American finance

Still bleeding

Fannie, Freddie and Lehman ensure August is anything but quiet

WITH blood stocks in New York perilously low, health officials in the city this month issued an emergency appeal for donations. The lifeblood of financial institutions—confidence—is in equally short supply. Five months after the Bear Stearns debacle, and a month after America’s Treasury unveiled unprecedented measures to support the mortgage market, some whose share prices had hinted at recuperation only a couple of weeks ago are once again looking dangerously anaemic.

At the top of the critical list are Fannie Mae and Freddie Mac. The quasi-private mortgage agencies are in danger of being overwhelmed by losses on their holdings of mortgages and mortgage-backed securities (MBS). Ajay Rajadhyaksha of Barclays Capital estimates that Freddie’s balance-sheet has a negative value of at least $20 billion when marked at market prices; Fannie is $3 billion in the red. Both saw their share prices fall by more than 20% on Monday August 18th as the odds of government intervention that wiped out existing shareholders shortened.

Loss of faith in the firms’ equity is one thing, ebbing confidence in their vast pile of debt altogether scarier. Spreads on the $1.5 trillion of paper issued on their own behalf have widened significantly. A five-year issue by Freddie on Tuesday sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade. As recently as May, Freddie had found takers at 0.69 points over treasuries.

A sudden pullback by overseas investors is largely to blame. Foreigners, mostly Asian central banks and funds, hold 35-40% of the mortgage agencies’ total debt. They continued to be avid buyers this year, but their appetite waned dramatically in the first half of August. American money managers have taken up the slack, but they too are becoming twitchy, according to a market participant.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks. The spread on the securities has risen to around 2.2 percentage points over government bonds, even wider than it was during March’s turmoil (after adjusting for today’s lower volatility). This has helped to push up interest rates on the “conforming” mortgages that Fannie and Freddie buy or guarantee, at a time when private finance has slowed to a trickle.

The banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success—even to the point of artificially boosting demand through deals known as “switches”. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise. If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin. A recent $3.5 billion issue by Fannie was helped along by “very significant” amounts of switching, says one banker involved in it. With a quarter of the agencies’ debt due to mature in less than a year, those charged with peddling it will have their work cut out—especially if the Asian investors continue to be put off by unkind headlines.

This is not what Hank Paulson, America’s treasury secretary, envisaged last month when he announced an emergency plan to rescue the twins. By pledging to invest in them if needed, he had hoped to calm markets and thus reduce the likelihood of a bail-out. That gamble looks ever less likely to pay off, however.

If a government recapitalisation does prove necessary, the treasury is likely to take one of two routes: a preferred-stock investment that allows the agencies to raise more capital of their own, or nationalisation through a common-equity injection that leaves current owners with nothing, and thus offers the taxpayer a better deal. Jeffrey Lacker, head of the Richmond Federal Reserve, this week threw his weight behind the second option.

This comes against an increasingly bleak backdrop. Lehman Brothers, the smallest of the four remaining full-service investment banks, is still struggling to persuade the stockmarket, and its clients, that it has a future on its own. Faced with another hefty quarterly loss, it is shopping both its worst assets (a toxic commercial-mortgage portfolio) and its best (Neuberger Berman, a fund manager). Selling a chunk of Neuberger would raise much-needed funds, but it would also leave Lehman looking far less diversified and less stable than it would like.

This week Goldman Sachs, the only investment bank still in decent shape, cut profit forecasts for all of its main capital-market rivals, including Lehman, citing the need for further write-downs and a drought in key business lines. (Some analysts had cut their Goldman forecasts the week before.) It also released a scathing report on American International Group, putting its losses from mortgage-related swaps at up to $20 billion, and even suggesting the giant insurer could suffer an “impairment of counterparty confidence”. The rate at which big banks lend to each other, meanwhile, hit a two-month high. One of them may go bust in coming months, mused Kenneth Rogoff, the IMF’s former chief economist, adding his name to the lengthening list of those who think the worst is yet to come. Given what has already been endured, that is a blood-curdling thought.

Wall Street gets a boost from rise in oil prices

By Herbert Lash

NEW YORK: Oil prices rose on Wednesday after Russia snapped at a U.S. missile shield agreement with Poland, while a gloomy economic outlook outside the United States helped the dollar resume a march toward 2008 peaks.

U.S. stocks gained on a rise in energy shares and strong results from Hewlett-Packard, raising hope that demand abroad would support technology spending.

U.S. government debt prices rallied in a bid driven by worries about the American mortgage finance giants Fannie Mae and Freddie Mac, but global stocks shrugged off those concerns to move higher.

Oil rose slightly after Russia's angry response to the U.S.-Polish accord raised the threat of a supply disruption from the huge energy producer.

The jump in oil reversed losses that were triggered by a U.S. government report showing the biggest weekly increase in U.S. crude inventories since 2001 because of a rebound in imports delayed by Tropical Storm Edouard.

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Financial stocks rebounded after Tuesday's sell-off, helping lift along with energy shares the Dow and S&P 500.

"Going into the day some reasonably good earnings gave us a positive bias, and also it seems to me that the commodity stocks, which have been pretty beaten up, are having a very strong rebound," said Eric Kuby, chief investment officer at North Star Investment Management in Chicago.

Uncertainty surrounding a potential bailout by the U.S. Treasury of Fannie and Freddie kept investors on edge.

Freddie stock slumped nearly 22 percent to $3.25, the lowest since 1990, and Fannie shares slid 27 percent to $4.40, the lowest since 1988.

Investors fear a collapse of Fannie and Freddie could add to risks of an already battered financial system, potentially exacerbating the U.S. housing slump and global credit crisis.

The Dow Jones industrial average rose 55.20 points, or 0.49 percent, to close at 11,403.75. The Standard & Poor's 500 index added 6.12 points, or 0.48 percent, at 1,272.81. The Nasdaq composite index gained 1.99 points, or 0.08 percent, at 2,386.35.

Bond market gains were capped by rising stock markets, where investors snapped up shares of technology companies after Hewlett-Packard reported a strong profit and outlook.

HP posted its biggest one-day rise in six months after the computer company said quarterly profit rose by 14 percent, raising hope that overseas demand would support technology spending even as the U.S. economy slows.

HP shares rose 5.7 percent to $46.16.

European stocks added to gains in late trading, propelled by a rally in heavyweight energy and mining stocks. Recently battered banking shares also trimmed losses.

Miners Rio Tinto rose 7.4 percent, and BHP Billiton and Kazakhmys each gained 6.7 percent.

Heavyweight oil shares BP, Total and Shell also gained, as oil traded higher for much of the European session, though crude closed lower at the end.

The pan-European FTSE Eurofirst 300 index ended up 0.5 percent at 1,165.31 points, with commodities the top four percentage gainers on the benchmark.

The dollar index firmed after retreating much of the New York session on Tuesday, as investors took profits following a 2008 high hit earlier that day on global markets.

The dollar was mixed against major currencies. Against the yen, the dollar was down 0.08 percent at ¥109.78.

The euro rose 0.31 percent at $1.4741.

Traders resumed buying the dollar, with some saying the rise was more a result of short-term position adjustment than anything else after nearly two weeks of unbroken gains.

"We're seeing this slightly bid tone in the U.S. dollar, but there's no real direction in the market. It's just uninspiring," said C.J. Gavsie, managing director for foreign exchange sales at BMO Capital Markets in Toronto.

"Nothing has changed fundamentally," and the same concerns about Europe and other economies over the past month continue to undermine non-U.S. dollar currencies, Gavsie added.

Longer-dated euro zone government bonds rebounded with the 10-year futures briefly hitting a fresh 3-month high in another thinly traded session that analysts said exaggerated moves.

But with no major euro zone or U.S. economic data, and little impetus from steadier European and U.S. equities, technical factors were once again the dominant driver.

The benchmark 10-year U.S. Treasury note rose 12/32 to yield 3.80 percent. The 30-year U.S. Treasury bond rose 14/32 to yield 4.45 percent.

U.S. crude futures rose 45 cents to settle at $114.98 a barrel while London Brent rose $1.11 to $114.36 a barrel.

U.S. gold futures ended lower, whipsawed by higher crude prices and a stronger dollar, but analysts said they had yet to see a sign of gold's market bottom.

The December contract for gold settled down 50 cents at $816.30 an ounce in New York.

Most Asian stock markets edged higher, rebounding from a two-year low, as cheap valuations proved irresistable and market chatter increased about fiscal stimulus in China.

The Asia-Pacific index, excluding Japan, rose 1.25 percent, but in Tokyo, the Nikkei share average fell 0.1 percent in a choppy sesssion dragged lower by exporters.

For India's Tech Titans,
Growth Is Waning

By NIRAJ SHETH

NEW DELHI -- India's information-technology industry, the engine of the nation's economic resurgence, is losing steam.

A decade ago, a host of Indian companies -- led by Infosys Technologies Ltd., Wipro Ltd. and Tata Consultancy Services Ltd. -- shot to global prominence by helping fix the "millennium bug" that threatened to crash many of the world's computers at the end of 1999. Often growing at 40% a year or more since, they quickly helped build a global tech-outsourcing industry that has changed how the world does business and how it views India.

Now that growth is slowing sharply. The credit crunch and spending slowdown in the U.S. are hurting the companies' biggest market, while a cheaper dollar shrinks their profits. Longer-term problems are surfacing. Competition is rising from other low-cost nations, ranging from Eastern Europe to the Philippines and Vietnam. And India's own success has raised labor expenses, cutting into the companies' low-cost advantage just as their revenue growth is slowing.

Infosys expanded its corps of software engineers by one-third between 2006 and 2007, adding 15,000 people. Its average salaries are rising 12% a year, and increasingly high turnover is forcing the company to spend more on training. Growth in profits fell to 18% in the most recent fiscal year, which ended March 31, compared with 56% the previous fiscal year. Tata Consultancy Services posted just a 4.9% increase in net profit in its latest quarter, compared with 37% in the same period a year earlier. Wipro's earnings growth slowed similarly, to 11.6% in the fiscal year ended March 30, down from 42.3% in the previous year.

The Indian tech industry's trade group, Nasscom, projects revenue to grow at 20% to 25% in coming years -- still heady by the standards of most industries, but barely half the recent rate. "The first round of growth is always easier," Nasscom President Som Mittal said last month. "The next 10 years is going to be different."

To compensate, India's outsourcing giants are trying to pivot into more ambitious -- and in some cases unfamiliar -- enterprises. In a project called "ShoppingTrip360," a team of Infosys engineers is pitching retailers on a wireless-equipped shopping cart that charts the most efficient path through a store based on a consumer's shopping list. Wipro won a contract to help design a water-flow system for the toilets in Airbus's new A380 superjumbo jet. Tata Consultancy Services has set up an "Innovation Lab" in Chennai where, for instance, engineers are trying to develop software that airlines could use to improve their customer service; the idea came from TCS executives' own airline peeves.

The efforts haven't yet been much help to the bottom line. Basic outsourcing remains the overwhelming share of their business -- 84% in the past fiscal year, according to Nasscom. But the revenues of Wipro's product-development unit rose by almost 50% in the past two years combined, to $686 million last year. The Indian tech firms are hoping they can leverage their ties to companies around the world to sell them on new ventures.

"We're in a challenging environment for growth," said S. Ramadorai, chief executive at TCS, India's largest technology company by sales, in an interview in Mumbai. The next opportunities won't be based merely on low-cost labor, he said, but on "innovation and strategy."

The industry's predicament is a rare setback for India's greatest business success story. In some recent years, technology companies have combined to hire more than 300,000 workers to keep up with soaring demand, as large Western companies sought to cut costs by sending back-office work overseas.

The change comes as India's broader economy already is slowing. Economists estimate that growth in gross domestic product will ease to between 7% and 7.5% this fiscal year, after five years of averaging almost 9% annually. The Indian economy depends heavily on service industries for expansion, and technology -- though a small piece of the overall pie -- has been India's fastest-growing sector for several years. It accounted for 4.5% of India's GDP in the year ended March 31, up from 2.5% in 2004. In contrast, agriculture, India's staple, has declined to 17% of GDP from 20% during that period.

The tech boom has especially transformed the southern cities of Bangalore and Hyderabad. American and European architects designed steel-and-glass high rises surrounded by manicured, palm-lined campuses, as a rural, developing region evolved into a driver of the globalization of the technology industry.

Global Phenomenon

Of course, tech outsourcing as a global phenomenon remains relatively new, and India's giants are still well-placed to gain a big share of new work. About 11% of the $1.7 trillion spent on technology world-wide last year was sent to tech outsourcers, according to the industry. The same companies also do outsourcing of back-office operations such as payroll processing, as well as call centers, though recent growth there also is reduced. "There is so much of outsourcing yet to be done," said K.R. Lakshminarayana, chief strategy officer at the Wipro Technologies division. "There is enough head space for all of us."

But snags started appearing two years ago. India's rupee, the currency in which the industry's costs are measured, began appreciating against the dollar. Most of the companies' sales were in dollars, so their revenues were worth relatively less when translated back to rupees. Between June 2006 and earlier this year, the rupee rose 16.4% against the dollar to 39.3 rupees from 47, though it has since given back about half of that gain.

Investment from private-equity firms and venture capitalists in India's smaller technology companies also started drying up, as investors became jittery over a stronger rupee and the U.S. slowdown. In the first half of 2008, such investments fell by 63% from the same period a year earlier, to $151 million, according to Chennai-based research firm Venture Intelligence.

The industry's frantic hiring drained the pool of skilled workers, drove up wages and increased turnover as employees job-hopped for more pay. The attrition rate for employees at Infosys was 13.7%, up from 11.2% in 2006.

To replenish the pool of recruits, India's tech giants are spending more on training and on educational initiatives at Indian universities, efforts that add to their expenses. Infosys sends trainers to nearly 500 colleges to teach engineering-school instructors how to foster discussion and collaboration in classes and rely less on rote memorization. TCS this year is training 1,500 college graduates who studied science to learn computer programming and communication skills, at a center it built for that purpose in Chennai.

The industry's biggest blow came last summer, when the meltdown in the U.S. subprime-mortgage industry and ensuing credit crisis froze new business from global banks and other financial institutions, which bring in close to half of the industry's revenues.

Earlier this year, TCS said two Wall Street banking clients had put a freeze on their tech spending until they could cope with the fallout. The Indian company now says that it expects sales in the banking sector to improve in the coming quarters. But other banks are asking for price reductions.

India's wage inflation, currency appreciation and high labor turnover have also started pushing tech work to smaller competitors in Eastern Europe and the Philippines that don't have the same problems. For example, Siemens AG has moved its in-house customer-service centers away from India. Over the past two years, Siemens has hired 1,500 workers to staff a customer center in Manila, where the company says the spoken English is closer to the American dialect of its U.S. customers. In the Philippines, Siemens says it has a 2.5% monthly turnover rate, compared with the 20% turnover it had in its India call center.

"India is still one place where a cost benefit is possible, but not always as much as it was before," says William McNamara, head of IT strategy for the company's North American office.

All that has added pressure on India's technology companies to find other sources of sales. In a departure from the tech companies' usual reliance on tech services provided at the behest of a customer, they are increasingly developing products on their own, then trying to pitch them to customers.

Engineers at Wipro in Bangalore are building a set-top box for digital-television subscribers that they hope to sell to cable companies. They started working on it two years ago after the U.S. Congress passed legislation mandating a move to digital cable by 2009. Now, the company is shopping its set-top box technology to American cable companies, targeting its cheaper, off-the-shelf box to smaller cable providers that may not want to pay for a fully customized product.

Infosys engineers have designed a cosmetics mirror that turns into an information screen when a radio-tagged lipstick is brought close it, to recommend coordinating colors and products to customers. They got the idea while doing work on inventory-maintenance applications for retailers in Singapore and elsewhere in Southeast Asia, where they learned that Asian shoppers don't trust salespeople to give them advice as much as computers, which are seen as more objective. The company has two pilot projects running in the Asia-Pacific region and is in talks with an American retailer to put some of the gadgets in U.S. stores.

They also are working on "smart shelves" that automatically track which piles of shirts customers have picked up the most often. That way, retailers know when their shirts attract a lot of attention but, for some reason, don't get bought. The company showcases the technologies to interested retailers at a mock apparel store on the company's campus in Bangalore, complete with a working checkout counter and muted classical music playing in the background.

The 'Innovation Lab'

At TCS's "Innovation Lab," the company's top programmers and engineers use experience gathered from working in certain industries to come up with products and services they hope to sell to clients. They've used information collected from TCS's airline clients to analyze passenger complaints and design marketing campaigns aimed at defusing them. One gadget: a radio-tagged pass that passengers only need to swipe at a terminal to check in, instead of manually typing in last names or confirmation codes. They've also developed software for handheld computers that lets the flight staff know frequent flyers' preferences -- if one needs a blindfold to sleep, for example.

Another group at TCS has hired life scientists and pharmacologists to do data analysis on clinical drug trials for pharmaceutical companies pursuing drug approvals from the Food and Drug Administration. They have secured contracts with GlaxoSmithKline PLC and Eli Lilly & Co., and the group is preparing to write applications to the FDA on the companies' behalf.

The tech companies also have been expanding into consulting, where they say revenue per employee is higher than in outsourcing. But they've struggled to break into the market, which is dominated by well-known names such as International Business Machines Corp. and Accenture Ltd., finding many of their own clients prefer to take advice from those companies rather than the Indian ones better known for their outsourcing. In the year ended March 30, TCS's consulting business contributed 3.4% to the company's total revenue -- the same as in the previous fiscal year.

India itself is emerging as a promising market after years when the companies generally sniffed at doing local work in favor of more lucrative and prestigious overseas assignments. One of the biggest recent orders in the industry was a $400 million government contract to build the technology to support India's new electronic passports, which have electronic chips to store information and make them harder to forge. After a 12-month bidding process, TCS won. The company declined to comment on the project, which is yet to be announced officially.

Russian Forces Outline Plans
For Major Military Presence

By JEANNE WHALEN in Moscow and GUY CHAZAN in Sukhumi, Georgia

Russia moved closer to recognizing the independence of two breakaway republics that helped spark the current conflict in Georgia, and outlined plans for a major military presence in and around the contested territories that would further undermine Georgia's sovereignty.

Coming over vociferous objections from the U.S. and Europe, the Russian moves highlight the West's limited leverage over the Kremlin in the current crisis, which escalated earlier this month when Russia sent troops into Georgia.

Thomas Dworzak for The Wall Street Journal

Humanitarian aid is distributed in Tkviabi, Georgia, under the supervision of several Russian soldiers.

Russian legislators on Wednesday said they expect the Kremlin-controlled parliament to recognize the independence of South Ossetia and Abkhazia, two pro-Russian republics that have long wished to break away from Georgia. Both houses of Russia's parliament are likely to hold special sessions early next week at which the independence issue could be discussed, legislators said.

A senior Russian general, meanwhile, said Russian troops are setting up a "buffer zone" around South Ossetia with eight military posts on the territory of Georgian itself. Russia's military also wants to enforce a no-fly zone over the area for Georgian planes, Anatoly Nogovitsyn, deputy head of Russia's General Staff, said at a news briefing. Georgian authorities, meanwhile, reported that Russian forces are building what appears to be a permanent checkpoint outside the strategically important Black Sea port of Poti.

Georgian Deputy Defense Minister Batu Kutelia called Russia's buffer-zone plans a "totally illegal and illegitimate move" that would violate a peace plan Russia and Georgia signed last week.

"What they are striving to do is by military means to achieve a political goal—to paralyze and asphyxiate the country," he said. "This is not a military or peacekeeping move, it's about destroying the sovereignty of a neighboring country."

Russia has long stationed peace-keeping troops in South Ossetia and Abkhazia but earlier this month sent in thousands more after Georgian forces attacked South Ossetia. Moscow signed a French-sponsored peace deal last week, but so far has been slow to fulfill its provisions calling for troop withdrawal.

Recognizing the independence of South Ossetia and Abkhazia independent republics could deepen Russia's isolation, since few other nations are likely to follow. But it would free Russia to keep as many troops as it likes in the regions, and to build more permanent military bases there.

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Konstantin Zatulin, a senior legislator from the pro-Kremlin United Russia party, said Moscow should keep at least 3,000 troops permanently deployed in each of the separatists republics. He said about 15,000 are in Georgia now.

Russia in the past has hesitated to recognize the republics as independent, in part because it didn't want to be the only country to do so, he noted.

But Georgia's invasion of South Ossetia this month has left Russia no choice, he said, adding that he doesn't "have any doubts" that parliament will pass such a decision. He said he believed Belarus and some of Russia's allies in Central Asia may also decide to back independence for the republics.

Reiterating past bids, Abkhazia's parliament on Wednesday again asked Russia to recognize its independence.

"After the blood that has been shed in South Ossetia, we are once more convinced that we cannot live together with Georgia," Sergei Shamba, Abkhazia's foreign minister, said in an interview in Sukhumi Wednesday.

He said that Russia earlier this year had about 3,000 peacekeepers in Abkhazia, but this month increased its total presence in the region to 9,000 troops. "I don't think we'll continue to have 9,000 Russian troops in Abkhazia, but we certainly want there to be a sufficient number to protect us from any attack by Georgia," he said.

European Pressphoto Agency

A Russian tank passes by a huge portrait of Russian prime minister Vladimir Putin as it passes through Tskhinvali, South Ossetia, Georgia.

M. Shamba added that Abkhazia would like Russian troops to take over two military bases that the Soviets abandoned in the early 1990s, including a major port at Ocamcire.

Declaring Abkhazia and South Ossetia independent from Georgia would mark a major turnaround for Russia. In February, as the U.S. considered recognizing Kosovo's independence, then-president Vladimir Putin said Russians wouldn't "ape" the West and do the same for Georgia's breakaway republics. "If someone makes a bad, illegal decision, it doesn't mean we have to do the same," he said.

If Russia undermines Georgia's territorial integrity by recognizing the provinces, the European Union would obviously declare its discontent, EU spokesman Martin Selmayr said. "We can't send stormtroopers, but we have a trade and economic policy we can discuss. We are an economic force," he said.

The EU's apparent last line of leverage is still an emergency summit French President Nicolas Sarkozy says he could call in early September to discuss ways of punishing Russia, including withdrawing support for Moscow's World Trade Organization membership or pulling out of trade and investment treaty negotiations.

The EU would be unanimous in condemning Russian recognition of the provinces, EU officials said. "International law says it's insufficient for one state to simply recognize another," said Vahur Soosaar, an Estonian official in Brussels. "There are rules. There has to be a wide consensus."