Boston College Financial, Summer 2013

Financial www.bc.edu/carroll

the center for asset management presents

written, edited, and managed by graduate students

carroll school of management

Vol. 8 | Summer 2013

Thinking Broadly on ROI: Social, Environmental, and Global Perspectives

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Social Impact Investing— A Maturing Asset Class

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Latin America Hedge Funds Industry— A Nascent Alternative

15

The United States Shale Gas Revolution

Financial

Thinking Broadly on ROI: Social, Environmental, and Global Perspectives Boston College Financial—a magazine written and managed by our graduate students—seeks to bridge the gap between financial research and practice, provide a platform for students to publish their work, and connect with the industry.

Following last year’s issue focusing on the continued crisis in Europe, this year, in the magazine’s eighth issue, we take a broad view of the meaning of returns.

The 2013 edition seeks a more comprehensive view on ROI, delving into more traditional themes such as stock dividends and hedge funds but also into topics like social impact investing and the economic and environmental impacts of natural gas extraction. Our graduate student contributors also make a few predictions, including a “soft landing” for China’s economy and a continued real estate recovery despite regulatory headwinds. In addition, they explore some timely issues, such as the growing use of technology by financial firms.

Our aim is to inspire and inform both the larger graduate school population and industry professionals. Like previous issues of Boston College Financial, this edition demonstrates a spirit of passion for finance that we hope will excite its readership. This magazine not only has an important impact on our students’ careers but also enhances the reputation of the Carroll School’s graduate programs and allows students to display their academic development to the Boston College community.

Summer 2013 Volume 8

Managing Editor Donald Hall

Senior Editor Cameron Kittle

Contributors Brendan Castricano Justin Christian Debashis Das Helios De Lamo Shyam Eati Sumayya Essack Christine Grascia Tracy To Mike Vitanza Terry Y. Zhou

Designer Progressive Print Solutions

Photography iStockphoto Please send editorial correspondence to asset.management@bc.edu or to individual reporters.

This publication expresses the personal opinions and thoughts of the Boston College Financial staff. The opinions expressed do not constitute the official position of Boston College or the Carroll School of Management.

Copyright ©2013 Boston College Financial.

Printed in the U.S.A. All publication rights reserved.

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Hassan Tehranian, PhD

Alan Marcus, PhD

Griffith Family Millennium Chair Professor & Chairperson, Finance Department

Mario J. Gabelli Endowed Professorship Professor, Finance Department

Boston College Financial is distributed free of charge, and is accessible online at www.bc.edu/gfa

Boston College Financial

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Contents 2

social impact investing—a maturing asset class by sumayya essack

5

a bungee jump—where stock dividends still prevail by terry y. zhou

8

the extraordinary rise of apple inc. and its impact on the stock market by justin christian

11 latin america hedge funds industry—

a nascent alternative by helios de lamo

14 the luxury rental market is thriving despite

uncertain recovery by mike vitanza

15 the united states shale gas revolution

by debashis das and tracy to

19 the financial service industry’s use of technology

by shyam eati

22 the impact of the debt ceiling is unclear

by christine grascia

23 government intervention’s impact on real estate

by brendan castricano

28 china—no hard landing (rise of the dragon)

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by debashis das

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social impact investing— a maturing asset class

By Sumayya Essack

T

he investment world is abuzz these days with rising interest in social impact investing. A growing social consciousness and emphasis on corporate social responsibility have helped impact investing gain momentum.

Several sessions at the 2013 Harvard Business School Social Enterprise Conference centered on impact investing, and the 2013 Net Impact Career Summit in Boston also included a session on the topic.

The Global Impact Investing Network defines impact investing as “investments made into companies, organizations, and funds with the intention to generate measurable social

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and environmental impact alongside a financial return.” In other words, it’s a new investment strategy that aims for a social return in addition to the traditional financial return.

Broader definitions of impact investing might include within them the concepts of crowd-sourced funds, foundation grants, venture philanthropy, and both for-profit and nonprofit funding.1 Impact investing isn’t without its challenges, but it is an exciting development that holds much promise and addresses a clear need for innovative funding in the social sector.

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figure 1 impact investing in the context of desired outcomes142 Chart 1: Impact Investing in the Context of Desired Outcomes High Financial First Investors

Financial Return

Pure profit-maximization quadrant

Prioritize financial returns over social impact

Intersection of maximum social impact and financial returns

Impact investing quadrant Impact First

Intersection of attractive social impact and financial returns

Low social impact & low financial return quadrant

Investors

Prioritize social impact over financial returns

Pure philanthropy quadrant

Low Low

the need for new solutions Governments are struggling to effectively address the mounting social and environmental challenges around the world, especially in the aftermath of the economic crisis. The demand for nonprofit services grew 20 percent in 2012, according to a sector survey from the Nonprofit Finance Fund,3 and many nonprofits have been unable to meet this demand, which points to the need for better funding strategies.

That’s not to say that there’s no money in the social sector. A 2008 Harvard Business School report on the social sector estimates there are $700 billion of foundation assets in the U.S.4 The challenge is allocating this funding effectively to address social needs. Entrepreneurs can find creative and innovative ways to address needs, but their ability depends on funding. For example, many grants require that funding go directly to services rather than to an organization’s infrastructure, thus hampering the organization’s ability to scale. This is where impact investing comes in to offer new ways of allocating capital. According to Roger Frank in the Stanford Social Innovation Review, impact investing has highlighted the fact

Social Impact

High

that addressing needs through commercial enterprises makes good sense.5 A 2013 survey report by the Global Impact Investing Network (GIIN) and J.P. Morgan expects investors to commit $9 billion of impact investments in 2013, a 12.5 percent increase over the $8 billion committed in 2012.6 A 2011 report by the same organizations predicted about nearly $1 trillion in the next decade, and last year Credit Suisse affirmed the $1 trillion opportunity.7 This staggering number does use a broad definition, as much of impact investing includes investments in more traditional businesses in the developing world, such as real estate and shopping malls.8 The broad definition draws attention to the growing role of impact investing. However, it obscures the fact that most investments still go toward quick, lucrative projects rather than those that directly serve the poor but are less lucrative and more challenging.9

social impact bonds One example of an impact investing tool that has garnered much attention lately is the social impact bond (SIB).

These bonds aim to achieve long-term impact by scaling up proven interventions.10 In this arrangement, govern-

ment agencies pay for measured social outcomes only when the organization contracted to provide the intervention achieves them. Rather than the traditional method of paying for programming up front (which may or may not have the intended results), the government pays at the conclusion of the contract in a “pay for success” manner.11 Since the government pays only at the conclusion, private investors fund the operating capital for the intervention or program. If results are achieved (determined by a third-party evaluator with agreed-upon measures), the government pays the entity, which then repays investors with a return.12 The risk shifts from the government to investors, and taxpayers are saved the burden of paying for an ineffective program. Some tout the SIB as reducing government inefficiencies, but others are more cautious, wanting to see a success record before drawing conclusions.

Social impact bonds were pioneered in the U.K. in 2010, and a few big names have brought SIBs to the U.S. A social impact bond in New York City in 2012 focused on reducing prison recidivism (defined as rearrest, reconviction, or return to prison with or without a new sentence within three years of a prisoner’s release).13 If successful, investors’ return will be up to 13 percent. Goldman Sachs is the investor, with $7.4 million of their $9.6 million investment backed by Bloomberg Philanthropies.14 In spite of the term, SIBs aren’t exactly bonds. A traditional bond has a guaranteed rate of return, whereas with social impact bonds, returns can vary.

SIBs are also riskier, since 100 percent of the investment can be lost if the outcome is not achieved. Some SIBs are working partial guarantees into the contracts, such as the 2012 social impact bond in New York City that is partly backed by Bloomberg Philanthropies.

Other contracts include sliding-scale agreements, which provide a higher return for outcomes that surpass a minimum threshold.

Social impact bonds are not consid-

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ered a catch-all financial solution for the social sector. Rather, they’re best suited for situations where interventions have evidence supporting their effectiveness and the outcome can be clearly defined and measured. Additional risks that all parties must contend with are the longer (often three to seven years) timeframe and the higher costs associated with layers of intervention providers and external evaluators.

challenges for the sector and social enterprises In spite of the great need for impact investing, the sector faces several challenges in becoming an established asset class. A clear one is the tension between the dual emphases on social return versus financial return. Emphasizing the financial return as the primary goal rather than solving social problems negates the point of developing these innovative financial tools. This is a large concern of professionals in the field.

On the other hand, it is difficult to attract investors without any kind of financial return, even for those who are primarily driven by impact. The language of impact investing invariably emphasizes helping people over financial gain, which makes traditional investors wary. Ideologically, investing is about obtaining the highest return possible, and the reality is that investments in organizations seeking to make a social difference will often not offer as high a return.

Many social entrepreneurs, especially those working in developing countries, face significant hurdles that prevent them from attracting adequate capital until much later, when they have established proof of concept—a problem known as the pioneer gap. The gap exists because of the misalignment between investors’ expectations of returns and the realities of building businesses that serve the poor.15 Many social enterprises may win business plan prize money or grants, but this funding only gets them through the seed stage. The more significant funding needed to grow can be difficult to find, as many investors

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hesitate to contribute at this early stage when the enterprise is still unproven.

Organizations serving the developing world face challenges such as weak infrastructure, the difficulty of attracting talent, and poor supply chains. Such obstacles translate into higher costs and risks. The result, according to the Stanford Social Innovation Review, is that investors avoid these companies or don’t invest until a much later stage.16 In fact, Monitor Inclusive Markets, a division of The Monitor Group (now Monitor Deloitte), found that of 84 funds investing in Africa, only 6 offered early-stage capital.17 Decisions to invest only at later stages might make sense financially, but they do little to promote the goal of social impact.18 This leaves the onus on the entrepreneur to figure out how to use the typical grant funding to make the organization more attractive to investors.19 Enterprise philanthropy, which is grant-making that also includes handson support, could pick up the slack, but this is resource-intensive and is not yet large enough to address demand.20

maturing sector Perhaps one way to draw capital in from the sidelines is to provide standardized analytics and ratings. This is exactly what the GIIRS Ratings & Analytics system, launched in 2011 at the Clinton Global Initiative, is designed to provide. (GIIRS, pronounced “gears,” stands for Global Impact Investing Rating System.)

According to Beth Richardson, leader of the GIIRS initiative at B Lab, GIIRS is a “comprehensive and transparent system for assessing the social and environmental impact of developed and emerging market companies and funds with a ratings and analytics approach analogous to Morningstar investment rankings and Capital IQ financial analytics.”21 Data is self-reported by companies and verified by Deloitte & Touche.

So far, there are over 300 rated companies and 66 funds that have committed to being rated.22 The system, meant to accelerate the

growth of impact investing, provides investors with a reliable way to compare opportunities and the performance of both funds and companies, which may alleviate hesitation surrounding a new investment type. The development of GIIRS demonstrates that impact investments are an evolving, maturing asset class.

The results of the 2013 J.P. Morgan and GIIN survey mentioned earlier show another indication that the sector is growing more sophisticated. The vast majority of survey respondents reported that “their impact investment portfolio performance is meeting or exceeding social, environmental, and financial expectations”—the type of performance needed to attract more capital.23, 24

impact investing’s future The potential for impact investing is incredibly large, and the need for new ways to address old problems is undeniable. However, we need to be clear about the nascent sector’s challenges as it matures in order to keep expectations in sync with reality.25 Part of impact investing’s challenge going forward is to align itself with traditional investment enough to attract capital while still defining realistic expectations. There is a risk that the capital the sector attracts will view social impact as secondary.

With that said, investors must understand that this is a different type of investment.

The concept of impact investing is well received overall and has generated much excitement, but its unfamiliar territory can keep traditional, risk-averse investors from reaching into their pockets.26 In spite of this, the growing societal demand for corporate and governmental transparency and responsibility bodes well for impact investing.27 The challenges the sector faces do not mean it’s doomed: it means that there is a learning curve, as with any new development, and we are still figuring out what works.

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a bungee jump—where stock dividends still prevail

By Terry Y. Zhou

a country where stock dividends prevail

T

he question was first raised at 2 A.M. on a summer night last year, when a couple of equity analysts finalizing their reports on Chinese stocks began to complain: “Past year’s EPS have to be adjusted again? Fortunately, I caught it, but why are these companies splitting their stocks every year?” “Easy, buddy, so is mine. It’s a stock dividend, actually.”

The effect of stock splits or stock dividends on stock prices and shareholders’ wealth has been discussed in finance for at least the past half century. The debate over whether or not a stock exhibits an excess return on either the announcement or ex-dividend day never ends, but the answer is obvious: maybe or maybe not. In recent years, we have seen a trend toward more stock splits than stock dividends. At the same time, the question of whether either a stock split or a stock dividend has a significant effect on the stock price has never stopped being asked. When Google’s stock price surged to more than $500 five years ago, Larry Page refused to split the stock. “If you own ten shares at $40 or one share at $400, it’s the same thing! You just need to know how to divide,” Page said.1 Bloomberg shows approximately 1,000 stock split and stock dividend records for stocks listed on the New York Stock Ex-

change and NASDAQ in 2012, 80 percent of which are stock splits, including both splits and reverse splits. Three to 4 percent of the roughly 6,000 total stocks listed on the NYSE had stock dividends last year. On the other side of the Pacific, China had 591 lines of record from Bloomberg. However, all of the records are stock dividends, and about 1 of every 10 stocks listed on the Chinese market declared a stock dividend in 2012.

Therefore, one of the largest stock markets in the world shows us a very different scene: while the rest of the world begins to use stock dividends less frequently and to question the effect of this financial policy, in China stock dividends still prevail.

why would you want a stock dividend?

Theoretically, stock splits and stock dividends are very similar, except for their accounting treatment. However, stock dividends have major disadvantages. First, since stock dividends are treated as dividend income, income tax is levied.

In addition, stock splits give companies more flexibility. A stock split allows companies to easily split one share into any number of shares they want, as it is just simple math. But for stock dividends, a journal entry is required to transfer some of the company’s retained earnings to the paid-in capital account. Due to the limit on the earnings each year, we usually

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see companies split one stock into only one and a half or two shares through stock dividends.

Then why are so many Chinese companies declaring stock dividends at the cost of additional taxes? The first reason is the absence of legal guidance.

The only thing mentioned in both China Corporate Law and Security Law is that the stocks may be issued at a price equal to or above the par value, but not below the par value.2 Nobody ever talked about how the par value is set and whether it could be split. Over time, the entire market has formed a common sense that par value should be 1 RMB so that all stocks would be priced at a comparable cost. The only exception happened in 2008 when Zijin Mining (SH.601899) issued their common stock at 0.1 RMB per share, and lots of arguments followed criticizing the company for setting a different price, trying to mislead the investors.

As a result, few companies want to touch this grey area and send out a negative signal that they are setting their initial price low because their company is cheap or less promising. The invisible constraint on stock splits forces the companies to resort to costly means to realize their intentions.

Second, an alternative way to realize similar results like stock splits is to transfer the reserve into a capital account. However, reserve accounts are usually even more limited than earnings. Besides, dividend policy generally

signals to investors that a company has strong earnings. And by using stock dividend, companies actually saved cash by not paying cash to the investors.

Finally, although the total wealth doesn’t change by simply splitting one share into two, with price divided by two at the same time, people do believe they create value through increased liquidity or confirmed signal to the market.3 And liquidity is certainly one of the concerns here as Chinese mainland stocks are sold in 100 shares.

excess returns and anomalies In the free market, constraints lead to inefficiencies and market anomalies. By simply examining daily returns before and after the ex-dividend days for stock dividends, we see an interesting situation in each of the past 10 years. Exhibit 1 shows the average stock returns from five days before to five days after the exdividend day for stock dividends. Based on the same sample companies, Exhibit 2 shows a wider window of 90 days before to 90 days after the ex-dividend day. Generally, in most of the days, the return appears to be normal, either before or after the dividend. However, several days before the dividend day, we see that the daily return goes up, suddenly plummets at the ex-dividend day, and then gradually returns to normal. It’s like a bungee jump: you climb up the stairs and jump off.

From Exhibit 1 we can clearly see a couple of positive abnormal returns before and negative abnormal returns after the date. If the abnormal negative return on Day Zero can be explained by taxes, how about the days after that?

Over the longer period as shown in Exhibit 2, stocks have weaker performance after the stock dividend, with fewer position bars on the right compared to the left, whether in bull years like 2006 and 2007 or bear years like 2008.

A possible explanation may be investors’ attempts to identify cash dividends, as stock dividends are sometimes paid along with cash dividends. As soon as the cash is received, they sell the stock.

Also, according to traditional theory, people have an expectation of price momentum for stocks that declare stock dividends. But this theory would better explain the abnormal return close to the announcement date as opposed to the ex-dividend date. And it would not explain the reason for the weak performance following stock dividends.

conclusion In a market where the shorting of stock is still not efficient,4 it would be hard to explore such a negative abnormal return. But at least, facing the bungee, our conservative investors could now consider selling the stock two or three days before the ex-dividend date to prevent unnecessary low returns from the days soon after it.

exhibit 1

Exhibit 1

Data Source: Bloomberg. Returns are calculated on a daily basis using stock prices adjusted for stock dividends. Total sample includes 2,457 valid records from 2003 to 2012, with varying number each year depending on the actual stock dividends that happened in that year.

Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

SD Error 0.001418 0.001415 0.001413 0.001409 0.001407 0.001406 0.001405 0.001405 0.001400 0.001402

95% confidence interval Low High -­‐0.29% 0.27% -­‐0.30% 0.26% -­‐0.30% 0.26% 0.04% 0.59% 0.27% 0.82% -­‐0.58% -­‐0.03% 0.11% 0.66% -­‐0.15% 0.40% -­‐0.33% 0.22% -­‐0.27% 0.28%

D-­‐5 0.07% -­‐0.04% 0.18% 0.98% 2.14% 0.70% 1.35% 0.40% 0.45% 0.61%

D-­‐4 1.06% 0.28% 0.89% 3.19% 3.87% 1.39% 1.72% 0.69% 0.63% 0.62%

D-­‐3 0.06% 0.20% -­‐0.24% 1.22% 1.37% 0.01% 0.36% -­‐0.27% 0.11% 0.08%

D-­‐2 0.03% -­‐0.30% 0.12% 1.32% 0.79% 0.42% 0.69% 0.39% 0.22% 0.44%

D-­‐5 ~ D+5 Daily Return D-­‐1 D0 D+1 -­‐0.24% -­‐1.16% -­‐0.94% -­‐0.61% -­‐1.33% -­‐1.26% -­‐0.45% -­‐2.54% -­‐1.22% 0.30% -­‐1.48% -­‐0.06% 0.20% -­‐0.20% -­‐0.70% -­‐0.43% -­‐2.43% -­‐2.06% -­‐0.31% -­‐1.03% -­‐0.48% -­‐0.25% -­‐0.85% -­‐0.99% -­‐0.42% -­‐1.75% -­‐1.04% -­‐0.38% -­‐2.12% -­‐0.49%

D+2 -­‐0.34% -­‐0.78% -­‐0.39% 0.89% -­‐0.36% -­‐0.74% 0.37% -­‐0.23% -­‐0.39% -­‐0.06%

D+3 0.00% -­‐0.34% -­‐0.35% -­‐0.34% -­‐0.18% -­‐0.46% 0.12% 0.02% -­‐0.19% -­‐0.30%

D+4 -­‐0.42% 0.10% -­‐0.16% 0.23% -­‐0.34% 0.13% 0.54% 0.16% -­‐0.12% 0.14%

D+5 -­‐0.09% -­‐0.33% -­‐0.35% 1.09% -­‐0.21% -­‐0.56% 0.36% 0.11% -­‐0.10% -­‐0.15%

Excess Positive Return Excess Negative Return

Data Source: Bloomberg. Returns are calculated on a daily basis using stock prices adjusted for stock dividends.

Total sample includes 2,457 valid records from 2003 to 2012, with varying number each year depending on the actual stock dividends that happened in that year.

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exhibit 2 Data Source: Bloomberg. Returns are calculated on a daily basis using stock prices adjusted for stock dividends. Total sample is identical to Exhibit 1 but showing 90 days before (D-90) to 90 days after (D+90) the ex-dividend day (D0).

Exhibit 2:

2003

2004

1.50%

1.50%

1.00%

1.00%

0.50%

0.50%

0.00%

0.00%

-0.50%

-0.50%

-1.00%

-1.00%

-1.50% D-90

D-60

D-30

D0

D+30

D+60

D+90

-1.50% D-90

D-60

D-30

D0

D+30

D+60

D+90

D+30

D+60

D+90

D+30

D+60

D+90

D+30

D+60

D+90

D+30

D+60

D+90

2006

2005 2.00%

1.50%

1.50%

1.00%

1.00% 0.50%

0.50% 0.00%

0.00%

-0.50%

-0.50%

-1.00%

-1.00% -1.50% D-90

-1.50% D-60

D-30

D0

D+30

D+60

D+90

-2.00% D-90

D-60

D-30

2007

D0 2008

2.00%

1.50%

1.50%

1.00%

1.00% 0.50%

0.50% 0.00%

0.00%

-0.50%

-0.50%

-1.00%

-1.00%

-1.50%

-2.00% D-90

D-60

D-30

D0

D+30

D+60

D+90

-1.50% D-90

D-60

D-30

D0 2010

2009 1.00%

1.50% 1.00%

0.50% 0.50% 0.00%

0.00% -0.50%

-0.50%

-1.00% -1.50% D-90

D-60

D-30

D0

D+30

D+60

D+90

-1.00% D-90

D-60

D-30

2011 1.00%

1.00%

0.50%

0.50%

0.00%

0.00%

-0.50%

-0.50%

-1.00% D-90

D-60

D-30

D0

D0 2012

D+30

D+60

D+90

-1.00% D-90

D-60

D-30

D0

Data Source: Bloomberg. Returns are calculated on a daily basis using stock prices adjusted for stock dividends.

Total sample is identical to Exhibit 1 but showing ninety days before (D-­‐90) to ninety days after (D+90) the ex-­‐ dividend day (D0).

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the extraordinary rise of apple inc. and its impact on the stock market

By Justin Christian

O

n January 9, 2007, Apple Computer Inc. shortened its name to Apple Inc.1 Not only did Apple drop “Computer” from its name but it also marked the beginning of a new era in consumer electronics. This date also marked the time when Apple announced its plans to unveil a smartphone device that would soon revolutionize the cell phone industry. Less than three years later, Apple would release a tablet device that would help catapult the company into rare corporate profitability. Steve Jobs really meant it when he said that he was going to change the world. He was also, inadvertently, referring to the stock market.

Until 2007, Apple’s market value had been growing at an impressive rate. In March 2003, Apple’s portable digital music player, the iPod, had been on the market for a couple of years when the iTunes Music Store was launched. At the time, Apple’s shares were being priced at $7.07. iTunes soon became wildly popular in conjunction with subsequent releases of new iPod versions. Each iPod model had been updated to be a sleeker and more robust version than the previous generation. Shoppers flocked to Apple stores in droves to purchase these music players. The success of the iPod helped serve as a

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catalyst for Apple’s quarterly earnings reports and pushed the stock price to a 1,200 percent gain between 2003 and 2007.

Jobs and Apple were creating a universe of products, known as an ecosystem, like the iPod and iTunes, to entice consumers to continue to purchase its products. Consumers were just starting to tap into Apple’s progressing ecosystem before the groundbreaking iPhone entered the picture.

At the time of Apple’s symbolic name change, its stock price stood at $91.762 (adjusted for dividends and splits) and equated to a free-floating market value of $79.5 billion.3 The continued momentum of Apple’s iPod and iTunes presence increased Apple’s stock price to $120.97 (see Chart 1) when the first iPhone was unveiled on June 29, 2007. This was an increase of 31.83 percent from the beginning of the year, and its free-float market cap eclipsed the $100 billion mark to $105.558 billion. Apple experienced steady growth in its stock price with ensuing iPhone releases. At the time of the iPhone 3G product release, Apple’s stock had risen to $171.06, an increase of 41.41 percent from the first iPhone launch. Although the stock price on each product launch date profited from the previous product launch’s success and revenue growth, there

rolling 1

were also momentum and excitement factors built into the share price from the market. Speculators started to understand Apple’s real opportunity to gain market share and be a threat to competitors in the consumer electronics space. Each of the iPhone product launches experienced rapid growth, exceeding 30 percent from one product launch to the next except for one instance when Apple’s stock price actually decreased from July 11, 2008, to June 19, 2009 (see Table 1), when the iPhone 3GS was released. This wasn’t a result of a poor product launch of the iPhone 3GS, but it was the impact of the financial crisis on the entire equity market.

Over 25 percent of the S&P 500’s value fell during this date range while Apple’s value fell only 19.18 percent. To demonstrate Apple’s strong performance during an utterly dire time in our economy, during the date range between the first iPhone launch and the iPhone 3G, Apple’s stock price increased 41.41 percent while the S&P 500 index fell by 17.55 percent. This is quite a remarkable performance during one of the U.S. stock market’s darkest periods.

Apple’s stock price performance has grown impressively during the iPhone era but has really grown exponentially since the introduction of the iPad. Apple’s stock price appreciated at an average rate of 18.02 percent between each of the first three iPhone launches (see Chart 2 and Table 1). The first three iPhones were launched over a period of a little less than two years (721 days, or an average of 240 days between each product launch). When the iPad was introduced, Apple’s stock price grew at an average rate of 25.11 percent. This is the percentage rate Apple grew between product launches from both the iPad and the iPhone, which included seven product launches over the span of a little more than two and a half years (944 days, or an average of 135 days between each product launch from April 3, 2010, to November 2, 2012). This extraordinary growth rate of Apple’s stock not only grew more during the iPad era but actually accelerated over shorter

out new products consumers didn’t know they needed, it will continue to change the world. If Apple “Apple Drops ‘Computer’ From Corporate Moniker,” last modified January 9, 2007. Financial Boston College continues to change the world, it will continue to change the stock market as well. http://www.informationweek.com/apple-­‐drops-­‐computer-­‐from-­‐corporate-­‐moni/196802415.

2 Yahoo! Finance: http://finance.yahoo.com/q/hp?s=AAPL+Historical+Prices 3 Bloomberg Market Data 4 “ Apple S hares S lide A fter E arnings; $13 billion Doesn’t Buy a Lot on the Street,” last modified January 23, 2013. http://blogs.wsj.com/marketbeat/2013/01/23/apple-­‐shares-­‐slide-­‐after-­‐earnings-­‐13-­‐billion-­‐doesnt-­‐buy-­‐a-­‐lot-­‐on-­‐ 1 “Apple Drops ‘Computer’ From Corporate Moniker,” last modified January 9, 2007. the-­‐street/ http://www.informationweek.com/apple-­‐drops-­‐computer-­‐from-­‐corporate-­‐moni/196802415.

5 2 Tim Koller, Richard Dobbs, and Bill Huyett, Value: The Four Cornerstones of Finance, McKinsey & Company Yahoo! Finance: http://finance.yahoo.com/q/hp?s=AAPL+Historical+Prices (Hoboken: John Wiley & Sons Inc., 2011), p. 42.

3 table 1Market Data loomberg 6 B 4 Ibid, p. 15.

“Apple Shares Slide After Earnings; $13 billion Doesn’t Buy a Lot on the Street,” last modified January 23, 2013. apple’s price changes versus the s&p 500 http://blogs.wsj.com/marketbeat/2013/01/23/apple-­‐shares-­‐slide-­‐after-­‐earnings-­‐13-­‐billion-­‐doesnt-­‐buy-­‐a-­‐lot-­‐on-­‐ Table 1: Apple’s Price Changes versus the S&P 500 the-­‐street/ 5 Tim Koller, Richard Dobbs, and Bill Huyett, Value: The Four Cornerstones of Finance, McKinsey & Company (Hoboken: John Wiley & Sons Inc., 2011), p. 42.

AAPL AAPL % S&P 500 S&P 500 % Event Date Event 6 Close Change Close Change Ibid, p. 15.

1/9/2007 6/29/2007 7/11/2008 6/19/2009 Event Date 4/3/2010 6/24/2010 1/9/2007 3/11/2011 6/29/2007 10/14/2011 7/11/2008 3/16/2012 6/19/2009 9/21/2012 4/3/2010 11/2/2012 6/24/2010 3/11/2011 10/14/2011 3/16/2012 9/21/2012 Event11/2/2012 Date

table 2

Company Name Change $91.76 n/a $1,412.11 Table 1: Apple’s Price Changes versus the S&P 500 iPhone $120.97 31.83% $1,503.35 iPhone 3G $171.06 41.41% $1,239.49 iPhone 3GS $138.25 -19.18% $921.23 AAPL AAPL % S&P 500 Event Close Change Close iPad 1st Generation $236.39 70.99% $1,187.44 iPhone 4 $266.63 12.79% $1,073.69 Company Name Change $91.76 n/a $1,412.11 iPad 2 $348.89 30.85% $1,304.28 iPhone $120.97 31.83% $1,503.35 iPhone 4S $418.29 19.89% $1,224.58 iPhone 3G $171.06 41.41% $1,239.49 iPad 3rd Generation $580.42 38.76% $1,404.17 iPhone 3GS $138.25 -19.18% $921.23 iPhone 5 $696.91 20.07% $1,460.15 iPad 1st Generation $236.39 70.99% $1,187.44 iPad 4th Generation and Mini $574.18 -17.61% $1,414.20 iPhone 4 $266.63 12.79% $1,073.69 iPad 2 $348.89 30.85% $1,304.28 iPhone 4S $418.29 $1,224.58 Table 2: Apple’s Market Value Weight on the S&P19.89% 500 and Nasdaq Indices iPad 3rd Generation $580.42 38.76% $1,404.17 iPhone 5 $696.91 20.07% $1,460.15 S&P Index S&P Index FreeNASDAQ Index iPad 4th Generation and Mini $574.18 -17.61% $1,414.20 Event Free-float float Weight % Free-float Weight

Change

Weight

n/a 6.46% -17.55% -25.68% S&P 500 % Change 28.90% -9.58% n/a 21.48% 6.46% -6.11% -17.55% 14.67% -25.68% 3.99% 28.90% -3.15% -9.58% 21.48% -6.11% 14.67% 3.99% NASDAQ Index -3.15% Weight Free-float % Change

apple’s market value weight on the s&p 500 and nasdaq indices 1/9/2007 6/29/2007 7/11/2008 6/19/2009 Event Date 4/3/2010 6/24/2010 1/9/2007 3/11/2011 6/29/2007 10/14/2011 7/11/2008 3/16/2012 6/19/2009 9/21/2012 4/3/2010 11/2/2012 6/24/2010 3/11/2011 10/14/2011 3/16/2012 9/21/2012 11/2/2012

Company Name Change 0.64% 2.09% Table 2: Apple’s Market Value Weight on the S&P 500 and Nasdaq Indices iPhone 0.81% 0.16% 2.64% iPhone 3G 1.43% 0.62% 4.70% S&P Index S&P Index FreeNASDAQ Index iPhone 3GS 1.56% 4.67% Event Free-float float0.13% Weight % Free-float iPad 1st Generation 2.26% 0.71% 6.50% Weight Change Weight iPhone 4 2.57% 0.31% 7.37% Company Name Change 0.64% 2.09% iPad 2 2.79% 0.22% 7.99% iPhone 0.81% 0.16% 2.64% iPhone 4S 3.58% 0.79% 10.00% iPhone 3G 1.43% 0.62% 4.70% iPad 3rd Generation 4.38% 0.80% 12.18% iPhone 3GS 1.56% 0.13% 4.67% iPhone 5 5.07% 0.69% 13.81% iPad 1st Generation 2.26% 0.71% 6.50% iPad 4th Generation and Mini 4.33% -0.74% 12.18% iPhone 4 2.57% 0.31% 7.37% iPad 2 2.79% 0.22% 7.99% iPhone 4S 3.58% 0.79% 10.00% iPad 3rd Generation 4.38% 0.80% 12.18% iPhone 5 5.07% 0.69% 13.81% iPad 4th Generation and Mini 4.33% -0.74% 12.18%

0.55% 2.06% NASDAQ Index -0.03% Free-float Weight % 1.83% Change 0.88% 0.61% 0.55% 2.02% 2.06% 2.18% -0.03% 1.63% 1.83% -1.63% 0.88% 0.61% 2.02% 2.18% 1.63% -1.63%

product launch periods. The infusion of the revenue from the iPad since its debut was clearly the driving catalyst for Apple’s stock price.

At the beginning of 2007, the S&P 500 had a total free-float market value of $12.347 trillion, and the NASDAQ Composite’s was $3.807 trillion. Apple is considered one of the largest and leading companies publicly traded on a U.S. stock market exchange and is officially listed on the NASDAQ Composite Index. The commonly used and reported free-floating market capitalization (share price x [number of shares outstanding minus locked-in shares]) numbers will be referred to instead of regular market capitalization figures.

Apple’s market value weight on the S&P 500 and NASDAQ was 0.64 percent and 2.09 percent, respectively (see Table 2 and Chart 3). Apple’s market value has increased with every product

launch they have unveiled (until recently) in relation to the S&P 500 and NASDAQ Composite Indices. Of course, this shouldn’t be surprising given the rapid appreciation of the stock price over the same period of time. The increase of Apple’s presence in relation of the S&P 500 should be more scrutinized. With the release of the iPhone 5 on September 21, 2012, Apple’s market cap consisted of 5.07 percent of the S&P 500 total market capitalization and 13.81 percent of the NASDAQ Composite Index. Apple’s market capitalization on this date was $656.273 billion and the total S&P 500 and NASDAQ market capitalizations were $12.941 and $4.752 trillion, respectively. This means that, on this date, about 1 point out of every 20 point changes in the S&P 500 were attributed to the movement of Apple’s stock. For the NASDAQ, about 1 point out of a little less than 10 point changes

9

were reliant on Apple. These are truly astonishing numbers.

Lately, Apple’s stock price has sputtered and stumbled a bit. So what does the future hold for the technology giant? For the final quarter of 2012, Apple recorded one of the largest corporate quarterly earnings ever, with $13.1 billion in profits during the first quarter of its fiscal year in 2013.4 Investors weren’t impressed. These stout profits actually drew down the stock a few percentage points because they disappointed analysts on Wall Street. It appears that Apple could be headed to a reversion in its stock price performance. The stock could occasionally surprise and exceed expectations from quarter to quarter, but it will be difficult to maintain the rampant pace it has experienced over the past few years.

There are a couple of reasons for this. One of the cornerstones McKinsey & Company’s Value: The Four Cornerstones of Corporate Finance5 talks about is called “the expectations treadmill.”

This staple of finance explains how the value of a company is reflected in the return to investors. The analogy used compares the speed of a treadmill that is built into a company’s share price. If a company continues to beat expectations and the market believes that this is sustainable, the stock price will go up. Consequently, this accelerates the speed of the treadmill as performance improves, and, once the treadmill continues to speed up, the company has to run faster to keep up and maintain its new stock price. The expectations treadmill analogy describes the difficulty of continually outperforming the stock market. At one point or another, it becomes impossible for a company to meet or exceed expectations without stumbling, just as anyone will eventually falter once the treadmill becomes too fast for their ability.

This is the problem that Apple is encountering. Although Apple continues to deliver enormous profits each quarter, the market’s expectations are starting to become unrealistic for Apple to meet. History has shown that new prod-

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chart 1

Chart 1 Chart 1

apple inc. stock price andChart the1 iphone

chart 2

Chart 2 Chart 2

apple inc. stock price andChart the2 ipad

Chart 3 Chart 3

chart 3

Chart 3

aapl market cap

ucts like the iPhone and iPad facilitate high earnings for Apple. In order for Apple to sustain its remarkable stock performance, it will need to continue to innovate and convince consumers that they need personal electronics that they didn’t previously think they would need.

Apple’s value creation is driven by its return on invested capital and its ability to sustain both over an extended period of time.6 As Jay Pearlstein, a portfolio

manager for Atlantic Trust, noted, “[R] eturn on invested capital is our single most important factor when evaluating a company’s growth prospects.” If Apple is successful in rolling out new products consumers didn’t know they needed, it will continue to change the world. If Apple continues to change the world, it will continue to change the stock market as well.

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latin america hedge funds industry—a nascent alternative

By Helios De Lamo

T

he Latin American hedge fund industry has been growing substantially over the last decade, in terms of not only number of funds but also the total amount of assets under management. In addition, Latin American hedge funds have become much more sophisticated regarding their investment strategies. Figure 1 shows that the number of funds has grown nearly by four times since 2000, amounting to over 450 funds by 2010, and the assets under management have increased by more than 20 times during the same period, totaling $58 billion by 2010.

Even though funds based entirely in Latin America or managed from another region were also under pressure during the recent financial crisis, they were losing capital at the same pace as a global hedge fund. But by the end of 2009 when the industry started to recover, the Latin American hedge funds’ assets had already returned to the levels before the crisis. This is quite different from the global hedge funds, which at that

time were still 20 percent short of reaching the flow of assets they had by the end of 2007 (Figure 2). This is mainly due to numerous advantages the continent offers, like natural resources, a young populace, a kind climate (for industries such as renewable energy), tax laws for setting up offshore funds, and the fact that these funds can be utilized by nonLatin American managers to diversify their global portfolios.1 Admittedly, performance has also been a significant factor contributing to the trend we see today. As they did in 2011, Latin American hedge funds also leading the world in returns during 2012. According to the November Eurekahedge Report, which tracks global returns through October, Latin American funds were up 8.17 percent in 2012, well ahead of Asia ex Japan, with 6.40 percent, and emerging markets in general, with 6.14 percent. These are impressive numbers for a relatively nascent hedge fund industry that is still off the radar for many global investors.2

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A reputable example of a Latin American hedge fund is that offered by Gávea Investimentos, which is based in Brazil. This particular fund is considered to be highly stable, one of the best options for hedge fund investment. In fact, Highbridge Capital, a company owned by JPMorgan Chase, acquired a majority interest in the fund during the early part of 2010. Hedging-Griffo’s Verde Fund is also well established, but is dedicated to systematic growth. This has led to situations in which not everyone who wants to participate in the fund is able to do so, even those who are willing to commit to a longer term. Considered to be one of the top performing hedge funds in not only Latin America but also the entire world, it has a long waiting list not likely to be reduced by any measurable amount anytime soon.

Another highly successful fund is Tarpon HG Fund-A, an offshore fund that enjoyed an annualized return of 30 percent for the period between 2005 and 2010.3 Following this further, the growth of Brazil’s economy has been an important lever in contributing to the tremendous growth in the industry, as more than 65 percent of Latin American hedge funds are headquartered in that country.4

figure 1 industry growth over the years Source: Eurekahedge

Source: Eurekahedge

figure 2 asset flows to latin american hedge funds vs. global hedge funds Source: Eurekahedge

fund domiciliation The Latin American onshore hedge fund market is largely dominated by Brazil, which not only hosts a number of service providers but also employs one of the most comprehensive regulatory frameworks in the world. Moreover, there has not been a single case of fraud in the region, partly because regulations require independent (thirdparty) service providers and external risk assessment for domestic hedge funds.5 As shown in Figure 3, the confidence in the industry and the efforts of regulators have paid off, given that the numbers of onshore and offshore funds were basically the same in 2000. More recently, the difference has widened, as there are now about 250 onshore funds compared to about 200 offshore funds.

However, it is important to mention

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Figure 2: Asset flows to Latin American hedge funds vs. global hedge funds

Source: Eurekahedge

that when considering the amount of assets under management, it is clear that the benefits of offshore domiciliation are well understood by investors, given that only $20 billion sits onshore versus over $40 billion of assets under management registered offshore.

Today, the countries that more commonly use offshore vehicles are Argentina, Mexico, Brazil, and Venezuela.

More conservative countries, such as Chile, are not yet as keen to use these vehicles.6 These funds are generally established either in the British Virgin Islands or the Cayman Islands. Unsurprisingly—as it is the jurisdiction of choice for Brazilian managers—the Cayman Islands retain the majority of the Latin American funds that are set up offshore. The rest of the Latin Amer-

Figure 3: Onshore and offshore industry growth over the years

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ican countries, with the exception of Chile, have a preference for the British Virgin Islands.

Less common options for Latin American funds include Ireland, Bermuda, the Bahamas, and Luxembourg.

Even though there is a growing interest in jurisdictions such as Ireland or Luxembourg, they are still expensive and too heavily regulated for Latin American managers. In some cases, there might be some advantages in creating onshore vehicles. However, this is not the rule but rather the exception.7

figure 3 onshore and offshore industry growth over the years Source: Eurekahedge

regulation: recent developments in the region In Brazil, the Securities Commission recently passed new rules regarding the organization and management of funds through the creation of the Fundo de Investimento em Participacoes, which is equivalent to a private equity fund in the United States. This structure is a very flexible approach that allows investments in shares, warrants, convertible bonds, and debentures. At the same time, there has been interest in Mexico in creating a more attractive regulatory framework. In fact, its government has just appointed one of the largest and most prestigious law firms in Mexico to draft specific legislation.

Moreover, the Chilean government is following the same pattern, as it also appointed a leading law firm together with the Inter-American Development Bank to draft new legislation.

On the other hand, Argentina has been introducing important restrictions on foreign investors, especially in respect to the registration of foreign

Source: Eurekahedge

entities in order to conduct business in the country and to purchase shares in local companies.8

cused mostly on Brazilian equities. Brazil’s BM&F Bovespa is the largest stock market in the region and the third largest in the world.9 However, three of Latin America’s future of the industry smaller but most dynamic econoIn light of Mexico’s and the Andean

1 http://www.eurekahedge.com/database/latinamericanhedgefunddirectory.asp (accessed: 24 February, mies—Chile, Colombia, and Peru— region’s strong macro numbers and 2013) 2 want to combine forces to offer greatly improved equities markets, reVictor Hugo Rodriguez, “LatAm alternatives,” http://www.alternativelatininvestor.com/353/hedge- a viable funds/ali-speaks-with-victor-hugo-rodriguez-of-latam-alternatives.html February 2013) markets alternative (accessed and open up24,their gional equity funds are adjusting their 3 “Latin American Funds Take Off,” World Finance, November 14, 2011. to local and international investors. allocations to focus especially on inhttp://www.worldfinance.com/wealth-management/hedge-funds/latin-american-funds-take-off (accessed 10, 2013) These countries are moving ahead with ternalMarch 4 growth and domestic consumpMartin Litwak, “Litwak Partners on LatAm’s growing hedge fund sector”, World Finance, February 21, http://www.worldfinance.com/wealth-management/hedge-funds/litwak-partners-on-latamsa project to join a common regional tion. 2012.

Mexican equities are particularly growing-hedge-fund-sector (accessed February 24, 2013) stock exchange. Mercado Integrado strong, similar to the Brazilian market 5 http://www.eurekahedge.com/database/latinamericanhedgefunddirectory.asp (accessed February 24, Latinoamericano, (MILA)—Integrated of a decade ago. The Peruvian equi2013) Latin American Market—which they ties market has made great strides, hope can compete with Latin America’s though it continues to be dominated biggest capital markets for foreign inby commodities companies. In Brazil, vestors by offering a larger supply of the education sector offers the best opsecurities and issuers and also larger portunities in terms of earnings growth sources of funding.10 in an otherwise sluggish market. Latin American equity funds have long fo-

“… the growth of Brazil’s economy has been an important lever in contributing to the tremendous growth of the industry, as more than 65 percent of Latin American hedge funds are headquartered in that country.”

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the luxury rental market is thriving despite uncertain recovery

By Mike Vitanza

W

hile the credit crunch is still a problem for much of the middle class, it appears that even the most wealthy are opting to forego home-buying for the time being. In major metro areas like New York and Los Angeles, the highend luxury rental market is thriving, as an increased number of prospective buyers are waiting out the current economic state in the hopes of better conditions in the near future.

In New York City, apartments and townhomes listed at $15,000 per month and over represent 1.3 percent of the rental market—a figure that has nearly tripled from what it was just a year ago.1 Even in California, an area hit particularly hard with economic hardships over the past decade, Los Angeles luxury rentals are increasing by 5 to 10 percent each year. Particularly in NYC, where inventory of such properties is low and demand is high, unsolicited rental offers to properties being listed for sale have become commonplace. Players in the market are also capitalizing on this trend and purchasing luxury apartments and condos with the sole purpose of renting them out.

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While not a new idea, these purchases are happening in large quantities; for example, in Hollywood, California, the El Royale, a 56-unit property, recently sold for $29.5 million to a group of investors looking to take advantage of this thriving industry. At nearly $530,000 per unit, this is one of the highest prices ever paid for an older building in southern California.2 In addition, according to the 2012 Elliman Report, rentals in the NYC luxury market continue to outpace the overall market, with the number of new rentals continuing to increase on a quarterly basis.3 With liquidity cited as one of the main reasons for opting to hold off on purchasing property in the short term, these “trophy rentals” allow wealthy individuals to remain liquid while at the same time maintaining their high quality of life—all of this while realizing a minimal amount of risk. For these investors, lessening exposure in an uncertain marketplace is key; once the market returns to a more stable state, these same people are likely to return to owning property. For the time being, however, luxury rentals offer the best of both worlds.

In the macro-environment, housing prices continue to rise—up 5.5 percent from November 20114—giving even more incentive for individuals to wait out the market, especially given the state of the global economy. According to Bloomberg, prices for single-family homes rose in 88 percent of U.S. cities in the fourth quarter of last year, likely driven by low interest rates and decreased unemployment.5 While this is encouraging for the growth of the economy, the savvy investor is aware of the fragility of both the domestic and foreign markets at this point and will likely seek more definitive evidence that the worst is behind us.

Until some stabilization occurs, the possibility of another recession looms heavy, and for many, this means staying away from purchasing real estate for the time being. As conditions improve, the luxury rental market is likely to take a hit; until that day comes, however, it’s a safe bet that we will see increased activity in this sector and an even higher proportion of wealthy individuals entering the space in the near future.

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the united states shale gas revolution

By Debashis Das and Tracy To

T

he United States is sitting on large oil and natural gas reserves. These reserves have been further increased by the newly discovered Bakken Shale and Utica Shale formations. Coupled with the new technology of horizontal drilling and hydraulic fracturing (also known as “fracking”), this opens up new potential for companies in this industry and for the country. The supply glut has helped push natural gas prices down, which is beneficial for a host of secondary industries including electric power generation utilities, chemical companies, steel companies, etc. The shale revolution in the United States is creating many jobs in places like North Dakota, where, due to the Bakken Shale formation, the unemployment rate is lower than in the rest of the country. This article looks at the different shale regions, how natural gas is extracted from the shale formations, what drives the price of natural gas (i.e., the different aspects of supply and demand), and also the environmental aspects of horizontal drilling.

u.s. shale regions The major oil and gas shale formations in the continental U.S. include the Bakken Shale, Barnett Shale, Eagle Ford

Shale, Haynesville Shale, Marcellus Shale, and Utica Shale formations. The Bakken Shale formation, located in Montana and North Dakota, is estimated to hold 4.3 billion barrels of oil and is the largest oil find in U.S. history. The estimates may grow as more companies drill and find oil in that region.

The formation ranges in depth from 4,500 to 7,500 feet, with an average thickness of 22 feet. In 2009, Bakken Shale in North Dakota produced eighty million barrels of oil, making it the fourth largest oil producing state after Texas, California, and Alaska.

In Texas, Barnett Shale, the nation’s most developed shale gas play, is estimated to hold 43.4 trillion cubic feet (Tcf) of natural gas and has already produced more than 4.8 Tcf. It stretches across 6,500 square miles, and its natural gas reserves are enough to power all of Texas’s homes for almost 200 years. Also in Texas, the Eagle Ford Shale formation, which did not become productive until 2008, has an estimated 21 Tcf of natural gas and 3.35 billion barrels of oil reserves.

This shale formation ranges in depth from 5,700 to around 10,200 feet and covers about 3,000 square miles.

Surpassing the Barnett Shale formation, the Haynesville

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figure 1

figure 2

hydraulic fracturing process

u.s. dry natural gas production historical data (1930 –2013)

Graphic by AJ Granberg

Source: U.S. Energy Information Administration

Shale gas formation located in western Louisiana, east Texas, and southwestern Arkansas has an estimated 74.7 Tcf of shale gas reserves and ranges between 10,500 and 13,500 feet in depth. The area encompasses more than 9,000 square miles, is about 200 to 300 feet thick, and is considered to be the second largest natural gas shale formation in the United States.

The Marcellus Shale formation, stretching across five states (New York, Pennsylvania, West Virginia, Ohio, and Maryland), is estimated to contain 410 Tcf of shale gas. The total area is around 95,000 square miles, and the depth is from 4,000 to 8,000 feet. The thick, organic-rich shale intervals are concentrated in northeastern Pennsylvania, coincident with where the highest leasing activities are.1 The Utica Shale formation, a relatively new shale discovery, is located a few thousand feet below the Marcellus Shale. Utica Shale, believed to be larger and thicker than Marcellus based on the early testing results, is still under evaluation. Much of the exploration in the Utica Shale formation is occurring in eastern Ohio, where this shale formation is closest to the ground. It is estimated to hold more than 15 Tcf of natural gas and 5.5 billion barrels of oil as per the Ohio Geological Survey.

shale gas—extraction process Today, hydraulic fracturing is used extensively for shale oil and gas extraction. It uses a combination of water, oil, sand, and chemicals as a fluid through concentric steel tubes to create fractures in the rock. The chemical additives include sodium chloride (table salt), ethylene glycol (present in household cleaners), borate salts (used in cosmetics), sodium/potassium carbonate (used in detergent), guar gum (used in ice cream), and isopropanol (used in deodorant).2 The hydraulic fracturing fluid is injected into the well at very high pressure to open cracks into the shale rocks. The sand remains in the fractures, holding the fissures open and allowing the oil and gas to flow into the well, along with the fluids. Figure 1 illustrates the process of hydraulic fracturing, or “fracking.”3 With hydraulic

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fracturing and horizontal drilling, much shale resource once considered inaccessible has become available. Additionally, horizontal drilling has drastically reduced the footprints that exploration and production (E&P) companies leave on the surface of the drilling pad site.

Natural gas (primarily methane) extracted from a well has liquefiable hydrocarbons (e.g., propane, butane, etc.) as well as other contaminant gases (carbon dioxide, hydrogen sulfide, etc.) and is referred to as “wet natural gas.” Natural gas with liquefiable components and contaminants removed is referred to as “dry natural gas.” This separation is done at a natural gas processing plant close to where the gas is extracted. Dry natural gas is consumer-grade and sent through pipelines for distribution to consumers or for liquefaction for export purposes.

natural gas—supply, demand & price stability Natural gas prices hit a bottom of around $1.90/MMBtu (per million British thermal units) in April 2012 from a high of around $14/MMBtu during the commodities boom of 2007–2008. There are a few reasons for this price fluctuation, including the state of the economy, the supply and demand scenario, variations in weather patterns in winter and summer, imports, severe weather conditions (e.g., hurricanes, which are normal, and which hit the Gulf Coast, often leading to the shutdown of production facilities), storage capacity, alternate fuel usage, and industrial and consumer demands.

A common measure of the long-term viability of U.S. domestic crude oil and natural gas is the remaining technically recoverable resource, also called remaining TRR. Estimates of TRR are often not certain, specifically for the new sites where few wells have been drilled. The remaining TRR consists of “proved reserves” and “unproved resources.” Proved reserves of crude oil and natural gas are the estimated volumes that are expected to be produced with certainty under existing economic and operating conditions. Unproved resources are additional volumes expected to be produced without consideration of economics or operating conditions.

As wells are drilled, unproved resources become proved reserves and ultimately contribute to the production figures.

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Estimates of unproved resources can change significantly as more is learned about the fields where drilling continues.

Unproved resources have dropped to 482 Tcf in the Annual Energy Outlook 2012 report (as of January 1, 2010) from 827 Tcf (as of January 1, 2009).4 Nevertheless, the proved reserves of U.S. wet natural gas at December 31, 2010, increased to 318 Tcf from 284 Tcf at December 31, 2009, an 11.9 percent increase.5 The Energy Information Administration (EIA) expects that natural gas consumption in the United States will average around 70 Bcf/d in both 2013 and 2014. Closer-toaverage temperatures in 2013 and similar forecasts for 2014 (compared to record warm temperatures in 2012) have led to higher-than-average usage of natural gas for commercial and residential heating.

U.S. dry natural gas production totaled 24.05 Tcf following 22.9 Tcf in 2011,6 an increase of 5.0 percent in 2012, 7.8 percent in 2011, 3.4 percent in 2010, and 2.3 percent in 2009 year-on-year as shown in Figure 2. Figure 2 also shows the record production levels achieved in 2011 and in 2012, surpassing the previous record production levels from the early 1970s. The increase in production is attributed to various factors, including more cost-efficient drilling techniques, such as horizontal drilling, which have resulted in an increased output from the shale formations. In the long run, increase in supply will push prices down and will deter exploration and production companies from increasing their drilling acreage.

This will reduce the gas output, thereby decreasing production, and hence maintaining the equilibrium between supply and demand.

It is surprising but true that although the United States is awash in natural gas through its various shale formations, the country still imports natural gas for its domestic usage through pipelines, primarily from Canada and Mexico, and also as LNG (liquefied natural gas) from Africa, the Caribbean, and the Middle East. Imports increased from the mid’80s to around 2007. Since that time, imports have decreased due to various factors, including a weak economy, high storage levels, and increasing production here in the United States, as shown in Figure 3.7 Economic growth can fuel consumption of natural gas and hence positively affect the demand and support higher prices.

Higher demand exists from industrial and commercial sectors during times of strength in the economy. Steel plants use natural gas as their plant fuel and, similarly, companies in the chemical sector (e.g., Dow Chemical or Lyondell Basell) and fertilizer companies use natural gas as their raw feedstock.

Economic downturns as well as the cyclical nature of these industries can have a negative effect on demand.

Natural gas in underground storage fields also plays a critical role in the supply-and-demand equation and helps maintain the price equilibrium. During sudden demand spike situations, either due to weather conditions (hot or cold) or pipeline outage issues, reserves are released to meet the additional needs in the market and thus support price stability.

Natural gas levels in storage typically increase from April to October and decrease during the heating season from November to March. This “saw-tooth” pattern repeats every year and is shown in Figure 4.8 Prices of other alternative fuels also have an effect on natural gas prices, specifically the prices of crude oil and coal. Between the EPA’s coming down hard on the use of coal, and strict emission standards in power plants, there has been a push to move into a generation of cleaner natural-gas-based electricity. This trend has been helped by lower natural gas prices and higher supply, thus creating demand.

Higher crude oil prices will tend to move some of the demand over to natural gas. An example of this is 18-wheeler trucks, which could run on natural gas and not only save on diesel fuel costs as compared to the cheaper natural gas but also pollute the atmosphere less. The hedge fund investor T. Boone Pickens has been pushing for government subsidies in the trucking sector for years, but this has yet to be passed, although it is gaining support from the president and politicians from both parties. Clean Energy Fuels Corp., which is majority-owned by Pickens, has been installing natural gas stations for refueling purposes. More and more companies like United Parcel Service, Inc. and others have started adopting natural gas-based vehicles, although the number is currently not large.

export and import landscape Cheniere Energy is the first company to get approval from the Federal Energy Regulatory Commission (FERC) for the

figure 3 u.s. natural gas imports historical data (1970 –2013) Source: U.S. Energy Information Administration

figure 4 lower 48 states natural gas working underground storage historical data (1994–2013) Source: U.S. Energy Information Administration

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construction and operation of a facility that would liquefy and export domestically produced natural gas from the Sabine Pass LNG terminal located in Louisiana (owned 100 percent

by Cheniere). The Sabine Pass terminal has regasification and send-out capacity of 4.0 billion cubic feet per day (bcf/d) and storage capacity of 16.9 billion cubic feet equivalent. This approval would help to add even more capacity to the current Sabine Pass LNG terminal. Cheniere has also entered into a long-term contract for sale of LNG on the order of 16.0 mtpa (million tons per annum) to the following: BG Gulf Coast LNG (5.5 mtpa), Gas Natural Fenosa (3.5 mtpa), Korea Gas Corp (3.5 mtpa), and GAIL India Ltd. (3.5 mtpa).9 Earlier in 2012, Cheniere entered into a contract with Blackstone Capital Partners, an affiliate of the popular private equity firm The Blackstone Group, whereby Blackstone Capital Partners agreed to fund the equity needed for the expansion of the Sabine Pass LNG terminal project, highlighting the importance of this project to the investment community. Net imports (imports minus exports) have been falling and are at their lowest level since 1992, as shown in Figure 5,10 which is good for the overall U.S. economy as it becomes less dependent on foreign reserves of natural gas.

figure 5

conclusion

u.s. annual average natural gas net imports (1973–2011)

Shale oil and gas production in the United States has risen to record levels over the last few years due to improvements in drilling technology. Because of the abundance of supply from existing and recently discovered shale formations, improvement in drilling techniques and technologies, and stalled economic activity, and for various other reasons including seasonal change in demands, prices have fallen drastically from their 2007–2008 highs, although lately they have risen back up from the lows of April 2012, when the price fell below $2/ MMBtu. Lower natural gas prices are a boon for some industries, including chemical, steel, fertilizer, and power generation utility companies. Exploration and production companies drilling for natural gas need to ensure proper precautions when horizontal drilling for oil and gas in the shale regions to avoid water contamination. The current shale reserve estimates are good enough to support the needs of the United States for many years to come and are prompting companies to export natural gas globally to other places where, because of less supply, it demands higher prices—e.g., China, Japan, and other countries in Asia. Politicians in this country should take a closer look and take necessary steps to ensure that the United States can reap the full benefits of what exists in abundance naturally, including passing laws to promote liquefied natural gas export and opening up areas where natural gas can be used easily. This would help the United States to boost employment, as companies drill for more natural gas which finds usage in different industries both within this country and globally.

Source: U.S. Energy Information Administration billion cubic feet per day

environmental aspects of shale gas drilling Although natural gas is a relatively clean energy which, in use, releases fewer emissions than does coal or oil, its production process can create an environmental impact if proper precautions are not employed. Above all, the potential water impact is the most troubling. As the hydraulic fracturing process uses large volumes of water, which later results in wastewater, there can be impacts on drinking water resources and aquatic ecosystems. As mentioned earlier, hydraulic fracturing fluids consist of water, oil, sand, and chemicals. In case of spills or leaks from the storage onsite where the fluid is placed before injection, or through the injection well, surface water and underground aquifers may be contaminated on contact with the fluids. Once the fracturing is completed, the hydraulic fracturing wastewater is withdrawn and returned to the surface. In addition to the fracturing fluid, the flowback fluid can contain

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natural gas, high levels of total dissolved solids (chemicals), metals, and naturally occurring radioactive materials.11 Typically, this wastewater is recycled for use in fracturing fluid, transported to treatment facilities, or disposed of by injection into deep wells. The environmental impact would be severe should the wastewater be improperly handled and discharged to surface soil or water during storage for reuse, transportation to treatment plants, or disposal into wells. In addition, historical cases suggest that wastewater injection into deep wells induces earthquakes, and that there is a correlation between the magnitude of the largest earthquake and the total volume of wastewater injection.

While FracFocus, the national hydraulic fracturing chemical registry, discloses chemicals that are used in hydraulic fracturing and also provides public access to the official state chemical disclosure for 10 states,12 a report highlights that energy companies didn’t report thousands of their oil and natural gas wells as having been hydraulically fractured on FracFocus.org.13 Air quality is also affected near natural gas production areas. Emission of a high volume of volatile organic compounds (VOCs), hazardous air pollutants (HAPs), and methane are associated with the wastewater returning to the surface.

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the financial service industry’s use of technology

By Shyam Eati

C

itigroup is the largest company in financial services, yet it has just 3 percent of market share. The fragmented nature of the industry makes it even more important for firms to search for an advantage, and that’s why the industry is a leader in using information technology (IT).

For example, IT services at banks such as Citibank reduce operational costs by standardizing low value-added transactions such as bill payments, balance enquiries, and account transfers and let banks focus on value-generating operations such as building clients, improving efficiency, and investment banking.

Companies find the most profitability in risk management, investment expertise, understanding individual customers’ evolving needs, and building investor confidence. In response to these market drivers, service providers are applying vast computing power to each of these areas, and the result is a paradigm shift in the way technology is integrated into the financial services industry. This is present in every corner of the industry: banking, securities, investments, and financial

marketplaces. Technology has become an essential tool to ensure a company’s standing in the highly competitive market of financial services.

In addition to staying competitive, financial firms have also shifted the ways they use technology to meet customer needs.

Companies provide an experiential service by enabling customers with data, tools, and analytics. Customers today have greater transparency of information, which translates to improved portfolio management and reduced risk. To better understand how financial services firms are building trust with their customers, let’s look at some of the technology offerings that investment and wealth management firms are providing.

customer-centric tools— mutual funds firms Investors want their portfolios to be as diverse as possible.

Postmodern portfolio theory (PMPT) and modern portfolio theory (MPT) suggest rational investors should use diversification to optimize their positions. Traditionally, investors

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depended on mutual fund advisors for asset management. Today, many asset management firms have created complex software applications to model portfolio risk and return based on financial theories such as PMPT and MPT. Asset managers have been using an array of financial models to manage money more accurately. Some of these computational tools are now available to investors for a fee. For example, investors trade using investment tools like the Active Trader Pro Platforms from Fidelity Investments, which provide customers with real-time market information and let them trade equities, options, and mutual funds. These customer-centric tools benefit firms through focused marketing, timely advice, and an improved relationship.

In a volatile bond and equity market, investors tend to be more organized than lucky. Investors, over time, want to adjust their portfolios to balance risk and preserve their wealth. Asset allocations should be adjusted from time to time to conform to the changes in the market. Many financial services firms have highly customized rebalancing tools that advisors use to tailor customer portfolios. Advisors rebalance customers’ portfolios using tools such as Fidelity’s WealthCentral platform for registered investment advisors (RIAs).

Financial companies now have rebalancing tools for individual investors, which can be used to customize portfolios. Traditionally, portfolio-rebalancing methods have balanced target allocations based on a set period or on risk tolerance. The risk-tolerance-based approach triggers one or more trades when a predetermined threshold is met, which is better than time-series rebalancing or no rebalancing at all.

Rebalancing portfolios has transaction costs and can be expensive. However, a new approach using dynamic programming allows an investor not only to explicitly weigh the trade-off between sub-optimal costs and transaction costs but also to account for the fact that a rebalancing decision made today affects the rebalancing decisions available in

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the future. Investors are rebalancing their portfolios using predictive models that use multi-period optimization technology.

Investors also want their 401(k) plans to generate a continuous stream of income post-retirement; however, this is possible only by means of an early planned investment. Many financial services firms are now educating customers by offering tools and services, so that customers will start contributing earlier on in their careers. Tools such as these benefit both the firm and the investor. Income analysis tools designed for 401(k) plans, like Putnam’s Lifetime Income SM Analysis Tool, are designed to help 401(k) plan participants project how much income their current retirement savings will generate compared to what they may need, and offers a series of actions to positively influence plan participants’ retirement preparedness.

Technology has enabled small and large investors to use these intelligent tools to make investment decisions on par with financial services firms. However, technology alone can’t create super investment strategies for individuals.

Those familiar with both technology and investment strategies are best prepared to make risk-free investments, so beginners still seek out guidance from financial consultants, who are experts in the field.

Still, few people are knowledgeable enough to make investment decisions on their own, or they lack confidence in their own investment strategy. Instead, they depend on mutual fund firms or registered investment advisors. Financial firms have enabled these advisors with technologically advanced tools to model a portfolio. Financial firms sometimes use back-tests to develop a hypothetical investment strategy. For example, a researcher who wants to test the efficacy of a particular rebalancing rule could evaluate how it would have performed over any given time period and set of assets for which he or she has data. While the adage “past performance is no guarantee of future results” is especially applicable to back-

tests, they do provide insight into the relative merits of alternative strategies and serve as a key component of the quantitative research tool kit.

While the application of technology to portfolio management and asset allocation reduces risk and increases assets, it also has unintended consequences that can effectively eliminate the value that technological models create. For example, financial firms’ predictive models about mortgage trend analysis or the mortgage-backed collateral debt obligations (CDO) that were created in 2008 failed miserably and triggered the 2008 financial crisis.

moore’s law There have been plenty of occasions when technology was the culprit in trading losses. Prime examples include the $440 million loss incurred by U.S. investment firm Knight Capital after its trading systems placed thousands of unwanted trades, or JPMorgan Chase’s $2 billion trading loss from its hedging strategy. These happen because the financial industry is able to achieve technology prowess through cheaper computing power. Moore’s Law, named for Intel co-founder Gordon Moore, states the proposition that the number of transistors on a semiconductor can be inexpensively doubled about every two years. This cheaper computing power has allowed companies to build faster, cheaper models for calculating cash movements that can be used as financial instruments. These financial instruments have become profitable, and so budgets for each instrument have increased significantly or firms started seeking more esoteric swaps, like collateral debt obligations (as in the case of JPMorgan Chase’s $2 billion loss).

Highly powerful financial systems created financial markets that were difficult to unwind and eventually resulted in events such as the creation and destruction of the mortgage crisis in 2008 or the 2010 flash crash on May 6, 2010, at 2:45 p.m. that led the Dow Jones Industrial Average to plunge about 1,000 points (9 percent).

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use of technology to forestall financial crisis Financial services firms have also used technology to rapidly accelerate their own capabilities by integrating a network of systems programmed to produce results that far exceed the sum of their parts. These technology improvements have not only made processes efficient but also enabled firms to function according to the regulations set by government agencies. For example, to comply with SEC regulations, financial firms now have a workflow management system, where every document or communication from the firm is sent to Financial Industry Regulatory Authority (FINRA) for review.

These technology improvements have enabled institutions to forestall future financial fall down and streamline business processes by keeping pace with market conditions.

future of technology innovations Financial services firms now see technology as an integral part of every strategic decision. They have to leverage five key technology areas to be innovative and build software products for the future: • Real-time Information Management—This refers to collective enterprise infrastructure that enables capture, storage, management, and distribution of information to various stakeholders. This includes the use of technology such as service oriented architecture (SOA), data warehousing, and business intelligence.

• Modeling and Complex Analytics— These are autonomous models that drive business processes by continuously valuating information and initiating action independently by interpreting qualitative data and continuously learning from the data. Solutions such as probabilistic databases are used to make complex models of patterns in real time, like that of consumer behaviors and preferences.

• Intelligent Agents—These are autonomous software programs that offer sophisticated, proactive, and reactive assistance to owners, supported by the emergence of semantic web. These software programs become trusted agents in owners’ delegating decisions.

• Semantic Web—Semantic web is a framework of standards that recognizes data separately from the documents that contain them and is able to relate data to actual objectives. XML and SAOP data-transfer mechanisms allow data to be easily shared and reused across applications, enterprises, and communities. Web 2.0 features enable Web sites that are participative, social, and collaborative and create twoway communication between the Web page and the intelligent agent.

• Grid and Utility Computing—Grid and virtual computing tap unused capacity on individual machines and tie them together. They enable utility computing, which makes computer power available on an on-demand, pay-per-use basis delivered through the Web.

key to the future Technology will become an integral part of the financial industry to process real-time information and develop strategies on the fly using mathematical models and complex algorithms.

Behind the vast computing power of financial services firms lies the data.

Financial services firms collect, store, and analyze massive volumes of data for three major reasons: • Most of the financial services firms’ services and products have become commoditized and almost all services are available online, which has the potential for collecting huge amounts of consumer data.

• Online activity has increased from a growth in smartphones and led to a huge customer base. Firms are now able to enter areas that were not reachable earlier.

• Government regulations require

firms to be more proactive and to screen activities of its customers and its employees to identify irregularities.

Data should be used to accurately predict patterns and generate models that can drastically minimize risk exposure and open doors to new areas for firms to grow. Dashboards and financial reports should be filled with meaningful forward-looking analytical data created by tools that synthesize data at a very granular level. Analysts and technology architects should be able to present more useful information to users, as data can be made available over the cloud in a highly processed snapshot.

Financial industries should leverage this highly synthesized data to successfully predict patterns, good and bad, and build strategies around the events.

The financial services industry has relied extensively on technology to build models and tools for making investment decisions. Technology has helped the financial services industry build trust between firms and their customers. Many investment decisions today are taken by computers before humans intervene. Although these innovations are helping investment firms and investors, some of the technology innovations have bad outcomes. Technology firms should be able to stop failures in investment, and this is possible by creating a built-in system that checks for any kind of malfunction.

A healthy financial market is essential for firms to raise capital and for individuals to invest in mutual funds or stocks to save money for their children’s college educations or to accumulate a safe retirement income.

An efficient market is a necessity and not a choice for people to invest.

Financial firms should use technology to build an efficient market and not to abuse technology prowess to increase their earnings.

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the impact of the debt ceiling is unclear

By Christine Grascia

I

t is inevitable. With the debt ceiling avoided and the fiscal cliff talks delayed, it seems that the U.S. government’s poison pill of unattractive budget cuts can no longer be averted.

Lately, news channels and political talk have been abuzz over the sequester cuts imposed by the government, which took effect March 1. Many wonder how these cuts will impact the U.S. market and its growth. My belief is that it is too early to say for sure what the actual impact will be.

First, it is important to understand what programs are being affected or subject to cuts from the nearly $1.2 trillion sequester and how the gov-

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ernment is proceeding to make these cuts. So what exactly is being cut? According to data from the Pew Analysis of Congressional Budget Office, $454 billion in cuts will be made in government defense programs—roughly 42 percent of the overall sequester. Another $294 billion, or 27 percent, will be made in non-defense discretionary programs such as biomedical research, educational support, and housing support for low-income families. Other cuts are $169 billion (16 percent) in interest cuts; $123 billion (11 percent) toward Medicare; and the remaining 4 percent, or $47 billion, for other miscellaneous, mandatory cuts. Discre-

tionary spending cuts will total $85.4 billion in 2013, a figure that will rise gradually to $109.3 billion in 2021.

One may wonder how, or why, $85.4 billion for 2013 could have such an effect on the economy, given that it makes up only about 1 percent of GDP. A big difference between this sequestration and prior budget cuts is that the government is following through with its plan. This real impact means that programs are being cut and as many as 700,000 jobs removed. This ultimately will destroy confidence for the consumer, for the investor, and for businesses, which will not hire but instead will cut back on spending. As the economy experiences slow growth due to the 2008 recession, anything with a negative influence can seriously detract from its overall growth.

However, the markets seem to depict a different story, despite concerns that the economy could stagnate or fall into a deeper recession. The stock market experienced an all-time high in early March, leaving some investors bewildered and others confident that the sequester will have positive effects.

Anthony Chan of JPMorgan Chase believes that this positive outcome is a reflection of confidence in Washington. Chan’s optimism, in line with the opinions of many others, is further reflected by the falling unemployment rates used to boost consumer confidence. These signs are also attributed to the Federal Reserve’s helping hand in campaigning to yield assets while pushing investors into the equity markets. Even with a 0.5 percentage-point decline in GDP and a cost of 700,000 jobs, analysts believe that the increase in multiple-job holders to 340,000 from private sectors will help to balance this negative outcome.

Still, many urge caution. While the stock market may seem unaffected by the sequestration, it is still too early to judge the full outcome. Wall Street may lag behind but could react poorly after all cuts are made. Much like a weather forecast, it is difficult to predict further into the future, especially

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as all cuts are not yet made. The longer the sequestration is in effect, the more those effects will be felt. Since the news of government cuts were already advertised, this information was already priced into the market. Therefore, although markets did rise after the sequestration on March 1, this rise could be due to other, entirely unrelated sources. Another piece to consider is how the markets will behave once the Fed decides to drop its monetary stimulus. Will its exit strategy be enough to keep the market upright?

Ultimately, it is still too early to assume how markets are really impact-

ed, especially as the bulk of the cuts do not take effect immediately. A 0.5 percentage-point decrease in GDP will slow the growth of the economy, but at worst it appears to be a lateral move.

Some political leaders, including Massachusetts State Representative Vincent deMacedo, claim that government budget cuts are a necessary evil, and repercussions are likely to occur, if the government is serious about investing in the future of the United States. President Obama, for example, asserted that these cuts are “absolutely necessary” and a “reflection of shared responsibility.” Taxation alone cannot

provide potential solvency. However, small, gradual cuts are a compelling starting point. Albeit these cuts consist of only $1.2 trillion over the course of several years in a several-trillion-dollar debt, it is imperative for the U.S. government to make these changes. Unfortunately, with only a month since the cutting of the red tape, there isn’t enough data to conclude how, and where, the sequester has impacted the United States. Will people be affected by this in some way down the road?

Yes, but at this point, the sequester talks and their impacts are more about politics than policy.

government intervention’s impact on real estate

By Brendan Castricano

In the wake of the 2008 Great Recession, government officials began to take historic steps to reform the U.S. economy. Some of the most pronounced impacts are being made with the Basel III Accords and the Dodd-Frank Wall Street Reform and Consumer Protection Act as well as the fiscal cliff deals. These reforms are having a significant impact on the real estate sector as it enters its fifth year of recovery.

BASEL III

F

ounded on May 30, 1930, the Bank of International Settlements (BIS) is the oldest international financial institution in the world. It is the center for cooperation and coordination between the central banks of 27 nations.

Since 1988, the BIS’s Basel Committee of Banking Supervision (BCBS) has been meeting to provide recommendations on regulation standards known as the Basel Accords.1 The BCBS sought to reform and strengthen the resiliency of the international financial system after the 2008 recession.

By July 2010, the committee’s negotiations had led to a set of agreements on capital adequacy, market liquidity risk, and stress testing known as Basel III. These included a series of changes, such as an increase in the minimum amount of com-

mon equity (from 2 to 4.5 percent) and Tier 1 capital (from 4 to 6 percent). But perhaps the most critical recommendation involves the application of the liquidity coverage ratio (LCR).

This new standard strengthened the short-term resiliency of banks by ensuring that they have a sufficient stock of highquality liquid assets (HQLA) to survive a 30-day crisis, such as a credit downgrade. This also established the first global minimum standard for bank liquidity in regulatory history.2 One of the critical challenges faced by the Basel III agreements is that the required changes are being made at a time when the international economy is relatively weak. In 2013, the U.S. economy faces the prospect of a double-dip recession as Congress attempts to balance growth and debt load reductions in their negotiations over the debt ceiling and sequestra-

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tion. On top of this, a 2011 OECD report However, by 2015 the belt will begin to downward to 35 percent if the LTV decalculated that the implementation of tighten even further. creases to below 60 percent. Naturally, Basel III would likely decrease annual In addition to this, another series of this would create strong incentives for gross domestic product (GDP) by 0.05 Basel III reforms has been proposed traditional mortgages as well as strong to 0.15 percent, which could potentially to commence in 2015. In June 2012, disincentives for riskier, nontraditional make a difficult situation even worse. 3 the Federal Reserve, the FDIC, and mortgages.8 the OCC released three notices on proIn response to this concern, the BCBS Additional rules are also being conposed rulemaking (NPRs) for the Basel announced on January 6, 2013, that sidered for certain acquisition, developIII risk-based capital standard. For the they had agreed to a more gradual imment, and construction (ADC) loans in real estate sector, the most critical of plementation of certain portions of Bathe commercial real estate sector. Notathese proposed rules is the Standard sel III. The most critical change among bly, a subset of ADCs called high volatilApproach. This series of rules presents these involves the minimum LCR, ity commercial real estate (HVCRE) asIn addition this, set another series Basel IIIa reforms hasweighting been proposed to for commence new risk system vari- insets is proposed to receive a risk weight which is no to longer to take full of effect ous on- and off-balance sheet assets in in 2015. Instead, the minimum LCR of 150 percent. These are ADC loans 2015. In June be 2012, Federal the FDIC,smaller and the OCC releasedwith threefewer noticesthan on institutions would 60 the percent of Reserve, the previously where one of the following must be $250 billion in assets.7 established minimum value in 2015, intrue: (a) the borrower contributed less proposed rulemaking (NPRs) for the Basel III risk-based capital standard. For the real estate creasing 10 percentage points per year than 15 percent of the “as completed” One key proposal from the Standard until it reaches 100 percent on January Approach is for residential mortgages, sector, the most critical of these proposed rules is the Standard Approach. This series of rules appraisal value of the project, (b) the 1, 2019.4 The revisions also include an LTV is greater than the designated “apwhich would be separated into two risk plicable maximum supervisory LTV,” categories: (1) traditional and in(2)smaller nondefinition of what qualifies as onpresentsexpanded a new risk weighting system for various and off-balance sheet assets (c) the project is not a one-to-four-family traditional. Here, a traditional Category an HQLA. For example, the minimum institutions with fewer 250 billion assets.7 1 mortgage would be characterized by residential property, or (d) the borrower requirement forthan corporate debt in securicontributed the capital deposit after the a maximum 30-year duration, regular ties has been lowered to BBB-, with a Onepercent key proposal from the Standard Approach is for residential which wouldbank issued the loan funds, and this periodic payments,mortgages, limited interest50 haircut.

Similarly, certain deposit is not contractually required to rate increases (2 percent per year and residential mortgage-backed securities be separated into two risk categories: (1) traditional and (2) nontraditional. Here, a traditional remain in place until the project is com6 percent total) as well as various prurated AA now qualify, with a 25 percent 5 dent underwriting practices.

Alternahaircut.

Category 1 mortgage would be characterized by: a maximum 30 year duration, regular periodic pleted. Similarly to this, a 150 percent weight would be applied to real estate tively, nontraditional, Category 2 loans The committee’s 2013 revisions to loans on accrual or past 90 days due.9 failand to 6meet the qualifications Basel III reflect an attempt to balance payments, limited interest-rate increases (2 percent would per year percent total), as well for as the traditional loan or be characterized the delicate tradeoff between growth Ultimately, this is only a small samvariousand prudent underwriting practices.industry Alternatively, Category90 2 loans would fail by nontraditional, junior liens, payments days past liquidity for the banking ple of the numerous regulatory rules due, negative amortization, balloon payand the international economy. In the proposed by the Standard Approach to meetshort the qualifications for thethis traditional loan or ments, be characterized by: junior liens, payments and it has not yet been decided if they deferred repayment of principal, to medium term, will likely and so forth. Additionally, risk weights fend off the risk of a credit crunch stemwill actually go into effect. Nonetheless, 90 days past due, negative amortization, balloon payments, deferred repayment of principal, and would be applied as a function of the ming directly from the belt-tightening in combination with the LCR capital mortgage’s loan to value (LTV) ratio. restrictions of the new regulation.

This requirements, these proposed reforms so forth. Additionally, risk weights would be applied as a function of the mortgage’s loan to As shown in Figure 1, a baseline 100 is critical for capital-intensive indushave the potential to make a substantial risk100 level is setrisk forlevel Category tries, such estate.

Theappended commer-table,percent value (LTV) ratio.as Asreal shown in the a baseline percent is set 1for impact on the real estate sector in 2015. mortgages with an LTV of under 90 percial real estate sector alone is seeking to Category 1 mortgages an LTV of under 90 percent. weight could shift dodd frank cent. From From here here,the therisk risk weight could refinance $300with billion in commercial shift upward to 200 percent if the loan mortgage-backed securities on an anIn the aftermath of the 2008 Great upwardnual to 200 percent the next loan three becomes Category 2, or it could shift 2, downward to 35shift percent Recession, Congress passed the Dodd6 becomes Category or it could basis overifthe years.

Frank Wall Street Reform and Conif the LTV decreases to below 60 percent. Naturally, this would create strong incentives for sumer Protection Act. As noted by Ben 8 Protess of the New York Times, this figure 1 traditional mortgages, as well as strong disincentives for riskier, nontraditional mortgages.

2,300-page document has produced Source: Moss-Adams LLP (http://www.communitybankers-wa.org/documents/baselIII_Moss.pdf ) the most wide-sweeping set of financial reforms since the Great Depression.

While an analysis of the entire body of legislation is beyond the scope of this article, it is worth noting some of the more significant new rules: (a) the Volcker Rule, separating investment from commercial banks; (b) the creation of

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costs to their customers. The specific the Consumer Financial Protection regulations that actually implement Bureau; (c) the creation of the Finanthis statute are known as “Regulation cial Stability Oversight Council, which Z,” but the two terms are often used can recommend that companies that interchangeably.13 In January 2013, get too big be regulated by the Federal Reserve; (d) the creation of a clearingCFPB published five new rules amendhouse where credit default swaps will ing Regulation Z. These changes cover be traded, regulated, and observed by a wide range of areas, from new loan the CFTC; and (e) the requirement that servicing standards to new appraisal rehedge funds register with the SEC and quirements for high-risk mortgages to provide certain trade data.10 new escrow requirements.14 Dodd-Frank calls for 400 new rules The most significant of these amendto be written by various agencies, such ments to Regulation Z is the new as the SEC and CFPB. However, as of “Ability-to-Repay” rule. This requires March 6, 2013, only a third of these lenders to look at consumers’ financial rules have been finalized.11 Amidst this information in order to verify that they have the capacity to repay their mortprocess, some agencies have had more gage. More specifically, the loan officer success than others. For example, the “good product, you cannot create 80 pools, and therewill hasn’t beento obtain reliable documenneed CFTC has completed nearly perenough [good product].” The market also requires more B-piece Mortgage Delinquencycentbuyers tation of itstorules.

CFTC Chairman Gary invest in the riskiest tranches, so originators have(W-2, held pay stub, etc.) on the folback, unwilling to warehouse loans. from a lowing eight types of information: (1) Gensler has stated, “We’ve gone the CMBS industry may need to confront bigger obstacles current income, or assets, (2) current generalButlaw to the specific rules to the in order to rebound fully. Although most interviewees contend that status, (3) credit history, specific rollout.…Next year (2013) is a properly functioning mortgage securities engineemployment is necessary 12 for liquidity in theimplementation.” real estate capital markets, they also express payment for the mortgage, (4) monthly about one word: serious concerns about failures to address evident problems in (5) since monthly payments on other curFor theunderwriting, real estateregulation, sector, ratings, the most CMBS and servicing the market collapse the depths the credit rentproblem mortgage loans, (6) monthly paysignificant new atrules stemof from thecrisis. “The for bond buyers remains”: the people running CMBS shops ments on other mortgage-related exnewly created Consumer Financial have “shuffled around,” underwriting is only marginally better,” (e.g., Protection Bureau (CFPB) as it overoriginators and issuers “don’t have enough skin inpenses the game” for taxes), (7) other debts, (8) an alignment of interests, the ratings agencies still monthly get paid bydebt-to-income ratio as well as hauls the mortgage market.

Following the issuers, and “attitudes haven’t changed.” In short, “nothing monthly income after debts are paid. the meaningful requirements of Dodd-Frank, the has happened” to correct the problems, which sent Furthermore, the consumer’s ability to bureau has been tasked with rulemakbond buyers running to the exits.

02 2006 2010 2012 Some interviewees say regulatory changes—like requiring repay cannot be determined through ing authority over the 1968 Truth in e Insurers. holding a portion of each loan or delays in realizing fees and teaser rates. Instead, lenders will have Lending Act. The act was created in promotes—could lower industry profitability and limit the number of willingclear to enter the business. to consider the highest interest rate the order to players establish standards forSome interviewees sence of much competiremain skeptical, “At first B-piece buyers will be reasonably consumer will pay within the first five lenders communicating loan terms and sually with high-credit disciplined. Then they will gradually loosen credit standards as

years.15 This new rule is best viewed in contrast to “NINJA” loans, which gained notoriety in the 2008 recession for being issued to consumers with “no income, no job, and no assets.”

An extension of the “Ability-to-Repay” rule is the “qualified mortgage” (QM).

QMs are sub-prime mortgages that have met certain safety requirements and are thereby granted special legal protections. Generally speaking, these are loans without high-risk features such as balloon payments, interest-only periods, negative amortization, and terms longer than 30 years. Furthermore, QMs will require that the consumers’ total monthly debt payments do not exceed more than 43 percent of their pre-tax income. There will also be limits on the upfront fees and discount points set at 3 percent of the loan value.

For mortgages that fulfill these requirements, lenders receive a “safe harbor,” which eliminates or reduces their legal liability. As it stands, this new rule is set to begin in January 2014.16 Following the announcement of these rules in January, Debra Still, chairwoman of the Mortgage Bankers Association, applauded the new “safe harbor” provision. However, she did express concern that parts of the regulation might tighten access to credit and inhibit competition.17 As noted by a Wall Street Journal reporter, many

onservatively achieve a transactions and money come into the market” until it’s time to ue ratios of 65 percent “revisit underwriting problems” and their consequences. In the d of us” on high-quality meantime, “bond buyers cannot get the same level of detail and e not pushing values and figure disclosure 2 we did pre-2007,” and more hedge funds, not real figure 3 ws. “That’s how they have u.s. single-family building permits Strengths aracteristically, they move u.s. cmbs issuance ExHIBIT 4-22 ExHIBIT 2-8 Mortgage some mezzanine lending Source: Commercial Alert.

Down for so long in an excruciating bump-along-the-bottom Source: Moody’s Economy.com U.S. Single-Family Building Permits U.S. CMBS Issuance eals to get higher yields; trough, housing finally advances and markets gain some real em reasonable. Making traction, although struggling along the way. In a classic buy$250 perties, insurers will not fill 2,000 ers’ market, institutional managers and savvy high-net-worth orrowers owning Class B investors take the plunge with conviction. They opportunistiwill try to limit the terms of $200 cally try a “pioneering” gambit, raising hundreds of millions of bt to hedge against the low1,500 dollars in capital for funds to vacuum up single-family product at nsurers may also enter the depressed prices, rent it for income, and eventually sell in any not be a game changer $150 Total (millions)

Thousands of units

Housing

full-bore recovery. Smaller players have already put together 1,000 localized ventures, and prices should firm up further in mar$100 kets that are drawing attention. Some prime neighborhoods in affluent enclaves escaped much damage and register modest 500 nal lenders—including gains, while “accelerating prices” for condominiums in “bet$50 en the way for private ter” markets like south Florida could be “a leading indicator for art-up lending shops, to recovery.” Skyrocketing apartment rents in certain infill and gate0 $0 citate the still-flagging way2000 markets also2004 provide incentives to2010 buy. 2012* Banks finally allow 1993 1995 1997 1998 2002 2006 2008 rom “a shadow of what it more short sales and convert delinquent owners into renters, Source: Moody’s Economy.com.

Source: Commercial Mortgage Alert. rch back into the financing helping the inventory of problem loans, which weighs down *Forecasts *Issuance total through August dent 30, 2012 as ofasAugust *Forecasts of August2012 2012. *Issuance total through August 30, 2012. creases.” Without enough many commodity markets.

rward

13

Weaknesses Even with relatively low mortgage rates, home sales have languished and the homeownership rate has dropped to 50-year lows, revealing lack of pent-up demand and the depths of many Americans’ shaky personal finances in a problematic jobs market; they simply cannot afford to own homes. Others just do not

1999 2001 2003 2005 2007 2009 2011* 2013* 2015*

amply documented in reams of housing-bust publicity. Rational credit standards, which require reasonable downpayments and good borrowing histories, shut out some potential buyers who would have had no trouble scoring a mortgage in the precrash lending environment. More than 10 million homeowners, meanwhile, remain underwater on mortgages worth more than actual house values. Any distressed selling will continue to dampen

25

banks may be more hesitant to originate unqualified mortgages, “at least at first, given the legal liability.” Similarly, Fannie Mae and Freddie Mac are unlikely to bundle these loans into securities, thereby making them harder to remove from the bank’s balance sheet.18 However, the new “safe harbor” rule may also end up helping the struggling CMBS market. As shown in Figure 2, the issuance of these securities suffered a deep drop after 2007, from a peak above $200 million to lows of around $25 million. In a 2012 survey of real estate industry professionals, one interviewee noted “without enough good product, you can’t create pools, and there hasn’t been enough [good product].” As such, the QM rule may help would-be investors and interviewees who are concerned that mortgage originators “don’t have enough skin in the game.” Regardless, most of their interviewees continue to expect the CMBS market to return to levels of around $70 to $95 million.19

the fiscal cliff, sequestration, and the debt ceiling The United States currently holds over $16 trillion in debt, with an annual deficit of approximately $1 trillion.20 However, Congress has demonstrated intensely partisan politics and disagreements with regard to how to balance the budget—with either spending cuts, tax increases, or a mix of both. In order to bypass this political gridlock, Congress passed the 2011 Budget Control Act. This set forth $543 billion in automatic spending cuts and tax increases effective January 2, 2013.21 Former Federal Reserve Chairman Ben Bernanke has termed this event the “fiscal cliff,” and the term has generally stuck with the media.22 According to the Congressional Budget Office (CBO), the full impact of the fiscal cliff would cause real GDP to be reduced by 2.9 percent. Considering this in context of the 2 percent average annual growth that the United States has experienced throughout the recov-

26

ery (2009–2012), the CBO has estimated a net decline in real GDP of 0.3 percent for 2013.23 The concept behind the fiscal cliff was that the automatic changes would create an economic shock so unfavorable to Americans that Congress would be putting themselves in a situation where they were forced to come to a better agreement. So far, this strategy has produced only partial results.

At midnight on Dec. 31, 2012, the United States technically fell over the fiscal cliff. Two hours after the last minute, the Senate approved the American Taxpayer Relief Act of 2012, as negotiated between Congress and the White House.24 Two of the most critical components of this legislation are directed at individuals who earn more than $400,000 per year. For this group, the Bush tax cuts will expire (increasing rates from 35 to 39.6 percent), and the capital gains tax will increase from 15 to 20 percent. Federal unemployment insurance and a full package of temporary business tax breaks will also be extended through 2013.25 However, this agreement was not as productive in generating results for the $85 billion in annual (or $1.2 trillion over 10 years) across-the-board budget cuts to various government agencies (the Pentagon, the National Park Service, the Transportation Security Administration, etc.) known as the “sequestration.” Instead of forcing themselves to come to an agreement by backing themselves into the fiscal cliff corner, Congress and the White House merely delayed the impacts of the sequestration for another two months, setting it to commence on March 1, 2013. Unfortunately, the extra two months of negotiating time were not sufficient to overcome the bipartisan gridlock, and the deadline passed without any new deals.26 As it stands, the nonpartisan Congressional Budget Office estimates this $85 billion reduction in expenditures will reduce GDP growth by 0.6 percent while eliminating 750,000 jobs.27 However, the full impact of these cuts is not expected to fully hit the public until April

or May. In turn, this will set the stage for Congress to address the next debt ceiling confrontation in July and August.28 While President Obama recently sat down again with Republicans in another attempt to establish a grand bargain, many investors are still concerned with the turbulent political and economic atmosphere. By the end of fourth quarter 2012, the ongoing debt-ceiling debates caused the first-ever U.S. credit downgrade, from AAA to AA+.29 During the same period, the U.S. GDP shrank to a negative value (-0.01 percent) for the first time in four years, triggering the threat of a double-dip recession.30 Alternatively, the economy did begin to show distinctly positive signs in March as the Dow industrial average peaked at an all-time high of 14,253.77.31 However, amidst the backdrop of economic uncertainty, this was received with an uncharacteristic lack of celebration from Wall Street.32 Similarly, in February 2013 the unemployment level shrank to a four-year low of 7.7 percent.33 But how this statistic will fare against the expected 750,000 jobs eliminated by the sequestration in the second half of 2013 is uncertain.

The challenges from the fiscal cliff, sequestration, and debt ceiling have many implications for the real estate sector. So far, the single-family housing market has fared well. In the fiscal cliff negotiations, it received a number of benefits including an extension of tax relief on mortgage debt forgiveness for one year, a continuance of the mortgage interest rate tax deduction, and a tax deduction allowance on private mortgage insurance lendees.34 However, the commercial real estate sector will experience direct negative impacts in the office market as a result of the fiscal cliff. Federal agencies currently lease some 167 million square feet (msf) of privately owned office space in the United States. This amounts to 3.3 percent of the total office inventory. Analysts at Cassidy Turley estimate that the full implementation of the fiscal cliff would result in -1 percent in office rents while increasing vacancy

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rates by 0.9 percent. 35 There would be similar negative impacts stemming from a loss of funds delivered to government contractors. In 2012, some $450 billion was allocated to defense (65 percent) and other contractors (35 percent) for the government.

More than one in six federal government dollars toward this procurement spending. As tenants, these contractors represent approximately 208 msf of office space—an amount roughly equivalent to the office inventory of the Dallas metro area. Under the full implementation of the sequestration, government expenditures on contractors would decline 9 percent for 2013, potentially rendering 18.7 msf empty across the United States. At the same time, these

figures do not represent the 44 percent of small government contractors, who would also tend to reduce expenses.36

conclusion In 2013, the U.S. real estate sector continues its slow path to recovery. As shown in Figure 3, single-family building permits are steadily returning to pre-crisis levels.37 Many economists are even expecting the housing market to be one of the primary drivers for growth for the entire U.S. economy.38 However, this will all take place amidst fundamental changes from the simultaneous implementation of Basel III, Dodd-Frank, and the fiscal cliff deals.

Combined with challenges from the European debt crisis and a slowdown

in China’s growth rate, this has created an atmosphere of uncertainty that undermines confidence in real estate development. As one interviewee in an Urban Land Institute survey put it, this uncertainty about government policy and global economics is “the industry’s biggest issue because we are so capital intensive, and it’s totally out of anyone’s control.” Nevertheless, it is an optimistic omen in this uncertainty that the “Oracle of Omaha,” Warren Buffet, recently placed an enormous bet on a housing recovery by creating a new residential mortgage brokerage franchise brand for 2013—Berkshire Hathaway Home Services.39

27

china—no hard landing (Rise of the Dragon)

By Debashasis Das

A

fter falling for more than two years, China’s economic growth picked up steam to register a GDP growth of 7.9 percent in Q4 2012, compared to a year earlier. HSBC Markit Purchasing Managers Index (PMI), a widely followed and important China macroeconomic metric, registered better-than-expected values for both December 2012 and January 2013.

Other indicators, including higher electricity consumption, steel production, and demand for crude oil, support this uptrend in China’s economy.

China is the world’s biggest consumer of iron ore and copper, and its rising prices in the world market suggest a strengthening Chinese economy. The global macro environment continues to struggle, with the European Union (EU) going through near-recessionary conditions and the United States registering a barely 1.5–2 percent annual growth rate. U.S. GDP had a contraction of 0.1 percent in Q4 2012 based on preliminary Q4 GDP data from the end of January 2013, which was then revised up by 0.1 percent growth for Q4 2012 based on data from the end of Feb. 2013. The BRIC (Brazil, Russia, India, and China) emerging market countries are struggling to live up to their expectations of either double-digit or high-single-digit growth, but based on the macroeconomic data from the last

28

couple of months, it seems that China has turned the corner and is trying to make a comeback. Economists and analysts who planned to write off China earlier and declared a “hard landing” (a substantial slowdown in economic growth) for the PRC (People’s Republic of China) should take a closer look at the recent economic data out of the country and rethink their strategy.

The economic data and numbers referenced in this article are from the same sources (primarily the People’s Bank of China and the National Bureau of Statistics of China) that are referenced by the financial world. Also, it needs to be noted that some of the economic data around January and February tends to be a bit skewed due to the Lunar New Year effect, when economic activity tends to be high compared to the rest of the year.

china economic indicators—gdp growth, hsbc markit pmi Recent macroeconomic data out of China depicts positive trends. China’s economy rebounded to register a GDP growth of 7.9 percent in Q4 2012

from a year earlier, after decelerating for more than two years and above polled analysts’ estimates of 7.8 percent. For the full year 2012, China registered a GDP growth of 7.8 percent, down from 9.3 percent growth in 2011.

The Chinese economy has slowed for the last few years due to various factors but primarily due to the slowdown of the global economy, which has curbed the demand for its products abroad.

After the financial crisis, China’s GDP

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growth reached a peak of 12.1 percent in Q1 2010 as shown in Figure 1, fueled not only by easy money policy and a massive stimulus package by the People’s Bank of China (PBC) but also due to rebuild and repair, which was going on in the global economy after a recession. Because China is the world’s second largest economy, its GDP numbers are widely monitored and followed in the investment community. China is also the center of a lot of estimation and speculation, and China’s GDP numbers move the global equity and currency markets as well as commodity prices.

Beijing had set a targeted growth rate of 7.5 percent for 2012 and 2013, and the new incoming leadership for the next decade of Xi Jinping and Li Keqiang will try to ensure that future growth is in line with those set targets or will even exceed targets. Other data points, which are not widely followed but also used, include railway freight data and electricity consumption, both of which have seen positive trends, as depicted in Figure 1. According to the new premier, Li Keqiang, both electricity consumption and railway freight are better indicators of growth than GDP data.

HSBC Markit China Manufacturing Purchasing Managers Index (PMI) is another critical indicator that the global investing community looks forward to at the beginning of every month for the prior month’s manufacturing activity in China. In January 2013, the HSBC Markit China PMI index recorded a

value of 52.3, up from 51.5 in December 2012 as shown in Figure 2, signaling robust growth in the manufacturing sector and supporting the boost in the GDP growth. A value above 50 indicates continued strength or expansion in the manufacturing sector, and a value below 50 indicates contraction or recessionary conditions. January marked the third month of growth in the Chinese manufacturing sector, including production and new export orders. The average reading for Q4 2012 was 50.5.

That is the strongest since 2011 and above the low average reading of 48.3 from Q3 2012, marking the turnaround for both the PMI as well as the closely correlated GDP growth, which is clearly evident from the plot of PMI and Gross Domestic Product in Figure 2. This plot also depicts the sharp contraction in the PMI measure as well as the GDP growth around Q1 2009 due to the financial crisis of 2008–2009.

commodity prices—iron ore, copper, and crude oil China’s industrial sector and its robust growth are main contributors of demand for commodities, including iron ore, copper, and crude oil, of which China is the biggest consumer. China’s demand drives the global prices of metals, including copper and steel, and commodities like iron ore and coal.

This demand in commodities is driven not only by the country’s growing housing sector but also by numerous

infrastructure projects that the government has undertaken since the crisis of 2008–2009. China sources its commodities mostly from mining-and-materials-rich Australia and Brazil, where most of the giant global miners—like BHP Billiton, Rio Tinto, Xstrata, and Vale SA—are based. Prices for these commodities and metals have rebounded in the last few months, signaling the rebound currently going through the Chinese economy.

The iron and steel industry in China is one of the most important and basic industries, and it plays a critical role not only in the country’s economic development but also globally. The growth of the iron and steel industry has kept pace with the rapid industrialization and urbanization in China that led to the development of the economy. Domestic steel consumption, after reaching a peak of 24.6 percent growth, has since come down to around 9 percent annual growth for the last two years due to a slowdown in steel-consuming businesses, such as real estate, automobiles, machinery, and household appliances. Demand for steel has fallen for the last few years due to a slowdown not only in the domestic economy but also in the global economy, which has dented demand for Chinese products in Figure 2: HSBC China Manufacturing PMI the foreign markets.

Iron ore prices are a key indicator of the Chinese domestic demand for steel and its economic condition. Iron ore prices (benchmark iron ore with 62

figure 1

figure 2

china gdp growth and other economic indicators

hsbc china manufacturing pmi and pmi versus gdp plotted against time

Source: Wall Street Journal1

Source: Markit2,3

Figure 2: HSBC China Manufacturing PMI

Figure 2: HSBC PMI and GDP

Figure 2: HSBC PMI and GDP

29

figure 3 comex copper (cu) futures (may 2013) price

Figure 3. COMEX Copper (Cu) Futures (May 2013) Price

percent iron content) have jumped 25

percent in December and around 3 percent in January and have come a long way up from the $100 level reached last year. Steel prices in China have stayed high amidst hopes that construction and manufacturing will pick up after the Chinese New Year holiday and are acting as a floor below the iron-ore prices. China is also the biggest consumer of steel-reinforcement bar (rebar), and Figure 11. Hang Seng Index performance for 5 yr the rebar futures contract for chart delivery in May 2013 was priced recently at 4144 yuan ($665),4 which is its highest level

since June 2012.

China accounts for 40 percent of global copper demand and is the biggest global consumer of copper. Copper prices were hit hard in the middle of last year due to economic concerns about a potential hard landing, which China has been able to avoid so far.

Copper prices shown in Figure 3 for COMEX Copper Futures, May 2013,

figure 4 china retail sales (mom, yoy) Source: www.tradingeconomics.com5

30

have been climbing fueled by the demand, restocking, and recovering economic conditions in China, based on positive economic data for the last few months.

China is the world’s second largest global oil consumer, and crude oil is the largest component of its import.

China’s crude oil imports for 2012 recorded a growth of 6.8 percent, which

was better than 6.1 percent of 2011 but lower than 2010 before a slowdown in the domestic economy ensued. With an expanding economy fueled by urbanization and more and more people moving up in their socio-economic status, the demand for imported crude oil will continue to rise and provide a good barometer of the health of the overall Chinese economy.

china retail sales With the global slowdown affecting major economies like the EU and the

United States, China needs to be more self-dependent on its increasing middle-class population migrating to bigger cities and spending more to stimulate the economy forward through internal consumption. Household consumption drives 70 percent of GDP in the United States, whereas in China it is around 35 percent. One large part of that percentage is retail sales, one of China’s key growth drivers. Retail sales hit 15.2 percent in Dec. 2012 compared to the same month in the previous year as reported by the National Bureau of Statistics (NBS) of China and depicted in Figure 4. NBS has started publishing month-on-month growth data from 2011 onward, also represented in Figure 4. Trends from both YoY and MoM retail sales show that consumers and businesses are more confident in their spending habits, which is critical to sustaining positive economic development.

china trade—exports, imports, and trade surplus The monthly export data from China is a gauge not only of the Chinese domestic economy but also of global economic demand and growth. China is the world’s largest exporter, having overtaken second-place Germany in 2009. The low cost of labor and land has helped China’s exporters keep the prices of their products down for years, as compared to the rest of the world, aided by an undervalued yuan (RMB). Strong export numbers are

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positive both for the domestic markets and for the global equities markets, as analysts, economists, and others watch the numbers closely to monitor the growth story in China as well as the rest of the world. Similarly strong import numbers signal big demand for commodities like iron ore, copper, and oil, of which China is the biggest importer. Also, there are often big price movements based on these numbers.

Exports climbed 25 percent in January 2013 after a 14.1 percent rise in December 2012, while imports rose 28.8 percent in January 2013 ahead of the 6 percent increase from December 2012, and both were better than the estimates. The trade surplus was slightly lower at $29.2 billion in January 2013, from $31.6 billion in December, but higher than $19.6 billion in November.6 The data could be impacted by seasonal distortion due to the Chinese Lunar New Year, which falls this year in February as compared to January last year. Nonetheless, it shows robust growth and sustainable economic momentum. Looking deeper into the recent export data, trends like exports to the United States and the European Union show signs of improvement and positive growth, which is healthy for the Chinese economy.

figure 5 china trade surplus/ deficit data for fy 2012

consumer price index (cpi)—measure of inflation After falling for close to a year the Consumer Price Index, a key measure of inflation, climbed back again in December by 2.5 percent YoY, as shown in Figure 6, for Consumer Prices monthon-month and year-on-year comparisons and in the China Inflation Rate graph as well, which has the year-onyear change. Food is a key part of the CPI basket, and food prices went up by 4.2 percent and were the biggest contributor while non-food prices went up by only 1.7 percent. Higher consumer prices lower the purchasing power of households, and as rising middle class families spend a lot of their income on food, higher food prices can be a cause of social unrest and are closely monitored by the central think-tank in Beijing. After the financial crisis in the middle of 2011, inflation levels went up (6–6.5 percent, food inflation of ~15 percent), close to the 2007 levels of doubledigit food inflation shown in Figure 7.

Unlike the European Central Bank (ECB), which closely monitors the inflation rate (2 percent target), or the Federal Reserve Bank, the People’s Bank of China does not have a formal inflation target, although Premier Wen Jiabao had targeted an inflation rate of 3.5 percent for 2013. The government had to increase the interest rates in the past to fight inflation, which has since cooled to manageable levels. An increase in inflation also arrests economic development and negatively affects commodity prices. Hence, there is always a keen eye on China’s inflation numbers to make sure that the growth story is not derailed by inflationary conditions, and so far it has held pretty well.

china monetary and economic policy analysis The People’s Bank of China is the central bank, and, like the United States’ Federal Reserve Bank (“the Fed”), it conducts various open-market operations to maintain and boost liquidity in the banking system. It also promotes

figure 6 consumer price index— month-on-month and yearon-year comparisons Source: www.stats.gov.cn/english7 CONSUMER PRICES IN DECEMBER Consumer Prices in December 5%

4.1% 4%

Y/Y 3.2%

3.6%

M/M

3.4%

3.0%

3%

2.2%

2%

1.5%

1%

0.3%

-­‐0.1%

0% -­‐1%

Dec/11

Y/Y

4.5%

Jan/12

Feb/12

0.2%

Mar/12

2.5% 1.8%

2.0%

1.9%

Apr/12

-­‐0.3%

May/12

0.3%

0.1%

0.1%

-­‐0.1%

-­‐0.6% Jun/12

Jul/12

Aug/12

Sep/12

Oct/12

Nov/12

Dec/12

CHINA INFLATION RATE CHINA INFLATION RATE AnnualAnnual Change onon Consumer Change Consumer Price Price index Index 7

6.4

6 5

5.4 4.9

4.9

5.3

5.5

6.5

6.2

6.1 5.5

4.2

4.4

4.5

4

3.2 3

3.6

3.4

3 2.2

2

M/M 4.1% 4.5% 3.2% 3.6% 3.4% 3.0% 2.2% 1.8% 2.0% 1.9% 1.7% 2.0% 2.5%

0.8%

0.6% -­‐0.1%

2.0%

1.7%

12/31/11 1/31/12 2/29/12 3/31/12 4/30/12 5/31/12 6/30/12 7/31/12 8/31/12 9/30/12 10/31/12 11/30/12 12/31/12

2.5 1.8

2

1.9

1.7

2

1 0

1/31/11 2/28/11 3/31/11 4/30/11 5/31/11 6/30/11 7/31/11 8/31/11 9/30/11 10/31/11 11/30/11 12/31/11 1/31/12 2/29/12 3/31/12 4/30/12 5/31/12 6/30/12 7/31/12 8/31/12 9/30/12 10/31/12 11/30/12 12/31/12

4.9 4.9 5.4 5.3 5.5 6.4 6.5 6.2 6.1 5.5 4.2 4.4 4.5 3.2 3.6 3.4 3 2.2 1.8 2 1.9 1.7 2 2.5

credit and lending to small businesses and farmers and for agricultural purposes in the rural areas as well as for government projects and various others. One such open-market operation is the cut in the reserve requirement ratio (called the “RRR”) to boost liquidity so that easy lending can occur, and the PBC has done that a few times during 2012 following a 0.5 percent cut in December 2011. It needs to be noted that a raise in the RRR would produce an opposite effect by absorbing the liquidity from the system. The first RRR cut last year of 0.5 percent was in February 2012, followed by another 0.5 percent cut in May 2012 to ensure adequate liquidity in the system. Another operation that PBC undertook was to cut the benchmark deposit and lending rates successively on June 8 and July 6, 2012.9 Upon completion of this operation, the one-year benchmark deposit rate was lowered to 3.00 percent, and the one-year lending rate was lowered to 6.00 percent. Additionally, PBC adjusted the floating bands of deposit and lending rates. The upper ceiling of the deposit rate was raised and the floor of the lending rate was lowered to promote borrowing by lowering its cost for companies.

The Chinese government announced a massive stimulus package of 1 tril-

31

0.3% 1.5% -­‐0.1% 0.2% -­‐0.1% -­‐0.3% -­‐0.6% 0.1% 0.6% 0.3% -­‐0.1% 0.1% 0.8%

4.1 4.5 3.2 3.6 3.4 3 2.2 1.8 2 1.9 1.7 2 2.5

figure 7 china consumer price index (cpi) and food prices comparison Source: The Wall Street Journal

8

lion yuan ($156 billion) on September 7, 2012, after the economy cooled to around 7.6 percent GDP growth for Q2 2012. The stimulus package consists of plans to build highways, waterways, urban rail and subway projects, and wastewater treatment plants to stimulate growth and prevent a halt in the economic expansion. Although this package is much smaller than the 4 trillion yuan ($631 billion) that was injected into the economy between 2009 and 2010, both the infrastructure spending stimulus and the open market operations point to the fact that PBC is ready to take action whenever necessary to promote liquidity and inject it into the system, thereby boosting the overall domestic economy.

china equity market analysis A comparison of the Shanghai Stock Exchange Composite Index [Bloomberg Index: SHCOMP, Figure 8] (from mainland China) and Hang Seng Index [Bloomberg Index: HSI, Figure 9] (from Hong Kong), both of which are good representatives of the China equity markets, is presented along with their short term (20-day), medium term (50-day), and long term (100-day) simple moving averages (MA) for the last year. Both charts paint a bullish picture of the cur-

rent state of the Chinese stock markets.

The SHCOMP index has been moving gradually up from the lows of end November. All retracements until now for this index have bounced from the shortterm 20-day moving average, which is very bullish. Similarly, the HS index has been moving up steadily from early June, and all retracements until now have bounced from the 50-day moving average, which is also very bullish overall. A look at the longer term (five-year) trends in the Chinese equity markets shows that the market descent that began around August 2009 [Bloomberg Index: SHCOMP, Figure 10] and ended around the end of November 2012 may have played out, and that the markets are ready to move up and are currently in the process of doing that. This is also positively confirmed from the longterm (five-year) chart of the closely re-

conclusion The macroeconomic data from the month of January and initial data from February continue to be impressive, pointing to the fact that there are further gains stored in the Chinese equity markets ahead in 2013. After an almost 43 percent correction in the Shanghai Stock Exchange Composite Index (Bloomberg Index: SHCOMP) from August 2009 to November 2012, Chinese financial markets have shot back up around 23 percent from December 2012 to mid-February and continue to be one of the global equity market leaders in 2013. In the words of Jim O’Neill from Goldman Sachs Asset Management (GSAM), who continues to be optimistic on China even a decade after he

figure 8 shanghai stock exchange composite index performance chart for 1 yr

20Eday SMA – 50 day SMAchart for 1yr. □ – 100 Figure 8. Shanghai S–tock xchange Composite Index performance – 20 day day SSMA MA □ – 50 day SMA □ – 100 day SMA

figure 9

hang seng index performance chart for 1 yr

– 20pday SMA chart for 1yr.

– 50 SMA –S100 Figure 9. Hang Seng Index erformance □ –day 20 day SMA □ – 50 day MA □day – 100 SMA day SMA

32

lated HS index [Bloomberg Index: HSI, Figure 11].

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first published his views on the BRIC economies, “While so many people still always seem to be looking for the worst in China, and so many believe that you can’t make money out of the story even if the economy continues to steam along, I find it amongst the more stable things to think about.”10 On September 17, 2012, China released its 12th five-year plan for financial sector development and reform.

This plan is going to herald a new phase in the growth of China, with the country moving from export and investment-led growth to a more internal consumption-based growth driven by 1.3 billion Chinese consumers. As global growth across most of the major economies slows, China is focusing more inward to fuel its next phase of growth. Premier Wen Jiabao, in his final report to the congress, said, “We should unswervingly take expanding domestic demand as our long-term strategy for domestic development,”11 stressing the importance of China to drive its growth based on the demand from its domestic consumption. The 12th five-year plan, with its emphasis on boosting employment, raising wages, and promoting more spending (as compared to saving), will help continue to support the growth trajectory.

This is also supported by the fact that there is a huge migration going on in China of people moving from the countryside to the cities, with income in urban areas more than three times that of rural areas.

Downside risks still exist in the Chinese economy, with inflation alone having the potential to stall growth.

Inflation has been identified as one of the top 10 major issues that must be addressed in the years ahead as part of the 12th five-year plan. If inflation starts picking up beyond a threshold, China needs to enact more money-tightening policies and higher interest rates to fight it. Rising wages may also have some effect. An increase in wages is seen as beneficial in terms of driving more internal consumption-based growth, but in the global markets it dampens

the demand for Chinese manufactured goods. The hukou—which is China’s system of resident permits—is a big obstacle to raising incomes and driving consumption. Some of the cities are trying different measures to overhaul this old system so that approximately 200 million rural migrant workers can settle in the city, find work, and have access to social benefits, including public school education for their children. Property prices in China have also been a major headache amongst many, including China’s leadership.

After staying flat for awhile, property prices in major Chinese cities have started climbing again. Property prices in Shanghai were up 41 percent from a year earlier for the first two months of this year, according to data from the real estate agency Soufun.12 China’s leadership has tried different tightening measures in the past to ensure less participation of speculators in its bubbly property market while ensuring affordability for the middle class. In its latest attempt, policy makers have

proposed implementation of a 20 percent capital gains tax on profits from sales of homes. Additionally, they are planning to implement measures including increasing the down-payment requirement and raising mortgage rates, which would make it difficult for second-home buyers to participate and speculate in the real estate market. All of these have the potential to dampen the domestic growth scenario.

Although we are far from the doubledigit annual growth that was normal in the last couple of decades, it is evident that the new regime in China will not allow the hard landing (GDP growth below 5 percent), which many in the world have feared. The new normal growth will be around the 7–8 percent range to avoid a slowdown or hard landing, and China is going to make sure, through various economic and monetary policies, that it stays around that level, with the country moving toward more consumption-led growth as opposed to the previous investment-led growth.

figure 10 shanghai stock exchange composite index performance chart for 5 yr

Figure 3 CSOMEX Futures (May 2013) Price 1. 0. hanghai Stock (Cu) Exchange Composite Index performance chart for 5 yr figure 11 Copper hang

seng index performance chart for 5 yr

Figure 11. Hang Seng Index performance chart for 5 yr

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Writer biographies

Helios De Lamo

Shyam Eati

Helios is an MBA & MSF candidate in the Class of 2013. At Boston College, Helios is the president of the Graduate Finance Association and is independently pursuing the CFA designation. He interned as an Investments Analyst at Banesco Bank Panama, where he will pursue a career after graduation. Prior to business school, Helios worked in treasury positions, first at a brokerage and then at a services company. Meanwhile, he cofounded and developed La Cantera Futsal, a small organization that offers an outdoor soccer field, focusing on promoting soccer and sports activities in Caracas, Venezuela. He is a 2009 graduate of Universidad Metropolitana, where he received his BS in management and financial engineering.

Shyam is an MBA candidate in the Class of 2014 specializing in corporate finance and asset management. Prior to Boston College, he was a technical IT architect at one of the largest financial services firms in Boston. Shyam holds an engineering degree from Andhra University and a certificate degree in financial management.

Brendan is an MBA candidate in the Class of 2013, with a specialization in corporate finance. Brendan interned at the Schlesinger Companies, where he was responsible for financial reports that were utilized for real estate investment decisions. Brendan graduated from Plymouth State University in 2010 with a BS in economics.

Sumayya is pursuing both an MBA and a master’s in social work, and is a member of the Class of 2013. She serves as the copresident of BC’s Net Impact chapter, and she organized an Impact Investing panel session for Net Impact’s 2013 inaugural Career Summit. Her experience within the social sector includes health coaching, market research, and program design and evaluation. Sumayya’s prior publications include photojournalism pieces on Argentina and Iceland, published with PeterGreenberg.com, and a piece in the International Museum of Women’s 2007 Imagining Ourselves digital exhibit. Sumayya graduated from the University of Miami with a BS in communication studies and international studies.

Justin Christian

Terry Y. Zhou

Justin is an MBA candidate in the part-time program at Boston College’s Carroll School of Management and a member of the Class of 2015.

He currently works for a healthcare-focused investment bank, Leerink Swann LLC, where he specializes in risk management and operations, helping to oversee and mitigate risk on the trading floor for both equities and derivatives. He graduated from Michigan State University with a BA in finance and earned an MSF degree from Northeastern University. In his free time, he enjoys attending live sporting events, reading, running, and spending time with family.

Terry is an MBA/MSF candidate in the Class of 2013. He did his internship as an equity research analyst at Neuberger Berman Investment Management, focusing on the real estate, construction, and materials industries. Prior to business school, Terry worked as an auditor for Deloitte, serving mainly European manufacturing companies in China.

He graduated with a BS from Fudan University in Shanghai in 2009.

Brendan Castricano

Mike Vitanza Mike is an MBA candidate in the Class of 2014. He has worked as a business writer for a number of different online publications and spent two years as an equities trader with a focus on domestic securities. In 2009, prior to starting his graduate studies, he graduated from Providence College with degrees in sociology and business studies. He will be concentrating on asset management during his second year at Boston College.

Debashis Das Deb is currently pursuing his MS in Finance degree at the Carroll School of Management with a focus on fundamental and equity analysis, portfolio theory, and risk management. He has worked at Fidelity Capital Markets (FCM) in fixed income operations support and in Fidelity Family Office Services (FFOS) as a business analyst. He also worked briefly at Investors Bank & Trust (a custodian bank) before joining Omgeo LLC, a Thomson Reuters/DTCC company, where he is a principal business analyst helping expand the functionality of its central trade matching product, working for the last five years with global investment managers and broker dealers on middle- and back-office financial solutions. Deb graduated from the Indian Institute of Technology, Kanpur (India), with a master’s degree in materials and metallurgical engineering, and plans to move into equity research and analysis upon graduation from the Carroll School.

Christine Grascia Christine is a part-time MBA candidate in the Class of 2015. After college, she spent three years as a software developer for Harvard Management Company learning about the financial industry. She now works for a Boston-based hedge fund, Bracebridge Capital. Christine graduated from Smith College in 2009 with a BA in computer science.

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Sumayya Essack

Tracy To Tracy is a part-time student in the MSF program and a member of the Class of 2014. At Boston College, she is also a member of Net Impact, whose mission is to improve business practices through a commitment to corporate citizenship. Tracy is currently a senior product analyst at Natixis Global Asset Management. Prior to Natixis, she was a fund accountant at Investors Bank & Trust. She received a BS in economics and finance from Bentley University.

Cameron Kittle Cameron is an MBA candidate in the Class of 2014 and is focusing his studies on marketing and information analytics. He was the senior editor for this issue of BC Financial, and is also a freelance writer for Tech Target’s SearchCRM.com on customer experience management and contact center technologies. He formerly worked as a newspaper reporter at the Telegraph in Nashua, New Hampshire, where he covered business and education stories, including an in-depth series about college debt. He has also written for USCHO.com and the Gloucester Daily Times, and served as executive editor of the New Hampshire while attending the University of New Hampshire, where he graduated with a BS in English and journalism.

Donald Hall Donald is an MBA candidate in the Class of 2013 and the managing editor of this issue of BC Financial. During business school, Donald interned as an analyst at a boutique investment bank, where he cocreated a complex statistical model that helps firms increase their valuation before a liquidity event. Before turning to finance, He was a successful turnaround specialist in the hotel and resort industry. Donald has accepted a position as a real estate economist at Property & Portfolio Research in Boston, where he will advise institutional investors on commercial real estate strategies. He is a graduate of the Schreyer Honors College at Penn State University where he majored in recreation, park, and tourism management and minored in business.

Boston College Financial

endnotes

social impact investing—a maturing asset class: 1 Roger Frank, “Impact Investing: What Exactly Is New?” Stanford Social Innovation Review, Winter 2012. http://www.ssireview.org/articles/ entry/impact_investing_what_exactly_is_new (accessed February 20, 2013) • 2 Phillips, Hagar & North Investment Management, “An Overview of Impact Investing,” November 2010. http://pfc.ca/en/ wp-content/uploads/files/home%20page%20temporary/Impact_ Investing_Nov_12_2010.pdf (accessed March 31, 2013) • 3 Antony Bugg-Levin, “Complete Capital,” Stanford Social Innovation Review, Winter 2012. http://www.ssireview.org/articles/entry/complete_capital (accessed February 20, 2013) • 4 Sir Ronald Cohen and William A. Sahlman, “Social Impact Investing Will Be the New Venture Capital,” Harvard Business Review Blog Network, January 17, 2013. http://blogs. hbr.org/cs/2013/01/social_impact_investing_will_b.html (accessed February 20, 2013) • 5 Roger Frank, “Impact Investing.” • 6 J.P. Morgan, “Survey Shows Market Growth in Impact Investments and Satisfaction Among Investors,” January 7, 2013. https://www. jpmorgan.com/cm/cs?pagename=JPM_redesign/JPM_Content_C/ Generic_Detail_Page_Template&cid=1320509594546&c=JPM_Content_C (accessed February 25, 2013) • 7 Sasha Dichter, Robert Katz, Harvey Koh, and Ashish Karamchandani, “Closing the Pioneer Gap,” Stanford Social Innovation Review, Winter 2013. http://www.ssireview.org/articles/ entry/closing_the_pioneer_gap (accessed February 20, 2013) • 8 Ibid.

• 9 Ibid. • 10 Center for American Progress, “Social Impact Bonds: Frequently Asked Questions.” http://www.americanprogress.org/ issues/economy/report/2012/12/05/46934/frequently-asked-questionssocial-impact-bonds/ (accessed February 20, 2013) • 11 Ibid. • 12 Ibid.

• 13 Bureau of Justice Statistics, “Recidivism,” last revised March 31, 2013. http://bjs.gov/index.cfm?ty=tp&tid=17 (accessed March 31, 2013) • 14 Caroline Preston, “Getting Back More than a Warm Feeling,” New York Times, November 8, 2012. http://www.nytimes.com/2012/11/09/ giving/investors-profit-by-giving-through-social-impact-bonds. html?pagewanted=all (accessed February 20, 2013) • 15 Sasha Dichter, Robert Katz, Harvey Koh & Ashish Karamchandani, “Closing the Pioneer Gap.” • 16 Ibid. • 17 Ibid. • 18 Ibid. • 19 Ibid. • 20 Ibid. • 21 Beth Richardson, “Sparking Impact Investing through GIIRS,” Stanford Social Innovation Review, October 24, 2012. http://www.ssireview.org/blog/entry/ sparking_impact_investing_through_giirs (accessed February 25, 2013) • 22 Ibid. • 23 Survey respondents included fund managers, development finance institutions, foundations, diversified financial institutions, and other investors with at least $10 million committed to impact investing.

Additionally, two-thirds of survey respondents are “principally seeking market-rate financial returns.” • 24 J.P. Morgan, “Survey Shows Market Growth.” • 25 Johanna Mair and Katherine Milligan, “Roundtable on Impact Investing,” Stanford Social Innovation Review, Winter 2012. http:// www.ssireview.org/articles/entry/qa_roundtable_on_impact_investing (accessed February 20, 2013) • 26 Roger Frank, “Impact Investing.” • 27 Ibid. a bungee jump—where stock dividends still prevail: 1 Stock Split for Google That Cements Control at the Top, New York Times, April 2012. However, Larry Page has been considering a stock split and discussing the idea with Google’s Board since last year. • 2 The Company Law of the People’s Republic of China (revised in 2005),

Chapter V, Article 128 • 3 E.F. Fama, L. Fisher, M.C. Jensen, and R. Roll (1969), “The adjustment of stock prices to new information,” International Economic Review, 10, 1–21. • 4 By the end of 2012, only 280 securities are allowed for short selling on the Chinese stock market, most of which are liquid, large-cap stocks. the extraordinary rise of apple inc. and its impact on the stock market: 1 “Apple Drops ‘Computer’ From Corporate Moniker,” last modified January 9, 2007. http://www.informationweek.com/appledrops-computer-from-corporate-moni/196802415. • 2 Yahoo! Finance: http://finance.yahoo.com/q/hp?s=AAPL+Historical+Prices • 3 Bloomberg Market Data • 4 “Apple Shares Slide After Earnings; $13 billion Doesn’t Buy a Lot on the Street,” last modified January 23, 2013. http://blogs.wsj. com/marketbeat/2013/01/23/apple-shares-slide-after-earnings-13-billiondoesnt-buy-a-lot-on-the-street/ • 5 Tim Koller, Richard Dobbs, and Bill Huyett, Value: The Four Cornerstones of Finance, McKinsey & Company (Hoboken: John Wiley & Sons Inc., 2011), p. 42. • 6 Ibid, p. 15. latin america hedge funds industry—a nascent alternative: 1 http://www.eurekahedge.com/database/ latinamericanhedgefunddirectory.asp (accessed: 24 February, 2013) • 2 Victor Hugo Rodriguez, “LatAm alternatives.” http://www. alternativelatininvestor.com/353/hedge-funds/ali-speaks-with-victorhugo-rodriguez-of-latam-alternatives.html (accessed February 24, 2013) • 3 “Latin American Funds Take Off,” World Finance, November 14, 2011. http://www.worldfinance.com/wealth-management/hedgefunds/latin-american-funds-take-off (accessed March 10, 2013) • 4 Martin Litwak, “Litwak Partners on LatAm’s growing hedge fund sector,” World Finance, February 21, 2012. http://www.worldfinance. com/wealth-management/hedge-funds/litwak-partners-on-latamsgrowing-hedge-fund-sector (accessed February 24, 2013) • 5 http:// www.eurekahedge.com/database/latinamericanhedgefunddirectory. asp (accessed February 24, 2013) • 6 Martin Litwak and Walter Smiths, “Hedge funds in Latin America: The Flavour of the Month,” “Latin America, free trade and investment,” November 2003, issue 141. http://www.offshoreinvestments.com/archive (accessed February 28, 2013) • 7 Martin Litwak, “Litwak Partners on LatAm’s growing hedge fund sector,” World Finance, February 21, 2012. http://www. worldfinance.com/wealth-management/hedge-funds/litwak-partnerson-latams-growing-hedge-fund-sector (accessed February 24, 2013) • 8 Martin Litwak and Walter Smiths, “Hedge funds in Latin America: The Flavour of the month,” “Latin America, free trade and investment,” November 2003. http://www.offshoreinvestments.com/ archive (accessed February 28, 2013) • 9 Sonia Villalobos, “Why LatAm Equity Funds are looking Beyond Brazil,” December 2012. http://www. alternativelatininvestor.com/351/hedge-funds/sonia-villalobos-of-the-lvpacific-opportunities.html (accessed February 28, 2013) • 10 “MILA: A New Phase of Integration in Latin America,” January 2011. http://www. alternativelatininvestor.com/101/hedge-funds/mila-a-new-phase-ofintegration-in-latin-america. (html accessed February 28, 2013) the luxury rental market is thriving despite uncertain recovery: 1 Candace Jackson and Lauren Schuker Blum, “A New Lease on Luxury.” Wall Street Journal, January 17, 2013. http://online.wsj.com/ article/SB10001424127887323596204578241712854783062.html •

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2 Ibid.

• 3 Douglas Elliman Real Estate, “2012 Elliman Report.” Elliman Report, December 2012. http://www.elliman.com/pdf/6bd01099be8a9cb dbfe233b9c0f68bfbbe59cc74 • 4 Connor Dougherty, “Home Prices Help Advance Economy’s Slow Recovery.” Wall Street Journal, January 29, 2013. http://online.wsj.com/article/SB10001424127887323829504578271653019 114288.html?mod=dist_smartbrief) • 5 Ibid. the united states shale gas revolution: 1 Marcellus Shale— Appalachian Basin Natural Gas Play: http://geology.com/articles/ marcellus-shale.shtml (accessed April 06, 2013) • 2 Understanding Fracturing Fluid: http://www.energyfromshale.org/hydraulic-fracturing/ hydraulic-fracturing-fluid (accessed March 31, 2013) • 3 What Is Hydraulic Fracturing?: http://www.propublica.org/special/hydraulicfracturing-national (accessed March 31, 2013) • 4 U.S. Energy Information Administration (EIA), Annual Energy Outlook 2012: http:// www.eia.gov/forecasts/aeo/pdf/0383(2012).pdf , 57 (accessed March 31, 2013) • 5 U.S. Crude Oil, Natural Gas, and NG Liquids Proved Reserves: http://www.eia.gov/naturalgas/crudeoilreserves/index. cfm (accessed March 31, 2013) • 6 U.S. Dry Natural Gas Production data: http://www.eia.gov/dnav/ng/hist/n9070us2A.htm (accessed March 31, 2013) • 7 U.S. Natural Gas Imports: http://www.eia.gov/ dnav/ng/hist/n9100us2a.htm (accessed March 31, 2013) • 8 Lower 48 States Natural Gas Working Underground Storage: http://www. eia.gov/dnav/ng/hist/nw_epg0_sao_r48_bcfw.htm (accessed March 31, 2013) • 9 FERC Approves the Sabine Pass Liquefaction Project: http://phx.corporate-ir.net/phoenix.zhtml?c=101667&p=irolnewsArticle&ID=1683624&highlight= (accessed March 31, 2013) • 10 U.S. natural gas net imports at lowest levels since 1992: http://www. eia.gov/todayinenergy/detail.cfm?id=5410 (accessed March 31, 2013) • 11 Natural Gas Extraction—Hydraulic Fracturing: http://www2.epa. gov/hydraulicfracturing#wastewater (accessed April 06, 2013) • 12 Frac Focus Chemical Disclosure Registry: http://fracfocus.org/welcome • 13 Benjamin Haas, Jim Polson, Phil Kuntz, and Ben Elgin, “Fracking Hazards Obscured in Failure to Disclose Wells,” August 14, 2012. http:// www.bloomberg.com/news/2012-08-14/fracking-hazards-obscured-infailure-to-disclose-wells.html (accessed April 06, 2013) the financial service industry’s use of technology: Gartner Report. http://www.financialexecutives.org/eweb/upload/ FEI/Gartner.pdf • 2 Fidelity Investments. http://www.fidelity. com/inside-fidelity/institutional-brokerage/fidelity-to-introducesophisticated-portfolio-modeling-and-rebalancing-tool • 3 Putnam Investments. https://www.putnam.com/401k/tool/ • 4 World Economic Forum. http://www3.weforum.org/docs/WEF_FS_Scenario_ ITandInovation2020_2010.pdf • 5 State Street. http://www.statestreet. com/vision/technology/pdf/TheEvolvingRoleTech.pdf 1

the impact of the debt ceiling is unclear: http://www.forbes.com/sites/afontevecchia/2013/03/08/stocks-atrecord-highs-reflect-market-confidence-in-president-obama-and-gopcompromise-jpm-economist/ • 2 http://www.washingtontimes.com/ news/2013/mar/1/sequester-dawns-stock-market-yawns/ • 3 http:// www.bankrate.com/financing/investing/sequester-a-stock-market-killer/ • 4 http://www.ksdk.com/news/article/365543/3/Sequestration-and-thestock-market1

government intervention’s impact on real estate: 1 Bank for International Settlements. About BIS. http://www.bis.org/about/ index.htm • 2 Bank for International Settlements. Basel Committee releases revised version of Basel III’s Liquidity Coverage Ratio, January 7, 2013. http://www.bis.org/press/p130107.htm • 3 OECD. Slovik, P. and B. Cournède (2011). “Macroeconomic Impact of Basel III,” OECD Economics Department Working Papers, No. 844, OECD Publishing. http://dx.doi.org/10.1787/5kghwnhkkjs8-en • 4 Bank for International Settlements. Basel Committee releases revised version of Basel III’s Liquidity Coverage Ratio. January 7, 2013. http://www.bis.org/press/ p130107.htm • 5 Bank for International Settlements. Basel III: The

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Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013. http://www.bis.org/publ/bcbs238.htm • 6 Urban Land Institute, PWC. “Emerging Trends in Real Estate: 2013.” http://www.pwc.com/ us/en/asset-management/real-estate/publications/emerging-trends-inreal-estate-2013.jhtml • 7 Moss-Adams. “How Basel III Will Transform Your Bank.” http://www.communitybankers-wa.org/documents/ baselIII_Moss.pdf. September 25, 2012. • 8 Morrison Foerster. “The Banking Agency’s New Regulatory Capital Proposals.” http://www.mofo. com/files/Uploads/Images/120613-Banking-Agencies-New-RegulatoryCapital-Proposals.pdf. June 2012. • 9 Morrison Foerster. “The Banking Agencies’ New Regulatory Capital Proposals.” http://www.mofo.com/ files/Uploads/Images/120613-Banking-Agencies-New-RegulatoryCapital-Proposals.pdf. June 2012. • 10 New York Times. Protess, Ben. “Deconstructing Dodd-Frank.” December 11, 2012. http://dealbook. nytimes.com/2012/12/11/deconstructing-dodd-frank/ • 11 National Journal. Hollander, Catherine. “What’s Behind the Endless Delays on New Rules for Wall Street.” March 6, 2013. http://www.nationaljournal. com/daily/what-s-behind-the-endless-delays-on-new-rules-for-wallstreet-20130306 • 12 New York Times. Protess, Ben. “Wall Street Is Bracing for the Dodd-Frank Rules to Kick In.” December 11, 2012. http:// dealbook.nytimes.com/2012/12/11/wall-street-is-bracing-for-the-doddfrank-rules-to-kick-in/ • 13 Federal Reserve. “Regulation Z: Truth in Lending Act.” http://www.federalreserve.gov/boarddocs/supmanual/ cch/til.pdf • 14 Consumer Financial Protection Bureau. “Regulations.” http://www.consumerfinance.gov/regulations/ • 15 Consumer Financial Protection Bureau. “Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z).” http:// www.consumerfinance.gov/regulations/ability-to-repay-and-qualifiedmortgage-standards-under-the-truth-in-lending-act-regulation-z/ • 16 Ibid. • 17 New York Times. Prevost, Lisa. “New Standards for ‘Safe’ Loans.” February 7, 2013. http://www.nytimes.com/2013/02/10/ realestate/mortgages-new-standards-for-safe-loans.html • 18 Wall Street Journal. Timiraos, Nick. “Ten Questions on the New Mortgage Rules.”

January 10, 2013 http://blogs.wsj.com/developments/2013/01/10/tenquestions-on-the-new-mortgage-rules/ • 19 Cassidy Turley Commercial Real Estate Services. “The Fiscal Cliff Impact Scenarios for Commercial Real Estate.” December 2012. http://www.cassidyturley.com/Portals/0/ Research/Fiscal%20Cliff%20Report.pdf • 20 U.S. National Debt Clock. February 2012. http://www.usdebtclock.org/ • 21 Cassidy Turley Commercial Real Estate Services. “The Fiscal Cliff Impact Scenarios for Commercial Real Estate.” December 2012. http://www.cassidyturley.com/ Portals/0/Research/Fiscal%20Cliff%20Report.pdf • 22 New York Times.

Topics: Federal Budget. February 14, 2013 http://topics.nytimes.com/top/ reference/timestopics/subjects/f/federal_budget_us/index.html?8qa.

• 23 Cassidy Turley Commercial Real Estate Services. “The Fiscal Cliff Impact Scenarios for Commercial Real Estate.” December 2012. http:// www.cassidyturley.com/Portals/0/Research/Fiscal%20Cliff%20Report. pdf • 24 Ibid. • 25 Washington Post. Khimm, Suzy. “Your fiscal cliff deal cheat sheet.” December 31, 2012 • 26 New York Times. Shear, Michael & Weisman, Jonathan. “As Cuts Arrive, Parties Pledge to Call Off Budget Wars.” March 1, 2013. http://www.nytimes.com/2013/03/02/ us/politics/obama-meets-with-congress-leaders-as-spending-cuts-near. html?pagewanted=all&_r=0 • 27 Bloomberg. Detrixhe, John. “Sequester Is ‘Speed Bump’ for Economy, Princeton’s Blinder Says.” February 26, 2013. http://www.bloomberg.com/news/print/2013-02-26/sequester-isspeed-bump-for-economy-princeton-s-blinder-says.html • 28 Financial Times. Luce, Edward. “A taste for mutually assured destruction.”

March 3, 2013. http://www.ft.com/cms/s/0/07184d86-81cf-11e2-b05000144feabdc0.html#ixzz2NVwgHruf • 29 New York Times. Appelbaum, Binyamin & Dash, Eric. “S.& P. Downgrades Debt Rating of U.S. for the First Time.” August 5, 2011. http://www.nytimes.com/2011/08/06/ business/us-debt-downgraded-by-sp.html http://www.nytimes. com/2011/08/06/business/us-debt-downgraded-by-sp.html?_r=0 • 30 New York Times. Appelbaum, Binyamin & Dash, Eric. “U.S. Growth Halted as Federal Spending Fell in 4th Quarter.” January 30, 2013.

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http://www.nytimes.com/2013/01/31/business/economy/us-economyunexpectedly-contracted-in-fourth-quarter.html?_r=0 • 31 New York Times. Eavis, Peter. “As Fears Recede, Dow Industrials Hit a Milestone.”

March 5, 2013 http://www.nytimes.com/2013/03/06/business/dailystock-market-activity.html?pagewanted=all • 32 Ibid. • 33 New York Times. “Unemployment at 4-Year Low as U.S. Hiring Gains Steam.”

Schwartz, Nelson & Appelbaum, Binyamin. March 8, 2013. http://www. nytimes.com/2013/03/09/business/economy/us-added-236000-jobsin-february.html?pagewanted=all • 34 CNBC. “‘Fiscal Cliff’ Deal Favors Housing Recovery.” Olick, Diana. January 2, 2013 http://www.cnbc. com/id/100349018/039Fiscal_Cliff039_Deal_Favors_Housing_Recovery • 35 Cassidy Turley Commercial Real Estate Services. “The Fiscal Cliff Impact Scenarios for Commercial Real Estate.” December 2012. http:// www.cassidyturley.com/Portals/0/Research/Fiscal%20Cliff%20Report. pdf • 36 Ibid. • 37 Urban Land Institute, PWC. “Emerging Trends in Real Estate: 2013.” http://www.pwc.com/us/en/asset-management/realestate/publications/emerging-trends-in-real-estate-2013.jhtml • 38 CNN Money. “Housing to drive economic growth (finally!).” Chris Isidore, January 27, 2013. http://money.cnn.com/2013/01/27/news/economy/ housing-economic-growth/index.html • 39 Businessweek. Buhayar, Noah.

“Berkshire Extends Housing Bet With Brookfield Venture.” November 31, 2012. http://www.businessweek.com/news/2012-10-31/berkshire-extendshousing-bet-with-brookfield-venture. china—no hard landing (rise of the dragon): 1 Tom Orlik, “Charting China’s Economy: The Fourth Quarter,” Wall Street Journal, January 18, 2013. • 2 HSBC China Manufacturing PMI, February 1, 2013: http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease. aspx?ID=10652 (accessed March 31, 2013) • 3 “Manufacturing PMI starts 2013 on two-year high,” January 24, 2013: http://www.markit. com • 4 “Rebar Climbs to Seven-Month High as China Manufacturing Expands,” January 31, 2013: http://www.bloomberg.com/news/2013-0201/rebar-climbs-to-seven-month-high-as-china-manufacturing-expands. html (accessed March 31, 2013) • 5 China Retail Sales. http://www. tradingeconomics.com/ (accessed March 31, 2013) • 6 Aaron Back, “China Exports Elevate Trade Surplus,” Wall Street Journal, January 10, 2013. • 7 National Bureau of Statistics of China: www.stats. gov.cn/english (accessed March 31, 2013) • 8 Tom Orlik, “Charting China’s Economy,” Wall Street Journal, January 18, 2013. • 9 China Monetary Policy Report, Quarter Two: http://www.pbc.gov.cn/publish/ english/3667/index.html, 10 (accessed March 31, 2013) • 10 Goldman Sachs Asset Management (GSAM), “Viewpoints from Chairman Jim O’Neill,” February 11, 2013: http://www.goldmansachs.com/gsam/ worldwide/index.html (accessed March 31, 2013) • 11 Tom Orlik, Bob Davis, and Esther Fung, “China Moves to Temper Growth—Property Bubble Is a Key Concern,” Wall Street Journal, March 5, 2013 • 12 Ibid.

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