continual scrapping of old technologies to make way for the new. Standards of living have risen because depreciation and other cash flows generated by industries employing older, increasingly obsolescent technologies have been reinvested to finance newly produced capital assets that embody cutting-edge technologies.

But there is also no doubt that this transition to the new high-tech economy, of which expanding global trade is a part, is proving difficult for a segment of our workforce that interfaces day by day with our rapidly changing capital stock. This difficulty is most evident in the increased fear of job-skill obsolescence that has induced significant numbers of our population to resist the competitive pressures inherent in globalization from workers in the major newly emerging market economies. It is important that these understandable fears be addressed through education and training and not by restraining the competitive forces that are so essential to overall rising standards of living of the great majority of our population. A fear of the changes necessary for economic progress is all too evident in the current stymieing of international trade negotiations. Fear of change is also reflected in a hesitancy to face up to the difficult choices that will be required to resolve our looming fiscal problems.

The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks. If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment.

The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances. That process of correction limits the size and the consequences of cyclical imbalances. Enhanced flexibility provides the advantage of allowing the economy to adjust automatically, reducing the reliance on the actions of monetary and other policymakers, which have often come too late or been misguided.

In fact, the performance of the U.S. economy in recent years, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence that we have benefited from an enhanced resilience and flexibility.

We weathered a decline on October 19, 1987 of a fifth of the market value of U.S. equities with little evidence of subsequent macroeconomic stress--an episode that provided an early hint that adjustment dynamics might be changing. The credit crunch of the early 1990s and the bursting of the stock market bubble in 2000 were absorbed with the shallowest recessions in the post-World War II period. And the economic fallout from the tragic events of September 11, 2001, was limited by market forces, with severe economic weakness evident for only a few weeks. Most recently, the flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years.

* * *

This morning I have tried to outline my perceptions of the key developments that have influenced the conduct of monetary policy over the past eighteen years. I acknowledge that monetary policy itself has been an important contributor to the decline in inflation and inflation expectations over the past quarter-century. Indeed, the Federal Reserve under Paul Volcker's leadership starting in 1979 did the very heavy lifting against inflation. The major contribution of the Federal Reserve to fashioning the events of the past decade or so, I believe, was to recognize that the U.S. and global economies were evolving in profound ways and to calibrate inflation-containing policies to gain most effectively from those changes.

For reasons that may not be too obscure, I will pay close attention to, and hope to learn from, the deliberations of the next couple of days. I have been asked to make a few closing remarks tomorrow about some of the unresolved challenges facing policymakers in the year ahead and about my experiences living inside the Federal Reserve for nearly two decades, after so many years of observing our institution from afar.

Cellphones Catapault Rural Africa to 21st Century - awesome story

 

Cellphones Catapult Rural Africa to 21st Century

By SHARON LaFRANIERE

YANGUYE, South Africa - On this dry mountaintop, 36-year-old Bekowe Skhakhane does even the simplest tasks the hard way.

Fetching water from the river takes four hours a day. To cook, she gathers sticks and musters a fire. Light comes from candles.

But when Ms. Skhakhane wants to talk to her husband, who works in a steel factory 250 miles away in Johannesburg, she does what many in more developed regions do: she takes out her mobile phone.

People like Ms. Skhakhane have made Africa the world's fastest-growing cellphone market. From 1999 through 2004, the number of mobile subscribers in Africa jumped to 76.8 million, from 7.5 million, an average annual increase of 58 percent. South Africa, the continent's richest nation, accounted for one-fifth of that growth.

Asia, the next fastest-expanding market, grew by an annual average of just 34 percent in that period.

"It is a necessity," said Ms. Skhakhane, pausing from washing laundry in a plastic bucket on the dirt ground to fish her blue Nokia out of the pocket of her flowered apron. "Buying air time is part of my regular grocery list."

She spends the equivalent of $1.90 a month for five minutes of telephone time.

Africa's cellphone boom has taken the industry by surprise. Africans have never been rabid telephone users; even Mongolians have twice as many land lines per person. And with most Africans living on $2 a day or less, they were supposed to be too poor to justify corporate investments in cellular networks far outside the more prosperous cities and towns.

But when African nations began to privatize their telephone monopolies in the mid-1990's, and fiercely competitive operators began to sell air time in smaller, cheaper units, cellphone use exploded.

Used handsets are available for $50 or less in South Africa, an amount even Ms. Skhakhane's husband was able to finance with the little he saves from his factory job.

It turned out that Africans had never been big phone users because nobody had given them the chance.

One in 11 Africans is now a mobile subscriber.

Demand for air time was so strong in Nigeria that from late 2002 to early 2003 operators there were forced to suspend the sale of subscriber identity module cards, or SIM cards, which activate handsets, while they strengthened their networks.

Villagers in the two jungle provinces of Congo are so eager for service that they have built 50-foot-high treehouses to catch signals from distant cellphone towers.

"One man uses it as a public pay phone," said Gilbert Nkuli, deputy managing director of Congo operations for Vodacom Group, one of Africa's biggest mobile operators. Those who want to climb to his platform and use his phone pay him for the privilege.

On a continent where some remote villages still communicate by beating drums, cellphones are a technological revolution akin to television in the 1940's in the United States.

Africa has an average of just one land line for every 33 people, but cellphones are enabling millions of people to skip a technological generation and bound straight from letter-writing to instant messaging.

Although only about 60 percent of Africans are within reach of a signal, the lowest level of penetration in the world, the technology is for many a social and economic godsend.

One pilot program allows about 100 farmers in South Africa's northeast to learn the prevailing prices for produce in major markets, crucial information in negotiations with middlemen.

Health-care workers in the rural southeast summon ambulances to distant clinics via cellphone.

One woman living on the Congo River, unable even to write her last name, tells customers to call her cellphone if they want to buy the fresh fish she sells.

"She doesn't have electricity, she can't put the fish in the freezer," said Mr. Nkuli of Vodacom. "So she keeps them in the river," tethered live on a string, until a call comes in. Then she retrieves them and readies them for sale.

William Pedro, 51, who deals in farm and garden plants, said he tried for eight years to lure customers to his nursery in a ragtag township near George, a resort town on South Africa's southern coast. Only when he got a cellphone two years ago, he said, did his business take off.

"White people are afraid to come here to my place in the township to buy plants," Mr. Pedro, who is of mixed race, said as he stood outside his makeshift greenhouses. "So now they can phone me for orders and I can deliver them the same day."

Hamadoun Touré, development director for the International Telecommunication Union, said the economic blessings of cellphones were magnified in the developing world.

"What is the alternative?" asked Mr. Touré, whose agency was founded in the days of the telegraph and is now part of the United Nations. "Somebody may have to leave work, travel for days, spending much more money" just to pass on a message.

Initially, he said, mobile operators based their predictions of cellphone use on the typical land-line user, someone with a bank account, a job and a fixed address.

"The woman selling vegetables in the market, with the baby and the umbrella, they weren't in the profile of the normal subscriber," Mr. Touré said. "But they use them."

Mobile operators cannot put up towers fast enough, not just in established markets like South Africa, which is already home to about one in four African mobile subscribers, but also in nations that barely have electricity, much less existing cellular networks ready for expansion.

Five years ago, for example, sub-Saharan Africa (excluding South Africa) accounted for one of every five mobile subscribers on the continent. That ratio has now doubled.

Executives of the MTN Group, another major African mobile operator, say the company's Nigerian network cost two and a half times as much as its South African network because of lack of infrastructure. But demand is so intense that MTN is adding hundreds of new base stations.

Congo was in the midst of a civil war when Alieu Conteh, a telecommunications entrepreneur, began building a cellular network there in the 1990's. No foreign manufacturer would ship a cellphone tower to the airport with rebels nearby, so Mr. Conteh hired local men to collect scrap and weld a tower together.

Now Vodacom, which formed a joint venture with him in 2001, is grappling with other problems. Its trucks get stuck in the mud. A crane is out of the question; it takes 15 to 20 men to haul each satellite dish into place with ropes. Base stations must be powered by generators. Each morning, executives send instant messages to employees containing the latest rate for the plunging local currency.

Despite all that, Vodacom Congo has 1.1 million subscribers and is adding more than 1,000 daily.

There are no current plans to extend land-line service to the surrounding steep mountains where Ms. Skhakhane lives, government officials here say. But that may not matter: six months ago, Vodacom erected a cellular tower whose signal can be picked up in the hills. Now it logs 10,000 calls a day.

Before the tower went up, Ms. Skhakhane communicated with her husband by letter. She waited weeks for a response. The nearest public telephone, outside a little shop more than 10 miles away, has been broken since March.

Ms. Skhakhane said she considered the $1.90 a month for a phone card to be money well spent. "I don't use the phone very often," she said, "but whenever there is something I really need to discuss, I do."

One problem remains even in the age of cutting-edge cellular technology: How does an African family in a hut lighted by candles charge a mobile phone? A bicycle-driven charger is said to be on the horizon. But that would require a bicycle, a rare possession in much of rural Africa.

In Yanguye, as in other regions, the solution is often a car battery owned by someone who does not have a prayer of acquiring a car. Ntombenhle Nsele keeps one in her home a few miles down the road from Ms. Skhakhane's. She takes it by bus 20 miles to the nearest town to recharge it in a gas station.

For 80 cents each, Ms. Nsele, 25, lets neighbors charge their mobiles from the battery. She gets at least five customers a week.

"Oooh, a lot of people," she said, smiling. "Too many."

 

The Rise of Fareed Zakaria: Muslim, Heartthrob, Super-Pundit

The Interpreter The Rise of Fareed Zakaria: Muslim, Heartthrob, Super-Pundit by Joy Press August 16th, 2005 10:58 AM

The Backstreet Boy of public broadcasting photo: Cary Conover

Fareed Zakaria's career reads like some crazy America fantasy: Neoconservative policy wonk becomes darling of the ultra-liberal Daily Show. Political columnist and editor of Newsweek International is dubbed an "intellectual heartthrob" by Jon Stewart. Upper-class Indian academic raised in mostly secular household becomes America's favorite explainer of the Muslim world, regularly appearing on Charlie Rose, This Week With George Stephanopoulos, and now on his own weekly PBS news series, Foreign Exchange With Fareed Zakaria (airing Saturdays at 10 a.m. on WNET).

Zakaria stands out from the crowd of lily-white talking heads that populate American news shows thanks to his tan skin, clipped Bombay lilt, and his insistence that we pay attention to the rest of the globe. Although he was a rising star in the serious foreign-policy world of the '90s (The Nation once described him as a "junior Kissinger"), it was his post–9-11 Newsweek cover story "Why They Hate Us" that put him on the mainstream map as someone who could make sense of the now threatening outside world. And he has continued to win himself a substantial following with his thoughtful critiques of the Bush administration's activities in Iraq. He is America's go-to man for global chaos, providing some urgently needed outside perspective on our never ending war on terror.

Sitting in his airy corner office at Newsweek, Zakaria is the definition of dapper, clad in a pale yellow checked shirt and crisp khakis. He ignores the constant ambient ping of incoming e-mails and phone calls as he talks about his PBS show. Zakaria may be the pundit world's answer to the Backstreet Boys, but there's nothing sexy about Foreign Exchange. It has the standard muted tones of a serious news program, complete with generic set and antiquated electronic theme music. "People ask how we'll distinguish ourselves from the competition," Zakaria says animatedly. "What competition? There's literally not another show on American television that deals only with foreign affairs—you know, the other 95 percent of humanity."

In a daring move, Zakaria has chosen to have mostly non-Americans as guests, a technique that often yields surprising insights. He's discussed the Iraq situation with the country's deputy prime minister, talked to a Yemeni editor about the connections between Yemen and Al Qaeda, and gabbed about Islam's treatment of women with Muslim feminists. Perhaps in another era this wouldn't have seemed like such a bold move, but as one nation under Bush, we've grown increasingly proud of our insularity. Zakaria sees the media's reaction to the London bombings as an example of American self-centeredness: "Ten minutes after the British have gone through this terrible tragedy, we were already saying, 'How safe are our subways? Sure, London has just suffered this terrible catastrophic loss—but enough about you, what about us!' " he says, smiling. "I think this attitude does translate into the way we interact with the world as a government and as a people." He envisions Foreign Exchange as a half-hour corrective: "If you want to understand what's going on in the rest of the world, listen to what foreigners are saying about it."

Although he exudes ambition—simultaneously editing a magazine, writing a weekly column, hosting a TV show, and writing a book—Zakaria refuses to infect his show with glitziness. Movie star Natalie Portman recently appeared on Foreign Exchange to riff on her pet cause, microfinancing in the third world. Most hosts would've been thrilled to nab an actor with crossover potential, but Zakaria agreed only on the condition that if she gave a vacuous interview, he could kill it. "It turned out she really knew her stuff, and it's an important issue that's not at all sexy. But I was still ambivalent, because I feel there's a reason to be a PBS show, and I don't want to lose that." Chances are mainstream news outlets will continue to court him, but Zakaria claims he doesn't want to be the new Peter Jennings. "I love the opportunity to amplify my voice through television, and I love the idea of making more Americans aware of what goes on in the world. But being a TV star, you're chained to the camera; you can never really travel. And I don't know how you can understand the world that way." He's been to Iraq, China, and Germany in the last few months alone—he'd travel even more, he says, if he didn't have two small children and a wife in New York.

In the last few years, Zakaria has become a kind of bridge to the Arab world—an Asian-born Muslim with a Yale and Harvard education who seems willing to act as a cultural interpreter. In some ways he was born for this role: His mother was the editor of an Indian newspaper, his father an important politician and scholar who wrote several books about religion, including one titled The Struggle Within Islam. Growing up in a country like India, riven by sectarian violence, Zakaria says, "you're absolutely aware of the power religion has, in a positive and negative sense—in its ability to inspire people and its ability to inspire people to kill." On the other hand, his own upbringing was open-minded and secular; he sang Christian hymns at school and celebrated Hindu as well as his own Muslim holidays. "I do know a lot about the world of Islam in an instinctive way that you can't get through book learning," he says thoughtfully, but admits he finds the role of token Muslim explainer in the American media slightly uncomfortable. "I occasionally find myself reluctant to be pulled into a world that's not mine, in the sense that I'm not a religious guy."

Zakaria is good at straddling worlds. Asked how a neocon who edited the journal Foreign Affairs ended up as a favorite of the Daily Show crowd, he protests that he is no longer a diehard Reaganite but a firm centrist. "And anyway, in America the entire spectrum has shifted to the right. I still like the same kinds of people I always did—conservative Democrats, moderate Republicans, call them what you will. But we're an increasingly embattled phenomenon in a country with a president talking about intelligent design." Jon Stewart's viewers probably don't have an inkling of Zakaria's political background, since they rarely chat about economic or domestic affairs. Mostly Zakaria is applauded for his willingness to call out our government's missteps in Iraq. (He initially supported the invasion but within a few weeks began lambasting the Bush administration in Newsweek pieces with titles like "The Arrogant Empire.") "I feel that's part of my job," he says, slightly defensively, "which is not to pick sides but to explain what I think is happening on the ground. I can't say, 'This is my team and I'm going to root for them no matter what they do.' "

He hopes Foreign Exchange can remain nonpartisan, unruffled by PBS's recent obsession with ideological balance. "Conservatives are now all of a sudden asking for affirmative action!" he quips, before bemoaning the way the media treat American politics as a partisan spectator sport. "The reality is that the American public isn't that polarized. I bet you a lot of conservatives watch Jon Stewart, and a lot of liberals watch O'Reilly, because they make news fun."

Bizarrely, Zakaria cites The Daily Show as an inspiration for his own earnest series, because "it gets to the core of news items in a funny, quick way. Obviously I have to do it differently since I'm not doing a comedy show—and, as Jon Stewart likes to say, I'm not preceded by talking puppets. But who knows, in some PBS markets Sesame Street might be on before me."

The REIT bubble

 

Pop!

The Other Real-Estate Bubble

By ANDREW BARY

THE NATIONWIDE INFATUATION with property has spilled over into the stock market, where shares of real-estate investment trusts have soared, despite spotty operating results and higher interest rates.

The run-up in REIT shares, which have doubled since early 2003, has raised concern on Wall Street that a bubble could be forming in the $300 billion sector. "Our view is that valuations are in uncharted territory, and the group is very susceptible to a correction," says Jonathan Litt, the REIT analyst at Smith Barney. What's the downside? Litt says that shares of real-estate investment trusts could fall more than 10%. This year, the major REIT indexes are up about 10% (including dividends) after 30%-plus returns in both 2003 and 2004.

Some cracks may be starting to form in the REIT sector. The group declined 2% Thursday and was down about 3% Friday., hurt by a setback in the bond market that followed the release of stronger-than-expected July employment data Friday morning.

The two-day selloff illustrates the volatility in REIT stocks. Morgan Stanley's REIT index, for instance, dropped 10% in January and had rallied 25% from late March until the middle of last week. Still, REITs often appeal to risk-averse investors who don't recognize this.

Litt acknowledges that a sustained REIT retreat might not come soon because "a wall of money" continues to chase the sector and the entire U.S. commercial property market in which the group invests.

What could derail the REITs? Further interest-rate increases, a bursting of the property bubble, a slowing economy or a shift in investor preference toward common stocks.

Danger signs abound. The group, which offered dividend yields of 8.75% in late 1999, now has an average yield around 4.5%. Some leading REITs, including Vornado Realty Trust, Simon Property Group, General Growth Properties, Boston Properties and Public Storage, yield less than 4% -- comparable to the rate on risk-free T-bills. The low REIT yields mean the sector is far less defensive than it used to be.

REITs look pricey based on virtually every historical financial metric: dividends, dividend yields relative to Treasury rates, and various earnings measures, including funds from operations, or FFO, and adjusted funds from operations, or AFFO. In fact, REIT dividend yields are at a 30-year low. And one measure of REIT's attractiveness -- their yields minus Treasury-bond yields -- is close to zero for the first time in seven years.

The REIT run-up has generated less attention than the surging prices of homes throughout the country. REITs don't own single-family homes, but they do control office buildings, apartment complexes, shopping centers, warehouses, storage facilities and other types of income-producing properties. The three biggest sectors are apartments, malls and office buildings. There are nearly 200 publicly traded realty trusts.

REIT INVESTORS HAVE SEEMED unconcerned about rising yields on Treasury paper, including the move in the benchmark 10-year T-note to 4.4% from a June low of 3.9%. As income vehicles, real-estate investment trusts become less attractive when yields on alternative investments move up. Short-term bond rates, now at 3.25%, probably are heading to 4%. That could hurt realty trusts that rely on floating-rate debt.

"There has been an enormous demand for yield and enormous demand for real cash income," says Greg Whyte, a REIT analyst at Morgan Stanley. "A lot of people are surprised at the amount of money chasing real-estate assets and REIT stocks." Where there once were three to five bidders for a $1 billion "trophy" commercial property, now there could be 20 or more.

Many Street analysts, including Litt and Whyte, have underestimated the power of the REIT rally. Earlier this year, one of the most prominent bears, David Shulman retired as the senior REIT analyst at Lehman Brothers. Shulman then was teased by Steve Roth, the influential and outspoken chief executive of Vornado Realty, one of the biggest owners of office buildings in Manhattan. Roth wrote in Vornado's annual report: "What can I say to my dear friend David, who has an IQ of 250 and had a three-year sell on Vornado with a $43 average target. I'm sorry, David. I just couldn't resist." Vornado now trades at 85.

The upside potential in REITs may be limited, barring a drop in long-term rates. REIT profits are rising, but outside the hot shopping-mall sector, the gains haven't been large. Profit growth could run at 6% to 7% annually in the coming years, barring an economic downturn.

OFFICE REITS CONTINUE to contend with the expiration of leases signed at high rents in 1999 and 2000. Another problem: continued corporate consolidation, which has hurt markets like Boston, where such big hometown employers as FleetBoston Financial, John Hancock and Gillette have been taken over. Apartment REITs are only starting to recover after a tough stretch in which occupancy and rents were pressured by the growing trend toward home ownership.

"REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you're going to have a decent consumer economy and lower rates forever." Siris points to steady insider selling by REIT executives as a sign of the sector's overvaluation.

Tables: Pricey Properties | High-Yield Alternatives1

REITs can pass along their profits to investors free of federal corporate income taxes. Since 2000, their shares, on average, have more than doubled, while prices of single-family homes nationally are up by more than 50%-with some hot markets in California, Florida and the Northeast gaining 100%. The recent REIT weakness may not bode well for America's inflated home market because the key factors that affect REITs -- interest rates and the economy -- also influence home prices.

It's notable that REIT shares bottomed just as the technology bubble was about to burst in March 2000. That was a time when many investors decided that commercial property was being rendered obsolete by the Internet. The thinking was that Americans were going to do their shopping at the likes of Amazon.com, eToys and Webvan (an Internet grocer) while doing their banking online.

The opposite is true now. Institutional investors are clamoring to buy virtually every kind of commercial real estate, not just in the U.S. but around the world. "There's a global rush to buy real estate," Litt says. "It's driven by a desire to own hard assets, diversify and buy into a group that has been working."

The yield demanded by institutional buyers on U.S. commercial property has fallen to the 4%-6% range from 9% as recently as 2002. These yields, called capitalization rates, are based on the annual income generated by a property, divided by its purchase price. Litt points out that cap rates outside the U.S. now are comparable to those domestically, reflecting the growing efficiency of worldwide real-estate markets and the tens of billions of dollars looking for opportunities.

Cap rates are distinct from dividend yields. Dividends on REITs are a result of the income thrown off by the underlying properties and the mix of financing -- common stock and debt -- used to finance the properties.

ONE CAVEAT: REIT DIVIDENDS didn't benefit from the cut in the federal tax rate on dividends two years ago. Thus, they're disadvantaged relative to payouts on common stocks. The after-tax dividend yield on a REIT yielding 4.5% is around 3.2% for an investor in a high tax bracket. An investor could buy common shares of non-REITs yielding 4% and get an after-tax yield of 3.4% -- beating the after-tax REIT yield.

A month ago, Litt did a computer screen and found that 88 companies in the S&P 500, S&P MidCap 400 and S&P 600 Small-Cap indexes had higher after-tax yields than the average REIT, up from just 27 in May 2003. The table, High-Yield Alternatives, lists some high-yielding alternatives to REITs, including the Baby Bells, Merck, Altria, Citigroup, Bank of America and Sara Lee.

What's the REIT bull case? Mike Kirby, the director of research at Green Street Advisors in Newport Beach, Calif., says that, if the U.S. is in a sustained period of low interest rates, REITs are apt to perform well. "The valuation question is tied up with the bigger-picture question of whether we're in a low-return environment for a long time. If that's the case, the 4.5% dividend yield on REITs doesn't strike me as too bad," given expectations that REITs' profits will rise 6% to 7% annually.

But Kirby and others acknowledge that REITs are likely to perform badly if the 10-year Treasury is heading toward a 6% yield.

REIT executives dismiss the bubble talk, pointing to the increasing demand among institutional investors for "alternative assets," as well as the underinvestment in real estate by pension funds and endowments relative to their equity holdings. The U.S. commercial property sector is pegged at about $5 trillion, about half the size of the S&P 500 index.

REIT enthusiasts say that commercial real estate has undergone a revaluation that's unlikely to reverse, driven in part by the increased cost of new buildings, which reflects higher costs for land, steel, copper, cement and other materials. The cost of putting up a new office building in Manhattan can run a stiff $650 a square foot -- if a builder can find a lot to put it on.

IN DISCUSSING the real-estate bull market in his annual shareholder letter, Vornado's Roth wrote: "It may be caused by low interest rates. It may be caused by excess liquidity in the worldwide system. It may be caused by the flight to hard assets. It may be technical -- worldwide institutions are under-allocated in this asset class; or it may even be for who knows what. And, it is a bull market in the face of flattish rents. Some think it is a bubble. I do not....Over the past several years, real estate has been repriced. I believe this is a long cycle move. Get used to it; give or take 10%, these prices are here to stay, for some time."

Buyers have been paying record prices for all types of real estate, including the Trump Place (top) and Aston (bottom) apartment buildings in Manhattan.

In part, demand for REIT shares is coming from institutional investors, redeploying money returned to them by firms that invest privately in real estate. Many funds are taking advantage of the bull market to monetize their holdings -- and reap sizable fees. This creates reinvestment demand among investors, which is being channeled into the REIT market.

REITs tend to be valued based on measures other than earnings. In fact, their followers tend to ignore reported earnings, which are based on generally accepted accounting principles.

Why? GAAP profits require a noncash charge for depreciation expense, which reduces reported earnings. REIT investors deem depreciation to be a phantom charge, like the depreciation of a cable TV facility, because the value of the underlying property probably isn't really falling. The preferred profit measure is funds from operations, essentially reported earnings with depreciation and certain other costs added back in.

The problem is that, based on FFO, REIT stocks are at record valuations. The group trades for 15 times projected 2005 funds from operations, versus an average multiple of 11 during the past dozen years, according to Morgan Stanley. The REIT FFO multiple is almost as high as the S&P 500's price-earnings multiple of 17, based on projected 2005 operating profits. That's a rarity; historically, the FFO multiple has been much lower than the S&P's P/E. The forward 12-month REIT FFO and S&P 500 P/E are about the same.

FFO, however, overstates true REIT profits and cash flow. A better measure, according to Kirby and other analysts, is adjusted funds from operations, which takes FFO and strips out ongoing and necessary expenditures that realty trusts typically capitalize. For apartment REITs, it's the cost of new roofs, carpets, drapes and appliances. For office REITs, it's the cost of improvements to space rented to tenants on long-term leases, as well as commissions paid to brokers.

While the gap varies by REIT, the difference between FFO and AFFO is often 25%. "The capital expenditures you deduct are really akin to the recurring cost of running the business," Kirby says. "To not factor them in is to miss a lot of information." Office REITs tend to have a big gap between FFO and AFFO while storage REITs, like Public Storage, usually have a small difference.

Measured by AFFO, REIT valuations looks particularly stretched because the typical company trades at about 20 times estimated 2005 AFFO, considerably above the S&P 500's P/E ratio. And REIT dividends average about 90% of AFFO, a high percentage. In contrast, the S&P 500's payout ratio is around 30%. This means the average company in the S&P has far more room to raise dividends than the typical REIT.

Equity Residential, the leading apartment REIT, is likely to have $2.44 a share in funds from operations this year. That's less than the $2.63 it earned in 2001, yet its shares, at their recent price around 40, were 60% higher. And its annual dividend of $1.73 will barely be covered by the $1.86 in AFFO it's likely to generate in 2005.

Equity Office Properties, a leading office REIT, has risen 20% this year, to 35. Its projected 2005 FFO of $2.52 a share (excluding losses on property sales) is less than what it earned in 2000. Boston Properties, a favorite among REIT investors because of its exposure to two of the hottest office markets, Manhattan and Washington, D.C., has risen 18% this year, to a recent 76. It trades for a lofty 18 times estimated 2005 FFO, 25 times projected 2005 AFFO and yields just 3.6%.

REIT enthusiasts' counter that, while valuations may be stretched, based on FFO, AFFO or cash flow, they're still reasonable based on private-market values. The reasoning is that if Boston Properties liquidated its portfolio, it would realize more than its current stock price after paying off debt.

AGGRESSIVE INSTITUTIONAL BUYERS increasingly are outbidding REITs when properties come up for sale. The non-REIT buyers are willing to use more leverage -- as much as 90% debt financing -- while REITs generally employ a roughly 50/50 mix of debt and equity. A similar situation exists in the home market, in which buyers making down payments of as little as 5% are helping to fuel demand.

The cautious stance of REITs regarding acquisitions is another sign of a frothy market. Boston Properties has been a net seller of office buildings, while Vornado has shifted gears and has sought real-estate plays in the stock market. Vornado is part of a group that purchased Toys "R" Us for $7 billion, and it took a sizable position in Sears Roebuck last year, prior to Kmart's deal to merge with Sears, because of Sears' valuable real estate. It now owns about $400 million of Sears Holding (SHLD) stock. Vornado issued nine million shares on Thursday at 86.75, leading bears to conclude that it wants to raise as much as it can before REIT stocks decline. The Vornado deal wasn't a winner because the stock fell $1.50 Friday to 85.50.

"Given our underwriting standards and our return requirements, we are seeing a paucity of acquisition opportunities," said Ed Linde, the chief executive of Boston Properties, on the company's second-quarter earnings conference call in late July. Boston Properties recently announced a $2.50-a-share special dividend, reflecting proceeds from property sales.

LINDE CITED ANOTHER SIGN of an overheated market. While buyers of office buildings historically have favored properties with high occupancy levels, many potential purchasers now prefer buildings with sizable vacancies because they assume they can push through big rent increases. The reality is that while office rents in key markets have firmed, many office REITs still are getting lower rents on new leases than on expiring leases signed in the 1999-2001 period.

Manhattan remains a center of the real-estate boom. Apartments fetch $1,000 a square foot or more. Thus, a modest-sized two-bedroom apartment can cost $1 million. Prime office space on Park Avenue is going for as much as $100 a square foot -- two times the rates for similar space in Boston and San Francisco.

Equity Residential, the country's largest apartment REIT, recently agreed to pay $816 million for three apartment buildings in Trump Place in Manhattan. That worked out to nearly $600,000 per apartment and a capitalization rate of only 4.5%. Bulls cited the opportunity for Equity Residential to turn the apartments into condos and sell them for a sizable gain -- although the buildings' seller presumably was aware of that possibility.

APARTMENT REITS ARE BACK in favor, partly because investors are figuring that they may engage in wholesale condo conversions to capitalize on the roaring condo market. Watch out if the condo market cools.

Elsewhere in Manhattan, another rental apartment building, the Aston, on the now-fashionable strip of Sixth Avenue in the mid-20s, recently was sold for $195 million to Archstone-Smith, another real-estate investment trust, according to the New York Post. That works out to $800,000 per unit and $1,000 a square foot. The Aston sale could be the richest ever for an apartment building on a per-unit basis. The Aston and Trump purchases reflect an effort by apartment REITs to upgrade their portfolios by buying properties in hot markets and selling them in weaker markets in the South and West, where rents are soft and barriers to new construction are low. The benefits to investors from this strategy are unclear because REITs are accepting earnings dilution by buying high and selling low.

Mall REITs have enjoyed some of the strongest profit gains because of a robust consumer economy. Simon Property, the leading mall REIT, recently reported a 16% gain in second-quarter FFO. Its FFO is expected to rise 11% this year and 6% in 2006. Simon, however, isn't cheap at 80, trading for 16 times projected 2005 FFO and 22 times AFFO.

The mall REITs face a challenge because of growth in off-mall retailers like Target and Wal-Mart Stores and the consolidation among department stores, highlighted by the coming merger of Federated Department Stores and May Department Stores, which will result in the closing of anchor stores in many malls. Guerrilla Capital's Siris notes that America "remains overstored," yet investors are more bullish than ever about mall and strip-center REITs. Siris fears that with anchor stores closing, "a lot of the second-class malls will get hurt badly."

The formerly dowdy storage REITs, led by Public Storage, have capitalized on Americans' penchant for accumulating more than they can fit into their homes. The storage industry has done particularly well in the South and West, where many homes lack basements.

Public Storage last week offered to acquire a smaller storage REIT, Shurgard Storage (SHU), for $2.5 billion, or about $53 a share -- 14% above Shurgard's share price prior to the offer. Shurgard dismissed the offer as inadequate, even though it amounted to 26 times that company's projected 2005 FFO of $2.05 a share. Shurgard was trading late last week at 52.

It's tough to say when real-estate investment trusts -- or any overheated industry group -- may cool down. Yet the feeding frenzy surrounding the group, along with the low yields and high valuations, has left many disciplined buyers on the sidelines. And it's turned some big institutions into sellers.

The California Public Employees Retirement System, which has one of the largest real-estate portfolios among public pension funds, has sold $7 billion of its $21 billion core portfolio since December. Calpers sold most of its office properties. "The prices that people were willing to pay were higher than what we felt the properties were worth," observes Michael McCook, Calpers' senior investment officer for real estate. He says the fund had bought the properties at cap rates, or yields, in the 7% to 9% range and sold them in the 4% to 6% area.

Bulls talk of a new era of permanently elevated property prices. Tech-stock boosters said much the same in 1999 and 2000, before that group collapsed. Given their huge run-up, REIT shares could be at least 10% lower within 12 months. So now might be a good time for investors to move away from them. In real-estate investing, location, location, location isn't always the most important thing. Often, timing is.

 

Pricey Properties

Table: High-Yield Alternatives⁰

The stocks of real-estate investment trusts have soared in the past year. REITs now trade at hefty multiples of their funds from operations -- a key measure of cash flow, calculated by adding depreciation to earnings -- while dividend yields have slid. Buyers have been paying record prices for all types of real estate, including the Trump Place and Aston (right) apartment buildings in Manhattan.

			Recent	52-Wk	FFO*	FFO*	AFFO**	AFFO**	Div	Market
REIT	Ticker	Type	Price	Gain	2005	Multiple	2005	Multiple	Yield	Value (bil)
Archstone-Smith	ASN	Apartment	$42.70	42.3%	$1.94	22.0	$1.42	30.1	4.1%	$8.5
Equity Residential	EQR	Apartment	40.40	35.5	2.44	16.6	1.86	21.7	4.3	11.6
Prologis	PLD	Warehouse	45.66	30.9	2.66	17.2	1.57	29.1	3.2	8.5
General Growth	GGP	Mall	46.88	49.9	3.18	14.7	2.43	19.3	3.1	11.2
Simon Property	SPG	Mall	80.53	49.4	4.82	16.7	3.54	22.7	3.5	17.7
Boston Properties	BXP	Office	76.16	42.9	4.27	17.8	3.07	24.8	3.6	8.4
Equity Office Prop	EOP	Office	35.04	32.3	2.52	13.9	1.71	20.5	5.7	14.3
Vornado Realty***	VNO	Office	87.40	47.4	4.82	18.1	3.45	25.3	3.5	11.3
Public Storage	PSA	Storage	65.28	36.3	3.37	19.4	3.12	20.9	2.8	8.4
Kimco Realty	KIM	Strip Mall	66.36	37.7	3.83	17.3	3.06	21.7	4.0	7.5

*FFO=funds from operations per share. **AFFO=adjusted funds from operations per share.
All figures related to FFO or AFFO are 2005 estimates.

***Vornado FFO estimate excludes one-time gains.

Sources: Thomson Financial; Green Street Advisors; Morgan Stanley

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High-Yield Alternatives

While REITs have become favorites of investors seeking income, many stocks offer relatively generous dividends, too.

		Recent	2005	Dividend
Stock	Ticker	Price	P/E*	Yield
SBC Comm.	SBC	$24.97	16.1	5.2%
Merck	MRK	30.82	12.4	4.9
Con Edison	ED	48.66	16.8	4.7
Verizon Comm	VZ	34.22	13.5	4.7
Bank of America	BAC	43.78	10.2	4.6
Wash. Mutual	WM	42.76	11.4	4.5
Bristol-Myers	BMY	25.10	17.6	4.5
Altria	MO	67.50	13.2	4.3
Southern Co.	SO	35.11	16.7	4.2
BellSouth	BLS	27.62	16.0	4.2
Citigroup	C	44.05	10.9	4.0
Sara Lee	SLE	20.35	14.1	3.9
J.P. Morgan	JPM	35.61	12.2	3.8
Albertsons	ABS	20.92	15.3	3.6
Wachovia	WB	51.16	12.0	3.6

*Estimated

Source: Thomson Financial/Baseline

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London police wrongfully shot Brazilian man

Pressure on London police grows over dead BrazilianWed Aug 17, 2005 8:46 AM ET
By Michael Holden
LONDON (Reuters) - London's police chief faced acute embarrassment on Wednesday after a leaked report revealed how a series of blunders led to a Brazilian man being shot dead by officers who wrongly thought he was a suicide bomber.
Jean Charles de Menezes was shot eight times by police on an underground train on July 22, the day after four would-be bombers failed in attacks on London's transport system.
A campaign group supporting de Menezes' family said the killing now resembled an illegal execution and called for the police's shoot-to-kill policy to be suspended.
"The police's version has not only been shown to be incorrect but the public were deliberately misled. It's evident we have been told lies and half-truths about how Jean died," Asad Rehman, a spokesman for the group, told Reuters.
Alex Alvez Pereira, de Menezes' cousin, said the officers involved should face murder charges.
"We won't rest until we have justice even if it takes years," he told the London Evening Standard newspaper.
Initial police reports said the Brazilian electrician was dressed suspiciously in a heavy coat, had fled armed officers, vaulted over ticket barriers and run onto a train.
But leaked documents obtained by ITV News said CCTV footage and eyewitness accounts showed he was not wearing a padded jacket which could have concealed a bomb, and walked calmly through the station, even stopping to collect a free newspaper.
According to witnesses and statements made by police officers involved, de Menezes then boarded a train and was restrained by a surveillance officer before he was shot.
The leaked report said the intelligence operation may have been botched because an officer carrying out surveillance had gone to the toilet when de Menezes left his home apartment block, which police suspected housed one of the suspect bombers.
London's Metropolitan police commissioner Ian Blair at first said the shooting was linked to the failed attacks on July 21, which came exactly two weeks after four suicide bombers killed 52 people on three underground trains and a bus.
He said de Menezes had been challenged but had refused to obey police instructions. He later apologized for the death.
"There must be serious questions raised about Ian Blair's position," campaigner Rehman said.
"CATASTROPHIC" REVELATIONS
Former London police commander John O'Connor said the reports were "catastrophic" and would put Blair under pressure.
"Whoever has leaked this report has caused him a great deal of embarrassment," he told BBC Television.
Police and the Home Office (interior ministry) have declined to comment on the ITV report until the Independent Police Complaints Commission (IPCC) completes a full investigation.
"The IPCC made it clear that we would not speculate or release partial information about the investigation, and that others should not do so. That remains the case," the IPCC said.
But campaigners said there should now be a full public inquiry to clear up whether CCTV footage had captured the dead man's final moments on film, or why cameras were not working as media reports have suggested.
"The de Menezes family ask for only one outcome and that that be swift; that is that the entire truth surrounding Jean Charles' death be made public now as a matter of urgency," the family's lawyers said in a statement.
"It is neither sane nor responsible to have issues of such enormous public importance ... to be allowed to drift toward ... an unspecified and perhaps inappropriate hearing."

First blog

This is the first posting to the blog, on Sunday August 14, 2005.
What could happen?
Only the ravioli knows.