Boston College Financial, Summer 2013

Thinking Broadlyon ROI:

Social, Environmental, and Global Perspectives

Financialwww.bc.edu/carroll

Vol. 8 | Summer 2013carroll school of management

written, edited, and managed by graduate students

the center for asset management presents

Social Impact Investing— A Maturing Asset Class

Latin America Hedge Funds Industry— A Nascent Alternative

The United States Shale Gas Revolution

2

11

15

2

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 stu-dents 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 invest-ing 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 regula-tory 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 reader-ship. This magazine not only has an important impact on our students’ careers but also enhances the reputation of the Car-roll School’s graduate programs and allows students to display their academic development to the Boston College community.

Alan Marcus, PhDMario J. Gabelli Endowed Professorship Professor, Finance Department

Hassan Tehranian, PhDGriffith Family Millennium Chair Professor & Chairperson, Finance Department

FinancialSummer 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

[email protected] 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.

Boston College Financial is distributed free

of charge, and is accessible online at

www.bc.edu/gfa

1

Boston College Financial

8

11 19

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) by debashis das

Contents

22

2

social impact investing— a maturing asset classBy Sumayya Essack

The investment world is abuzz these days with rising interest in social impact investing. A growing social consciousness and emphasis on corporate social re-

sponsibility 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 in-vesting as “investments made into companies, organizations, and funds with the intention to generate measurable social

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 with-in them the concepts of crowd-sourced funds, foundation grants, venture philanthropy, and both for-profit and non-profit 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 so-cial sector.

3


the need for new solutions

Governments are struggling to ef-fectively 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 mon-ey 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 ef-fectively to address social needs. Entre-preneurs can find creative and innova-tive ways to address needs, but their ability depends on funding. For exam-ple, 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, im-pact investing has highlighted the fact

that addressing needs through com-mercial enterprises makes good sense.5

A 2013 survey report by the Global Impact Investing Network (GIIN) and J.P. Morgan expects investors to com-mit $9 billion of impact investments in 2013, a 12.5 percent increase over the $8 billion committed in 2012.6 A 2011 re-port by the same organizations predict-ed about nearly $1 trillion in the next decade, and last year Credit Suisse af-firmed the $1 trillion opportunity.7 This staggering number does use a broad definition, as much of impact investing includes investments in more tradition-al businesses in the developing world, such as real estate and shopping malls.8 The broad definition draws attention to the growing role of impact invest-ing. 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 lu-crative and more challenging.9

social impact bondsOne 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 interven-tions.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 tradi-tional method of paying for program-ming up front (which may or may not have the intended results), the govern-ment pays at the conclusion of the con-tract 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 (deter-mined by a third-party evaluator with agreed-upon measures), the govern-ment 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 pay-ing for an ineffective program. Some tout the SIB as reducing government inefficiencies, but others are more cau-tious, 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 re-cidivism (defined as rearrest, reconvic-tion, or return to prison with or with-out a new sentence within three years of a prisoner’s release).13 If successful, investors’ return will be up to 13 per-cent. Goldman Sachs is the investor, with $7.4 million of their $9.6 million investment backed by Bloomberg Phi-lanthropies.14

In spite of the term, SIBs aren’t ex-actly 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 out-come is not achieved. Some SIBs are working partial guarantees into the contracts, such as the 2012 social im-pact bond in New York City that is part-ly backed by Bloomberg Philanthropies. Other contracts include sliding-scale agreements, which provide a higher re-turn for outcomes that surpass a mini-mum threshold.

Social impact bonds are not consid-

Chart 1: Impact Investing in the Context of Desired Outcomes14

Pureprofit-maximization

quadrant

Low social impact & low financial return

quadrant

Purephilanthropy

quadrant

Social Impact

Fina

ncia

l Ret

urn

Low High

Low

High

Financial First InvestorsPrioritize

financial returns oversocial impact

Impact FirstInvestorsPrioritize

social impact over financial returns

Intersection of maximum

social impact and financial returns

Intersection of attractive

social impact and financial returns

Impact investingquadrant

figure 1impact investing in the context of desired outcomes2

4

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 lon-ger (often three to seven years) time-frame 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 chal-lenges in becoming an established asset class. A clear one is the tension between the dual emphases on social return ver-sus financial return. Emphasizing the financial return as the primary goal rather than solving social problems ne-gates the point of developing these in-novative 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 fi-nancial return, even for those who are primarily driven by impact. The lan-guage of impact investing invariably emphasizes helping people over finan-cial gain, which makes traditional in-vestors wary. Ideologically, investing is about obtaining the highest return pos-sible, 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 es-tablished 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 sig-nificant funding needed to grow can be difficult to find, as many investors

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

Organizations serving the developing world face challenges such as weak in-frastructure, the difficulty of attracting talent, and poor supply chains. Such obstacles translate into higher costs and risks. The result, according to the Stan-ford Social Innovation Review, is that in-vestors 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 invest-ing 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 inves-tors.19 Enterprise philanthropy, which is grant-making that also includes hands-on support, could pick up the slack, but this is resource-intensive and is not yet large enough to address demand.20

maturing sectorPerhaps one way to draw capital in

from the sidelines is to provide stan-dardized analytics and ratings. This is exactly what the GIIRS Ratings & Ana-lytics system, launched in 2011 at the Clinton Global Initiative, is designed to provide. (GIIRS, pronounced “gears,” stands for Global Impact Investing Rat-ing 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 en-vironmental impact of developed and emerging market companies and funds with a ratings and analytics approach analogous to Morningstar investment rankings and Capital IQ financial ana-lytics.”21 Data is self-reported by compa-nies and verified by Deloitte & Touche. So far, there are over 300 rated compa-nies and 66 funds that have committed to being rated.22

The system, meant to accelerate the

growth of impact investing, provides in-vestors 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 invest-ments 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 report-ed that “their impact investment port-folio performance is meeting or exceed-ing 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 unde-niable. 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 in-vesting’s challenge going forward is to align itself with traditional investment enough to attract capital while still de-fining realistic expectations. There is a risk that the capital the sector attracts will view social impact as secondary. With that said, investors must under-stand that this is a different type of in-vestment.

The concept of impact investing is well received overall and has generated much excitement, but its unfamiliar ter-ritory can keep traditional, risk-averse investors from reaching into their pockets.26 In spite of this, the growing societal demand for corporate and gov-ernmental transparency and responsi-bility 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 de-velopment, and we are still figuring out what works.

5


a bungee jump—where stock dividends still prevailBy Terry Y. Zhou

a country where stock dividends prevail

The question was first raised at 2 A.M. on a summer night last year, when a couple of equity analysts fi-nalizing their reports on Chinese stocks began to

complain: “Past year’s EPS have to be adjusted again? For-tunately, 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 per-cent 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 list-ed 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 sim-

ilar, except for their accounting treatment. However, stock dividends have major disadvantages. First, since stock divi-dends 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 ac-count. Due to the limit on the earnings each year, we usually

6

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

Then why are so many Chinese com-panies declaring stock dividends at the cost of additional taxes? The first rea-son 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 Zi-jin Mining (SH.601899) issued their common stock at 0.1 RMB per share, and lots of arguments followed criticiz-ing 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 neg-ative signal that they are setting their initial price low because their company is cheap or less promising. The invis-ible constraint on stock splits forces the companies to resort to costly means to realize their intentions.

Second, an alternative way to real-ize similar results like stock splits is to transfer the reserve into a capital ac-count. However, reserve accounts are usually even more limited than earn-ings. 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 li-quidity or confirmed signal to the mar-ket.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 situa-tion in each of the past 10 years. Exhibit 1 shows the average stock returns from five days before to five days after the ex-dividend 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 be-fore or after the dividend. However, sev-eral 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 Ex-hibit 2, stocks have weaker performance after the stock dividend, with fewer po-sition 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 inves-tors’ 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 mo-mentum 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 perfor-mance following stock dividends.

conclusionIn a market where the shorting of

stock is still not efficient,4 it would be hard to explore such a negative abnor-mal return. But at least, facing the bun-gee, 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 1Data 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.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 SD Error Low High D-‐5 D-‐4 D-‐3 D-‐2 D-‐1 D0 D+1 D+2 D+3 D+4 D+52003 0.001418 -‐0.29% 0.27% 0.07% 1.06% 0.06% 0.03% -‐0.24% -‐1.16% -‐0.94% -‐0.34% 0.00% -‐0.42% -‐0.09%2004 0.001415 -‐0.30% 0.26% -‐0.04% 0.28% 0.20% -‐0.30% -‐0.61% -‐1.33% -‐1.26% -‐0.78% -‐0.34% 0.10% -‐0.33%2005 0.001413 -‐0.30% 0.26% 0.18% 0.89% -‐0.24% 0.12% -‐0.45% -‐2.54% -‐1.22% -‐0.39% -‐0.35% -‐0.16% -‐0.35%2006 0.001409 0.04% 0.59% 0.98% 3.19% 1.22% 1.32% 0.30% -‐1.48% -‐0.06% 0.89% -‐0.34% 0.23% 1.09%2007 0.001407 0.27% 0.82% 2.14% 3.87% 1.37% 0.79% 0.20% -‐0.20% -‐0.70% -‐0.36% -‐0.18% -‐0.34% -‐0.21%2008 0.001406 -‐0.58% -‐0.03% 0.70% 1.39% 0.01% 0.42% -‐0.43% -‐2.43% -‐2.06% -‐0.74% -‐0.46% 0.13% -‐0.56%2009 0.001405 0.11% 0.66% 1.35% 1.72% 0.36% 0.69% -‐0.31% -‐1.03% -‐0.48% 0.37% 0.12% 0.54% 0.36%2010 0.001405 -‐0.15% 0.40% 0.40% 0.69% -‐0.27% 0.39% -‐0.25% -‐0.85% -‐0.99% -‐0.23% 0.02% 0.16% 0.11%2011 0.001400 -‐0.33% 0.22% 0.45% 0.63% 0.11% 0.22% -‐0.42% -‐1.75% -‐1.04% -‐0.39% -‐0.19% -‐0.12% -‐0.10%2012 0.001402 -‐0.27% 0.28% 0.61% 0.62% 0.08% 0.44% -‐0.38% -‐2.12% -‐0.49% -‐0.06% -‐0.30% 0.14% -‐0.15%

Excess Positive ReturnExcess Negative Return

95% confidence interval D-‐5 ~ D+5 Daily Return

7


exhibit 2Data 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:

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).

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2003

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2004

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2005

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2006

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2007

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2008

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2009

-1.00%

-0.50%

0.00%

0.50%

1.00%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2010

-1.00%

-0.50%

0.00%

0.50%

1.00%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2011

-1.00%

-0.50%

0.00%

0.50%

1.00%

D-90 D-60 D-30 D0 D+30 D+60 D+90

2012

8

the extraordinary rise of apple inc. and its impact on the stock marketBy Justin Christian

On 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 be-

ginning 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 re-lease 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, inad-vertently, 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 mu-sic 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 genera-tion. Shoppers flocked to Apple stores in droves to purchase these music players. The success of the iPod helped serve as a

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 consum-ers 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 in-crease 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

9


were also momentum and excitement factors built into the share price from the market. Speculators started to un-derstand Apple’s real opportunity to gain market share and be a threat to competitors in the consumer electron-ics space. Each of the iPhone product launches experienced rapid growth, exceeding 30 percent from one product launch to the next except for one in-stance 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 finan-cial 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 demon-strate Apple’s strong performance dur-ing an utterly dire time in our economy, during the date range between the first iPhone launch and the iPhone 3G, Ap-ple’s stock price increased 41.41 percent while the S&P 500 index fell by 17.55 percent. This is quite a remarkable per-formance 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 be-tween 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 be-tween each product launch from April 3, 2010, to November 2, 2012). This ex-traordinary growth rate of Apple’s stock not only grew more during the iPad era but actually accelerated over shorter

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 Com-posite Index. The commonly used and reported free-floating market capitaliza-tion (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 per-cent 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 recent-ly) in relation to the S&P 500 and NAS-DAQ Composite Indices. Of course, this shouldn’t be surprising given the rapid appreciation of the stock price over the same period of time. The in-crease of Apple’s presence in relation of the S&P 500 should be more scru-tinized. With the release of the iPhone 5 on September 21, 2012, Apple’s mar-ket cap consisted of 5.07 percent of the S&P 500 total market capitalization and 13.81 percent of the NASDAQ Compos-ite 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

table 1apple’s price changes versus the s&p 500

table 2apple’s market value weight on the s&p 500 and nasdaq indices

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.

1 “Apple Drops ‘Computer’ From Corporate Moniker,” last modified January 9, 2007. 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 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-‐billion-‐doesnt-‐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.

Table 1: Apple’s Price Changes versus the S&P 500

Event Date Event AAPL Close

AAPL % Change

S&P 500 Close

S&P 500 % Change

1/9/2007 Company Name Change $91.76 n/a $1,412.11 n/a 6/29/2007 iPhone $120.97 31.83% $1,503.35 6.46% 7/11/2008 iPhone 3G $171.06 41.41% $1,239.49 -17.55% 6/19/2009 iPhone 3GS $138.25 -19.18% $921.23 -25.68% 4/3/2010 iPad 1st Generation $236.39 70.99% $1,187.44 28.90%

6/24/2010 iPhone 4 $266.63 12.79% $1,073.69 -9.58% 3/11/2011 iPad 2 $348.89 30.85% $1,304.28 21.48%

10/14/2011 iPhone 4S $418.29 19.89% $1,224.58 -6.11% 3/16/2012 iPad 3rd Generation $580.42 38.76% $1,404.17 14.67% 9/21/2012 iPhone 5 $696.91 20.07% $1,460.15 3.99% 11/2/2012 iPad 4th Generation and Mini $574.18 -17.61% $1,414.20 -3.15%

Table 2: Apple’s Market Value Weight on the S&P 500 and Nasdaq Indices

Event Date Event S&P Index Free-float

Weight

S&P Index Free-float Weight %

Change

NASDAQ Index Free-float

Weight

NASDAQ Index Free-float Weight

% Change

1/9/2007 Company Name Change 0.64% 2.09% 6/29/2007 iPhone 0.81% 0.16% 2.64% 0.55% 7/11/2008 iPhone 3G 1.43% 0.62% 4.70% 2.06% 6/19/2009 iPhone 3GS 1.56% 0.13% 4.67% -0.03% 4/3/2010 iPad 1st Generation 2.26% 0.71% 6.50% 1.83%

6/24/2010 iPhone 4 2.57% 0.31% 7.37% 0.88% 3/11/2011 iPad 2 2.79% 0.22% 7.99% 0.61%

10/14/2011 iPhone 4S 3.58% 0.79% 10.00% 2.02% 3/16/2012 iPad 3rd Generation 4.38% 0.80% 12.18% 2.18% 9/21/2012 iPhone 5 5.07% 0.69% 13.81% 1.63% 11/2/2012 iPad 4th Generation and Mini 4.33% -0.74% 12.18% -1.63%

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.

1 “Apple Drops ‘Computer’ From Corporate Moniker,” last modified January 9, 2007. 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 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-‐billion-‐doesnt-‐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.

Table 1: Apple’s Price Changes versus the S&P 500

Event Date Event AAPL Close

AAPL % Change

S&P 500 Close

S&P 500 % Change

1/9/2007 Company Name Change $91.76 n/a $1,412.11 n/a 6/29/2007 iPhone $120.97 31.83% $1,503.35 6.46% 7/11/2008 iPhone 3G $171.06 41.41% $1,239.49 -17.55% 6/19/2009 iPhone 3GS $138.25 -19.18% $921.23 -25.68% 4/3/2010 iPad 1st Generation $236.39 70.99% $1,187.44 28.90%

6/24/2010 iPhone 4 $266.63 12.79% $1,073.69 -9.58% 3/11/2011 iPad 2 $348.89 30.85% $1,304.28 21.48%

10/14/2011 iPhone 4S $418.29 19.89% $1,224.58 -6.11% 3/16/2012 iPad 3rd Generation $580.42 38.76% $1,404.17 14.67% 9/21/2012 iPhone 5 $696.91 20.07% $1,460.15 3.99% 11/2/2012 iPad 4th Generation and Mini $574.18 -17.61% $1,414.20 -3.15%

Table 2: Apple’s Market Value Weight on the S&P 500 and Nasdaq Indices

Event Date Event S&P Index Free-float

Weight

S&P Index Free-float Weight %

Change

NASDAQ Index Free-float

Weight

NASDAQ Index Free-float Weight

% Change

1/9/2007 Company Name Change 0.64% 2.09% 6/29/2007 iPhone 0.81% 0.16% 2.64% 0.55% 7/11/2008 iPhone 3G 1.43% 0.62% 4.70% 2.06% 6/19/2009 iPhone 3GS 1.56% 0.13% 4.67% -0.03% 4/3/2010 iPad 1st Generation 2.26% 0.71% 6.50% 1.83%

6/24/2010 iPhone 4 2.57% 0.31% 7.37% 0.88% 3/11/2011 iPad 2 2.79% 0.22% 7.99% 0.61%

10/14/2011 iPhone 4S 3.58% 0.79% 10.00% 2.02% 3/16/2012 iPad 3rd Generation 4.38% 0.80% 12.18% 2.18% 9/21/2012 iPhone 5 5.07% 0.69% 13.81% 1.63% 11/2/2012 iPad 4th Generation and Mini 4.33% -0.74% 12.18% -1.63%

10

were reliant on Apple. These are truly astonishing numbers.

Lately, Apple’s stock price has sput-tered and stumbled a bit. So what does the future hold for the technology gi-ant? For the final quarter of 2012, Apple recorded one of the largest corporate quarterly earnings ever, with $13.1 bil-lion 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 ana-lysts 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 Corner-stones 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 expecta-tions 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 con-tinues to speed up, the company has to run faster to keep up and maintain its new stock price. The expectations treadmill analogy describes the diffi-culty 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 eventu-ally falter once the treadmill becomes too fast for their ability.

This is the problem that Apple is en-countering. Although Apple continues to deliver enormous profits each quar-ter, the market’s expectations are start-ing to become unrealistic for Apple to meet. History has shown that new prod-

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 re-turn 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 evaluat-ing 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.

chart 1apple inc. stock price and the iphone

chart 2apple inc. stock price and the ipad

chart 3aapl market cap

Chart 1

Chart 2

Chart 3

Chart 1

Chart 2

Chart 3

Chart 1

Chart 2

Chart 3

11


The 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 pe-riod, totaling $58 billion by 2010.

Even though funds based entirely in Latin America or man-aged 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 as-sets they had by the end of 2007 (Figure 2). This is mainly due to numerous advantages the continent offers, like natu-ral 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 non-Latin 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 re-turns 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

latin america hedge funds industry—a nascent alternativeBy Helios De Lamo

1212

A reputable example of a Latin Amer-ican hedge fund is that offered by Gávea Investimentos, which is based in Bra-zil. This particular fund is considered to be highly stable, one of the best op-tions 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 ev-eryone who wants to participate in the fund is able to do so, even those who are willing to commit to a longer term. Con-sidered 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 Tar-pon HG Fund-A, an offshore fund that enjoyed an annualized return of 30 per-cent 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

fund domiciliationThe 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 regu-latory frameworks in the world. More-over, there has not been a single case of fraud in the region, partly because regulations require independent (third-party) service providers and external risk assessment for domestic hedge funds.5 As shown in Figure 3, the confi-dence 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

that when considering the amount of assets under management, it is clear that the benefits of offshore domicilia-tion 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 com-monly use offshore vehicles are Argen-tina, 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. Un-surprisingly—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 1industry growth over the yearsSource: Eurekahedge

Source: Eurekahedge

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

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

Source: Eurekahedge

Figure 3: Onshore and offshore industry growth over the years

13


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

Less common options for Latin American funds include Ireland, Ber-muda, the Bahamas, and Luxembourg. Even though there is a growing interest in jurisdictions such as Ireland or Lux-embourg, they are still expensive and too heavily regulated for Latin Ameri-can managers. In some cases, there might be some advantages in creating onshore vehicles. However, this is not the rule but rather the exception.7

regulation: recent developments in the region

In Brazil, the Securities Commis-sion recently passed new rules regard-ing the organization and management of funds through the creation of the Fundo de Investimento em Participa-coes, 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 gov-ernment 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 restric-tions on foreign investors, especially in respect to the registration of foreign

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

future of the industryIn light of Mexico’s and the Andean

region’s strong macro numbers and greatly improved equities markets, re-gional equity funds are adjusting their allocations to focus especially on in-ternal growth and domestic consump-tion. Mexican equities are particularly strong, similar to the Brazilian market of a decade ago. The Peruvian equi-ties market has made great strides, though it continues to be dominated by commodities companies. In Brazil, the education sector offers the best op-portunities in terms of earnings growth in an otherwise sluggish market. Latin American equity funds have long fo-

cused mostly on Brazilian equities. Bra-zil’s BM&F Bovespa is the largest stock market in the region and the third larg-est in the world.9

However, three of Latin America’s smaller but most dynamic econo-mies—Chile, Colombia, and Peru—want to combine forces to offer a viable alternative and open up their markets to local and international investors. These countries are moving ahead with a project to join a common regional stock exchange. Mercado Integrado Latinoamericano, (MILA)—Integrated Latin American Market—which they hope can compete with Latin America’s biggest capital markets for foreign in-vestors by offering a larger supply of securities and issuers and also larger sources of funding.10

“… 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.”

figure 3onshore and offshore industry growth over the yearsSource: Eurekahedge

Source: Eurekahedge

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-victor-hugo-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/hedge-funds/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-latams-growing-hedge-fund-sector (accessed February 24, 2013) 5 http://www.eurekahedge.com/database/latinamericanhedgefunddirectory.asp (accessed February 24, 2013)

14

While the credit crunch is still a problem for much of the middle class, it ap-

pears 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 high-end luxury rental market is thriving, as an increased number of prospective buyers are waiting out the current eco-nomic state in the hopes of better con-ditions 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 An-geles luxury rentals are increasing by 5 to 10 percent each year. Particularly in NYC, where inventory of such proper-ties is low and demand is high, unso-licited rental offers to properties being listed for sale have become common-place. Players in the market are also capitalizing on this trend and purchas-ing luxury apartments and condos with the sole purpose of renting them out.

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 liq-uid while at the same time maintain-ing their high quality of life—all of this while realizing a minimal amount of risk. For these investors, lessening ex-posure in an uncertain marketplace is key; once the market returns to a more stable state, these same people are like-ly to return to owning property. For the time being, however, luxury rentals of-fer 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. cit-ies 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 ac-tivity in this sector and an even higher proportion of wealthy individuals enter-ing the space in the near future.

the luxury rental market is thriving despite uncertain recovery By Mike Vitanza

15


the united states shale gas revolutionBy Debashis Das and Tracy To

The 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 in-dustries including electric power generation utilities, chemi-cal 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 un-employment 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 regionsThe 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 re-serves 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 estimat-ed 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

16

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 sec-ond 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 concen-trated 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 processToday, 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 cre-ate fractures in the rock. The chemical additives include sodi-um 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 fractur-ing 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

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 sur-face 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 ex-tracted. 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 fluctua-tion, including the state of the economy, the supply and de-mand 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 lead-ing 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. do-mestic 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 con-sists of “proved reserves” and “unproved resources.” Proved reserves of crude oil and natural gas are the estimated vol-umes that are expected to be produced with certainty un-der 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 re-serves and ultimately contribute to the production figures.

figure 1hydraulic fracturing processGraphic by AJ Granberg

figure 2u.s. dry natural gas production historical data (1930–2013) Source: U.S. Energy Information Administration

17


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) ex-pects that natural gas consumption in the United States will average around 70 Bcf/d in both 2013 and 2014. Closer-to-average 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 per-cent 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, sur-passing the previous record production levels from the early 1970s. The increase in production is attributed to various fac-tors, including more cost-efficient drilling techniques, such as horizontal drilling, which have resulted in an increased out-put 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 produc-tion, 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 Carib-bean, 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 sec-tors 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 criti-cal role in the supply-and-demand equation and helps main-tain 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 ad-ditional 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 Novem-ber 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 natu-ral gas prices, specifically the prices of crude oil and coal. Be-tween 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 de-mand 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 politi-cians 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 adopt-ing natural gas-based vehicles, although the number is cur-rently not large.

export and import landscapeCheniere Energy is the first company to get approval from

the Federal Energy Regulatory Commission (FERC) for the

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

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

18

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 ap-proval 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, Che-niere 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.

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 produc-tion process can create an environmental impact if proper pre-cautions are not employed. Above all, the potential water im-pact 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 un-derground aquifers may be contaminated on contact with the fluids. Once the fracturing is completed, the hydraulic fractur-ing wastewater is withdrawn and returned to the surface. In addition to the fracturing fluid, the flowback fluid can contain

natural gas, high levels of total dissolved solids (chemicals), metals, and naturally occurring radioactive materials.11 Typi-cally, 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, transporta-tion 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 be-tween the magnitude of the largest earthquake and the total volume of wastewater injection.

While FracFocus, the national hydraulic fracturing chemi-cal 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 or-ganic compounds (VOCs), hazardous air pollutants (HAPs), and methane are associated with the wastewater returning to the surface.

conclusionShale 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, improve-ment in drilling techniques and technologies, and stalled eco-nomic activity, and for various other reasons including sea-sonal 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 indus-tries, including chemical, steel, fertilizer, and power genera-tion 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 es-timates 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 abun-dance 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.

figure 5u.s. annual average natural gas net imports (1973–2011)Source: U.S. Energy Information Administration

billion cubic feet per day

19


the financial service industry’s use of technologyBy Shyam Eati

Citigroup is the largest company in financial services, yet it has just 3 percent of market share. The frag-mented 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 transac-tions such as bill payments, balance enquiries, and account transfers and let banks focus on value-generating operations such as building clients, improving efficiency, and invest-ment 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 en-sure 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 cus-tomers with data, tools, and analytics. Customers today have greater transparency of information, which translates to im-proved portfolio management and reduced risk. To better un-derstand 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 diversi-fication to optimize their positions. Traditionally, investors

20

depended on mutual fund advisors for asset management. Today, many asset management firms have created com-plex software applications to model portfolio risk and return based on fi-nancial 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, in-vestors trade using investment tools like the Active Trader Pro Platforms from Fidelity Investments, which pro-vide customers with real-time market information and let them trade equi-ties, options, and mutual funds. These customer-centric tools benefit firms through focused marketing, timely ad-vice, 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 alloca-tions 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 cus-tomer portfolios. Advisors rebalance customers’ portfolios using tools such as Fidelity’s WealthCentral platform for registered investment advisors (RIAs). Financial companies now have rebal-ancing tools for individual investors, which can be used to customize portfo-lios. Traditionally, portfolio-rebalancing methods have balanced target alloca-tions 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 pro-gramming 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 re-balancing decision made today affects the rebalancing decisions available in

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

Investors also want their 401(k) plans to generate a continuous stream of in-come post-retirement; however, this is possible only by means of an early planned investment. Many financial services firms are now educating cus-tomers 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 in-vestor. 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 retire-ment 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. How-ever, technology alone can’t create super investment strategies for individuals. Those familiar with both technology and investment strategies are best pre-pared 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. Finan-cial 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 rebalanc-ing 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 allo-cation 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 fi-nancial industry is able to achieve tech-nology prowess through cheaper com-puting 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 finan-cial instruments. These financial in-struments have become profitable, and so budgets for each instrument have increased significantly or firms started seeking more esoteric swaps, like col-lateral debt obligations (as in the case of JPMorgan Chase’s $2 billion loss). Highly powerful financial systems cre-ated financial markets that were diffi-cult to unwind and eventually resulted in events such as the creation and de-struction 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 In-dustrial Average to plunge about 1,000 points (9 percent).

21


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 pro-cesses efficient but also enabled firms to function according to the regula-tions set by government agencies. For example, to comply with SEC regula-tions, financial firms now have a work-flow management system, where every document or communication from the firm is sent to Financial Industry Regu-latory Authority (FINRA) for review. These technology improvements have enabled institutions to forestall future financial fall down and streamline busi-ness 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 innova-tive and build software products for the future:

• Real-time Information Manage-ment—This refers to collective en-terprise infrastructure that enables capture, storage, management, and distribution of information to various stakeholders. This includes the use of technology such as ser-vice 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 probabi-listic databases are used to make complex models of patterns in real time, like that of consumer behav-iors and preferences.

• Intelligent Agents—These are au-tonomous software programs that offer sophisticated, proactive, and reactive assistance to owners, sup-ported by the emergence of seman-tic web. These software programs become trusted agents in owners’ delegating decisions.

• Semantic Web—Semantic web is a framework of standards that rec-ognizes data separately from the documents that contain them and is able to relate data to actual objec-tives. XML and SAOP data-transfer mechanisms allow data to be easily shared and reused across applica-tions, enterprises, and communi-ties. Web 2.0 features enable Web sites that are participative, social, and collaborative and create two-way 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 de-livered through the Web.

key to the futureTechnology will become an integral

part of the financial industry to pro-cess real-time information and develop strategies on the fly using mathemati-cal 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 be-come 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 ir-regularities.

Data should be used to accurately predict patterns and generate models that can drastically minimize risk expo-sure and open doors to new areas for firms to grow. Dashboards and finan-cial reports should be filled with mean-ingful forward-looking analytical data created by tools that synthesize data at a very granular level. Analysts and tech-nology architects should be able to pres-ent 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 success-fully 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 in-vestment 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 in-novations are helping investment firms and investors, some of the technology innovations have bad outcomes. Tech-nology firms should be able to stop fail-ures 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.

22

the impact of the debt ceiling is unclearBy Christine Grascia

It is inevitable. With the debt ceil-ing avoided and the fiscal cliff talks delayed, it seems that the U.S. gov-

ernment’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 im-pact 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-

ernment is proceeding to make these cuts. So what exactly is being cut? Ac-cording to data from the Pew Analysis of Congressional Budget Office, $454 billion in cuts will be made in govern-ment defense programs—roughly 42 percent of the overall sequester. An-other $294 billion, or 27 percent, will be made in non-defense discretionary programs such as biomedical research, educational support, and housing sup-port 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 mis-cellaneous, 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 seques-tration 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 in-stead will cut back on spending. As the economy experiences slow growth due to the 2008 recession, anything with a negative influence can seriously de-tract from its overall growth.

However, the markets seem to de-pict 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 Washing-ton. Chan’s optimism, in line with the opinions of many others, is further reflected by the falling unemployment rates used to boost consumer confi-dence. These signs are also attributed to the Federal Reserve’s helping hand in campaigning to yield assets while pushing investors into the equity mar-kets. 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 bal-ance 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 pre-dict further into the future, especially

23


as all cuts are not yet made. The lon-ger the sequestration is in effect, the more those effects will be felt. Since the news of government cuts were al-ready advertised, this information was already priced into the market. There-fore, although markets did rise after the sequestration on March 1, this rise could be due to other, entirely unre-lated sources. Another piece to con-sider is how the markets will behave once the Fed decides to drop its mon-etary stimulus. Will its exit strategy be enough to keep the market upright?

Ultimately, it is still too early to as-sume 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 govern-ment 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. gov-ernment to make these changes. Un-fortunately, 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 estateBy Brendan Castricano

BASEL III

Founded 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 Supervi-sion (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 high-quality 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 agree-ments 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 reduc-tions in their negotiations over the debt ceiling and sequestra-

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.

24

downward to 35 percent if the LTV de-creases to below 60 percent. Naturally, this would create strong incentives for traditional mortgages as well as strong disincentives for riskier, nontraditional mortgages.8

Additional rules are also being con-sidered for certain acquisition, develop-ment, and construction (ADC) loans in the commercial real estate sector. Nota-bly, a subset of ADCs called high volatil-ity commercial real estate (HVCRE) as-sets is proposed to receive a risk weight of 150 percent. These are ADC loans where one of the following must be true: (a) the borrower contributed less than 15 percent of the “as completed” appraisal value of the project, (b) the LTV is greater than the designated “ap-plicable maximum supervisory LTV,” (c) the project is not a one-to-four-family residential property, or (d) the borrower contributed the capital deposit after the bank issued the loan funds, and this deposit is not contractually required to remain in place until the project is com-pleted. Similarly to this, a 150 percent weight would be applied to real estate loans on accrual or past 90 days due.9

Ultimately, this is only a small sam-ple of the numerous regulatory rules proposed by the Standard Approach and it has not yet been decided if they will actually go into effect. Nonetheless, in combination with the LCR capital requirements, these proposed reforms have the potential to make a substantial impact on the real estate sector in 2015.

dodd frankIn the aftermath of the 2008 Great

Recession, Congress passed the Dodd-Frank Wall Street Reform and Con-sumer Protection Act. As noted by Ben Protess of the New York Times, this 2,300-page document has produced 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 Vol-cker Rule, separating investment from commercial banks; (b) the creation of

tion. On top of this, a 2011 OECD report calculated that the implementation of Basel III would likely decrease annual gross domestic product (GDP) by 0.05 to 0.15 percent, which could potentially make a difficult situation even worse. 3 In response to this concern, the BCBS announced on January 6, 2013, that they had agreed to a more gradual im-plementation of certain portions of Ba-sel III. The most critical change among these involves the minimum LCR, which is no longer set to take full effect in 2015. Instead, the minimum LCR would be 60 percent of the previously established minimum value in 2015, in-creasing 10 percentage points per year until it reaches 100 percent on January 1, 2019.4 The revisions also include an expanded definition of what qualifies as an HQLA. For example, the minimum requirement for corporate debt securi-ties has been lowered to BBB-, with a 50 percent haircut. Similarly, certain residential mortgage-backed securities rated AA now qualify, with a 25 percent haircut.5

The committee’s 2013 revisions to Basel III reflect an attempt to balance the delicate tradeoff between growth and liquidity for the banking industry and the international economy. In the short to medium term, this will likely fend off the risk of a credit crunch stem-ming directly from the belt-tightening restrictions of the new regulation. This is critical for capital-intensive indus-tries, such as real estate. The commer-cial real estate sector alone is seeking to refinance $300 billion in commercial mortgage-backed securities on an an-nual basis over the next three years.6

However, by 2015 the belt will begin to tighten even further.

In addition to this, another series of Basel III reforms has been proposed to commence in 2015. In June 2012, the Federal Reserve, the FDIC, and the OCC released three notices on pro-posed rulemaking (NPRs) for the Basel III risk-based capital standard. For the real estate sector, the most critical of these proposed rules is the Standard Approach. This series of rules presents a new risk weighting system for vari-ous on- and off-balance sheet assets in smaller institutions with fewer than $250 billion in assets.7

One key proposal from the Standard Approach is for residential mortgages, which would be separated into two risk categories: (1) traditional and (2) non-traditional. Here, a traditional Category 1 mortgage would be characterized by a maximum 30-year duration, regular periodic payments, limited interest-rate increases (2 percent per year and 6 percent total) as well as various pru-dent underwriting practices. Alterna-tively, nontraditional, Category 2 loans would fail to meet the qualifications for the traditional loan or be characterized by junior liens, payments 90 days past due, negative amortization, balloon pay-ments, deferred repayment of principal, and so forth. Additionally, risk weights would be applied as a function of the mortgage’s loan to value (LTV) ratio. As shown in Figure 1, a baseline 100 percent risk level is set for Category 1 mortgages with an LTV of under 90 per-cent. From here, the risk weight could shift upward to 200 percent if the loan becomes Category 2, or it could shift

figure 1Source: Moss-Adams LLP (http://www.communitybankers-wa.org/documents/baselIII_Moss.pdf )

In addition to this, another series of Basel III reforms has been proposed to commence in

2015. In June 2012, the Federal Reserve, the FDIC, and the OCC released three notices on

proposed rulemaking (NPRs) for the Basel III risk-based capital standard. For the real estate

sector, the most critical of these proposed rules is the Standard Approach. This series of rules

presents a new risk weighting system for various on- and off-balance sheet assets in smaller

institutions with fewer than 250 billion in assets.7

One key proposal from the Standard Approach is for residential mortgages, which would

be separated into two risk categories: (1) traditional and (2) nontraditional. Here, a traditional

Category 1 mortgage would be characterized by: a maximum 30 year duration, regular periodic

payments, limited interest-rate increases (2 percent per year and 6 percent total), as well as

various prudent underwriting practices. Alternatively, nontraditional, Category 2 loans would fail

to meet the qualifications for the traditional loan or be characterized by: junior liens, payments

90 days past due, negative amortization, balloon payments, deferred repayment of principal, and

so forth. Additionally, risk weights would be applied as a function of the mortgage’s loan to

value (LTV) ratio. As shown in the appended table, a baseline 100 percent risk level is set for

Category 1 mortgages with an LTV of under 90 percent. From here the risk weight could shift

upward to 200 percent if the loan becomes Category 2, or it could shift downward to 35 percent

if the LTV decreases to below 60 percent. Naturally, this would create strong incentives for

traditional mortgages, as well as strong disincentives for riskier, nontraditional mortgages.8

25


the Consumer Financial Protection Bureau; (c) the creation of the Finan-cial Stability Oversight Council, which can recommend that companies that get too big be regulated by the Federal Reserve; (d) the creation of a clearing-house where credit default swaps will be traded, regulated, and observed by the CFTC; and (e) the requirement that hedge funds register with the SEC and provide certain trade data.10

Dodd-Frank calls for 400 new rules to be written by various agencies, such as the SEC and CFPB. However, as of March 6, 2013, only a third of these rules have been finalized.11 Amidst this process, some agencies have had more success than others. For example, the CFTC has completed nearly 80 per-cent of its rules. CFTC Chairman Gary Gensler has stated, “We’ve gone from a general law to the specific rules to the specific rollout.…Next year (2013) is about one word: implementation.”12

For the real estate sector, the most significant new rules stem from the newly created Consumer Financial Protection Bureau (CFPB) as it over-hauls the mortgage market. Following the requirements of Dodd-Frank, the bureau has been tasked with rulemak-ing authority over the 1968 Truth in Lending Act. The act was created in order to establish clear standards for lenders communicating loan terms and

costs to their customers. The specific regulations that actually implement this statute are known as “Regulation Z,” but the two terms are often used interchangeably.13 In January 2013, CFPB published five new rules amend-ing Regulation Z. These changes cover a wide range of areas, from new loan servicing standards to new appraisal re-quirements for high-risk mortgages to new escrow requirements.14

The most significant of these amend-ments to Regulation Z is the new “Ability-to-Repay” rule. This requires lenders to look at consumers’ financial information in order to verify that they have the capacity to repay their mort-gage. More specifically, the loan officer will need to obtain reliable documen-tation (W-2, pay stub, etc.) on the fol-lowing eight types of information: (1) current income, or assets, (2) current employment status, (3) credit history, (4) monthly payment for the mortgage, (5) monthly payments on other cur-rent mortgage loans, (6) monthly pay-ments on other mortgage-related ex-penses (e.g., taxes), (7) other debts, (8) monthly debt-to-income ratio as well as monthly income after debts are paid. Furthermore, the consumer’s ability to repay cannot be determined through teaser rates. Instead, lenders will have to consider the highest interest rate the consumer will pay within the first five

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. Further-more, QMs will require that the con-sumers’ 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 require-ments, 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 regu-lation might tighten access to credit and inhibit competition.17 As noted by a Wall Street Journal reporter, many

figure 2u.s. cmbs issuanceSource: Commercial Mortgage Alert.

figure 3u.s. single-family building permitsSource: Moody’s Economy.com

60 Emerging Trends in Real Estate® 2013

StrengthsDown for so long in an excruciating bump-along-the-bottom trough, housing finally advances and markets gain some real traction, although struggling along the way. In a classic buy-ers’ market, institutional managers and savvy high-net-worth investors take the plunge with conviction. They opportunisti-cally try a “pioneering” gambit, raising hundreds of millions of dollars in capital for funds to vacuum up single-family product at depressed prices, rent it for income, and eventually sell in any full-bore recovery. Smaller players have already put together localized ventures, and prices should firm up further in mar-kets that are drawing attention. Some prime neighborhoods in affluent enclaves escaped much damage and register modest gains, while “accelerating prices” for condominiums in “bet-ter” markets like south Florida could be “a leading indicator for recovery.” Skyrocketing apartment rents in certain infill and gate-way markets also provide incentives to buy. Banks finally allow more short sales and convert delinquent owners into renters, helping dent the inventory of problem loans, which weighs down many commodity markets.

WeaknessesEven with relatively low mortgage rates, home sales have lan-guished 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 mar-ket; they simply cannot afford to own homes. Others just do not want to venture the risk or deal with homeownership headaches,

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, mean-while, remain underwater on mortgages worth more than actual house values. Any distressed selling will continue to dampen prices—and what happens if interest rates increase?

DevelopmentNew construction levels have never been lower in 50 years, and if the market has any chance to recover more quickly, homebuilders and lenders would be wise to show continued discipline. Expected population gains will eventually lift demand and push housing starts, and builders should find some oppor-tunities in markets with better employment growth. They retreat from traditional greenfield subdivisions at the suburban fringe and seek more infill opportunities. Instead of building cavernous McMansions, they downsize models, consider more energy-efficient designs, and look to accommodate extended families in units comfortable for grandparents running out of retirement savings and adult gen-Y children unable to cut financial ties.

Best BetsFor anyone who wants to own and has the means, now is a good time to buy and lock in low long-term financing. Prices should continue to edge up, and mortgage rates are not expected to get better absent an economic reversal. Speculators, including the new housing fund ventures, should

Housing

ExHIBIT 4-22

U.S. Single-Family Building Permits

ExHIBIT 4-21

The S&P/Case-Shiller Home Price 20-City Composite Index

Source: Moody’s Economy.com.*Forecasts as of August 2012.

Source: Standard & Poor’s.*As of June 29, 2012.

Thou

sand

s of u

nits

0

500

1,000

1,500

2,000

2015*2013*2011*200920072005200320011999199719951993

Inde

x

100

150

200

250

2012*201120102009200820072006200520042003200220012000

*Forecasts as of August 2012

18 Emerging Trends in Real Estate® 2013

of the best senior loan deals in the absence of much competi-tion. They originate record volumes, usually with high-credit clients, and on a risk-adjusted basis conservatively achieve a considerable cushion with loan-to-value ratios of 65 percent or lower and “a lot of real equity ahead of us” on high-quality assets. Interviewees claim insurers are not pushing values and base underwriting on current cash flows. “That’s how they have stayed out of trouble” all along. Uncharacteristically, they move into multifamily housing and even do some mezzanine lending and construction to permanent loan deals to get higher yields; given current markets, these risks seem reasonable. Making their mark in avoiding commodity properties, insurers will not fill the lending void in helping troubled borrowers owning Class B or C properties. But in 2013, insurers will try to limit the terms of loans and offer more floating-rate debt to hedge against the low-interest-rate environment. Some new insurers may also enter the real estate lending space, but this will not be a game changer for borrowers.

CMBS Lurching ForwardNew regulatory restrictions on traditional lenders—including Basel III and Dodd-Frank—could open the way for private equity and hedge funds, as well as start-up lending shops, to fill some of the void or step in to resuscitate the still-flagging conduit business. “Sputtering to life” from “a shadow of what it was,” CMBS may have a chance to lurch back into the financing spotlight “once transaction activity increases.” Without enough

“good product, you cannot create pools, and there hasn’t been enough [good product].” The market also requires more B-piece buyers to invest in the riskiest tranches, so originators have held back, unwilling to warehouse loans.

But the CMBS industry may need to confront bigger obstacles in order to rebound fully. Although most interviewees contend that a properly functioning mortgage securities engine is necessary for liquidity in the real estate capital markets, they also express serious concerns about failures to address evident problems in CMBS underwriting, regulation, ratings, and servicing since the market collapse at the depths of the credit crisis. “The problem for bond buyers remains”: the people running CMBS shops have “shuffled around,” underwriting is only marginally better,” originators and issuers “don’t have enough skin in the game” for an alignment of interests, the ratings agencies still get paid by the issuers, and “attitudes haven’t changed.” In short, “nothing meaningful has happened” to correct the problems, which sent bond buyers running to the exits.

Some interviewees say regulatory changes—like requiring holding a portion of each loan or delays in realizing fees and promotes—could lower industry profitability and limit the num-ber of players willing to enter the business. Some interviewees remain skeptical, “At first B-piece buyers will be reasonably disciplined. Then they will gradually loosen credit standards as transactions and money come into the market” until it’s time to “revisit underwriting problems” and their consequences. In the meantime, “bond buyers cannot get the same level of detail and disclosure we did pre-2007,” and more hedge funds, not real

Sources: Moody’s Economy.com, American Council of Life Insurers.

ExHIBIT 2-7

U.S. Life Insurance Company Mortgage Delinquency and In-Foreclosure Rates

0

1

2

3

4

5

6

7

8

2012201020062002199819941990

In foreclosure

Delinquency

Perc

entag

e

Source: Commercial Mortgage Alert.*Issuance total through August 30, 2012.

ExHIBIT 2-8

U.S. CMBS Issuance

$0

$50

$100

$150

$200

$250

Total

(milli

ons)

2012*2010200820062004200220001998

*Issuance total through August 30, 2012

26

banks may be more hesitant to origi-nate unqualified mortgages, “at least at first, given the legal liability.” Similarly, Fannie Mae and Freddie Mac are un-likely to bundle these loans into secu-rities, 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 in-terviewee noted “without enough good product, you can’t create pools, and there hasn’t been enough [good prod-uct].” As such, the QM rule may help would-be investors and interviewees who are concerned that mortgage origi-nators “don’t have enough skin in the game.” Regardless, most of their inter-viewees 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 disagree-ments 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 effec-tive 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 Bud-get 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-

ery (2009–2012), the CBO has estimat-ed a net decline in real GDP of 0.3 per-cent for 2013.23 The concept behind the fiscal cliff was that the automatic chang-es would create an economic shock so unfavorable to Americans that Congress would be putting themselves in a situa-tion 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 min-ute, the Senate approved the American Taxpayer Relief Act of 2012, as negoti-ated between Congress and the White House.24 Two of the most critical com-ponents 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 tem-porary 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 tril-lion over 10 years) across-the-board budget cuts to various government agencies (the Pentagon, the National Park Service, the Transportation Se-curity 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 se-questration 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 with-out any new deals.26

As it stands, the nonpartisan Congres-sional Budget Office estimates this $85 billion reduction in expenditures will re-duce GDP growth by 0.6 percent while eliminating 750,000 jobs.27 However, the full impact of these cuts is not ex-pected 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 anoth-er attempt to establish a grand bargain, many investors are still concerned with the turbulent political and economic at-mosphere. By the end of fourth quarter 2012, the ongoing debt-ceiling debates caused the first-ever U.S. credit down-grade, 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 Al-ternatively, 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 un-certainty, this was received with an un-characteristic 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 hous-ing 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 de-duction allowance on private mortgage insurance lendees.34

However, the commercial real es-tate sector will experience direct nega-tive impacts in the office market as a result of the fiscal cliff. Federal agen-cies 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 es-timate that the full implementation of the fiscal cliff would result in -1 percent in office rents while increasing vacancy

27


rates by 0.9 percent. 35

There would be similar negative im-pacts stemming from a loss of funds delivered to government contractors. In 2012, some $450 billion was allocated to defense (65 percent) and other contrac-tors (35 percent) for the government. More than one in six federal govern-ment dollars toward this procurement spending. As tenants, these contractors represent approximately 208 msf of of-fice space—an amount roughly equiva-lent to the office inventory of the Dallas metro area. Under the full implementa-tion 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

conclusionIn 2013, the U.S. real estate sector

continues its slow path to recovery. As shown in Figure 3, single-family build-ing permits are steadily returning to pre-crisis levels.37 Many economists are even expecting the housing mar-ket 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 simul-taneous 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 cre-ated 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 indus-try’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 res-idential mortgage brokerage franchise brand for 2013—Berkshire Hathaway Home Services.39

28

china—no hard landing (Rise of the Dragon)By Debashasis Das

After falling for more than two years, China’s economic growth picked up steam to reg-

ister 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, regis-tered better-than-expected values for both December 2012 and January 2013. Other indicators, including higher electricity consumption, steel produc-tion, and demand for crude oil, sup-port 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 reg-istering a barely 1.5–2 percent annual growth rate. U.S. GDP had a contrac-tion of 0.1 percent in Q4 2012 based on preliminary Q4 GDP data from the end of January 2013, which was then re-vised 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 coun-tries 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

couple of months, it seems that China has turned the corner and is trying to make a comeback. Economists and an-alysts who planned to write off China earlier and declared a “hard landing” (a substantial slowdown in economic growth) for the PRC (People’s Repub-lic 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 refer-enced by the financial world. Also, it needs to be noted that some of the eco-nomic data around January and Febru-ary 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 per-cent. For the full year 2012, China reg-istered 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

29


growth reached a peak of 12.1 percent in Q1 2010 as shown in Figure 1, fu-eled 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 num-bers 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 elec-tricity consumption, both of which have seen positive trends, as depicted in Fig-ure 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 indi-cates continued strength or expansion in the manufacturing sector, and a val-ue below 50 indicates contraction or re-cessionary conditions. January marked the third month of growth in the Chi-nese 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 fi-nancial crisis of 2008–2009.

commodity prices—iron ore, copper, and crude oil

China’s industrial sector and its ro-bust 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 met-als, including copper and steel, and commodities like iron ore and coal. This demand in commodities is driv-en not only by the country’s growing housing sector but also by numerous

infrastructure projects that the govern-ment has undertaken since the crisis of 2008–2009. China sources its com-modities mostly from mining-and-ma-terials-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 rebound-ed 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 devel-opment 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. Do-mestic steel consumption, after reach-ing 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, automo-biles, machinery, and household appli-ances. 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 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 1china gdp growth and other economic indicatorsSource: Wall Street Journal1

figure 2hsbc china manufacturing pmi and pmi versus gdp plotted against timeSource: Markit2,3

Figure 2: HSBC China Manufacturing PMI

Figure 2: HSBC PMI and GDP

Figure 2: HSBC China Manufacturing PMI

Figure 2: HSBC PMI and GDP

30

percent iron content) have jumped 25 percent in December and around 3 per-cent 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 pric-es. China is also the biggest consumer of steel-reinforcement bar (rebar), and the rebar futures contract for 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 big-gest global consumer of copper. Cop-per 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,

have been climbing fueled by the de-mand, restocking, and recovering eco-nomic 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 re-corded 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 ur-banization and more and more people moving up in their socio-economic sta-tus, 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 salesWith the global slowdown affecting

major economies like the EU and the

United States, China needs to be more self-dependent on its increasing mid-dle-class population migrating to bigger cities and spending more to stimulate the economy forward through internal consumption. Household consump-tion 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 publish-ing month-on-month growth data from 2011 onward, also represented in Fig-ure 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 develop-ment.

china trade—exports, im-ports, 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

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

Figure 11. Hang Seng Index performance chart for 5 yr

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

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

31


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 Janu-ary 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 es-timates. 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 Novem-ber.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 mo-mentum. Looking deeper into the re-cent 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.

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 De-cember by 2.5 percent YoY, as shown in Figure 6, for Consumer Prices month-on-month and year-on-year compari-sons and in the China Inflation Rate graph as well, which has the year-on-year change. Food is a key part of the CPI basket, and food prices went up by 4.2 percent and were the biggest con-tributor 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 per-cent), close to the 2007 levels of double-digit food inflation shown in Figure 7. Unlike the European Central Bank (ECB), which closely monitors the infla-tion rate (2 percent target), or the Fed-eral 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 per-cent 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 develop-ment 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 opera-tions to maintain and boost liquidity in the banking system. It also promotes

credit and lending to small businesses and farmers and for agricultural pur-poses in the rural areas as well as for government projects and various oth-ers. One such open-market operation is the cut in the reserve requirement ratio (called the “RRR”) to boost liquid-ity so that easy lending can occur, and the PBC has done that a few times dur-ing 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. An-other 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 bench-mark deposit rate was lowered to 3.00 percent, and the one-year lending rate was lowered to 6.00 percent. Addition-ally, 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 low-ering its cost for companies.

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

figure 5china trade surplus/ deficit data for fy 2012

figure 6consumer price index—month-on-month and year-on-year comparisonsSource: www.stats.gov.cn/english7

Y/Y M/M12/31/11 4.1% 0.3% 4.1 0.31/31/12 4.5% 1.5% 4.5 1.52/29/12 3.2% -‐0.1% 3.2 -‐0.13/31/12 3.6% 0.2% 3.6 0.24/30/12 3.4% -‐0.1% 3.4 -‐0.15/31/12 3.0% -‐0.3% 3 -‐0.36/30/12 2.2% -‐0.6% 2.2 -‐0.67/31/12 1.8% 0.1% 1.8 0.18/31/12 2.0% 0.6% 2 0.69/30/12 1.9% 0.3% 1.9 0.310/31/12 1.7% -‐0.1% 1.7 -‐0.111/30/12 2.0% 0.1% 2 0.112/31/12 2.5% 0.8% 2.5 0.8

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%

0.3%

1.5%

-‐0.1% 0.2%

-‐0.1% -‐0.3% -‐0.6%

0.1% 0.6%

0.3% -‐0.1% 0.1%

0.8%

-‐1%

0%

1%

2%

3%

4%

5%

Dec/11 Jan/12 Feb/12 Mar/12 Apr/12 May/12 Jun/12 Jul/12 Aug/12 Sep/12 Oct/12 Nov/12 Dec/12

Y/Y M/M

Consumer Prices in December

1/31/11 4.92/28/11 4.93/31/11 5.44/30/11 5.35/31/11 5.56/30/11 6.47/31/11 6.58/31/11 6.29/30/11 6.110/31/11 5.511/30/11 4.212/31/11 4.41/31/12 4.52/29/12 3.23/31/12 3.64/30/12 3.45/31/12 36/30/12 2.27/31/12 1.88/31/12 29/30/12 1.910/31/12 1.711/30/12 212/31/12 2.5

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

0

1

2

3

4

5

6

7

CHINA INFLATION RATE Annual Change on Consumer Price index

CONSUMER PRICES IN DECEMBER

CHINA INFLATION RATEAnnual Change on Consumer Price Index

32

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 stimu-late growth and prevent a halt in the economic expansion. Although this package is much smaller than the 4 tril-lion yuan ($631 billion) that was inject-ed into the economy between 2009 and 2010, both the infrastructure spending stimulus and the open market opera-tions 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 do-mestic economy.

china equity market analysis

A comparison of the Shanghai Stock Exchange Composite Index [Bloom-berg 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 mar-kets, 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 No-vember. All retracements until now for this index have bounced from the short-term 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 over-all. A look at the longer term (five-year) trends in the Chinese equity markets shows that the market descent that be-gan 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 long-term (five-year) chart of the closely re-

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

conclusionThe macroeconomic data from the

month of January and initial data from February continue to be impressive, pointing to the fact that there are fur-ther gains stored in the Chinese equity markets ahead in 2013. After an almost 43 percent correction in the Shang-hai Stock Exchange Composite Index (Bloomberg Index: SHCOMP) from August 2009 to November 2012, Chi-nese 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 lead-ers in 2013. In the words of Jim O’Neill from Goldman Sachs Asset Manage-ment (GSAM), who continues to be op-timistic on China even a decade after he

figure 7china consumer price index (cpi) and food prices comparisonSource: The Wall Street Journal8

Figure 8. Shanghai Stock Exchange Composite Index performance chart for 1yr. □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

Figure 9. Hang Seng Index performance chart for 1yr. □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

figure 9hang seng index performance chart for 1 yr

Figure 8. Shanghai Stock Exchange Composite Index performance chart for 1yr. □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

Figure 9. Hang Seng Index performance chart for 1yr. □ – 20 day SMA □ – 50 day SMA □ – 100 day SMA

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

– 20 day SMA – 50 day SMA – 100 day SMA

– 20 day SMA – 50 day SMA – 100 day SMA

33


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 re-leased its 12th five-year plan for finan-cial 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 inter-nal consumption-based growth driven by 1.3 billion Chinese consumers. As global growth across most of the ma-jor economies slows, China is focus-ing 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 empha-sis on boosting employment, raising wages, and promoting more spending (as compared to saving), will help con-tinue 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 double-digit 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 be-low 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 poli-cies, that it stays around that level, with the country moving toward more con-sumption-led growth as opposed to the previous investment-led growth.

Figure 10. Shanghai Stock Exchange Composite Index performance chart for 5 yr

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

Figure 11. Hang Seng Index performance chart for 5 yr

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

figure 11hang seng index performance chart for 5 yr

34

Writer biographies

Helios De Lamo Helios is an MBA & MSF candidate in the Class of 2013. At Boston Col-lege, Helios is the president of the Graduate Finance Association and is independently pursuing the CFA designation. He interned as an Invest-ments Analyst at Banesco Bank Panama, where he will pursue a career after graduation. Prior to business school, Helios worked in treasury po-sitions, 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.

Brendan CastricanoBrendan 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.

Justin ChristianJustin is an MBA candidate in the part-time program at Boston Col-lege’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 equi-ties and derivatives. He graduated from Michigan State University with a BA in finance and earned an MSF degree from Northeastern Univer-sity. In his free time, he enjoys attending live sporting events, reading, running, and spending time with family.

Mike VitanzaMike 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 Provi-dence College with degrees in sociology and business studies. He will be concentrating on asset management during his second year at Boston College.

Debashis DasDeb is currently pursuing his MS in Finance degree at the Carroll School of Management with a focus on fundamental and equity analy-sis, portfolio theory, and risk management. He has worked at Fidelity Capital Markets (FCM) in fixed income operations support and in Fidel-ity Family Office Services (FFOS) as a business analyst. He also worked briefly at Investors Bank & Trust (a custodian bank) before joining Om-geo 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 solu-tions. Deb graduated from the Indian Institute of Technology, Kanpur (India), with a master’s degree in materials and metallurgical engineer-ing, and plans to move into equity research and analysis upon gradua-tion from the Carroll School.

Christine GrasciaChristine is a part-time MBA candidate in the Class of 2015. After col-lege, she spent three years as a software developer for Harvard Manage-ment 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.

Shyam EatiShyam is an MBA candidate in the Class of 2014 specializing in cor-porate 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.

Sumayya EssackSumayya 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 ses-sion 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 Peter-Greenberg.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 interna-tional studies.

Terry Y. ZhouTerry is an MBA/MSF candidate in the Class of 2013. He did his in-ternship 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 De-loitte, serving mainly European manufacturing companies in China. He graduated with a BS from Fudan University in Shanghai in 2009.

Tracy ToTracy 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 ac-countant at Investors Bank & Trust. She received a BS in economics and finance from Bentley University.

Cameron KittleCameron 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 col-lege debt. He has also written for USCHO.com and the Gloucester Daily Times, and served as executive editor of the New Hampshire while attend-ing the University of New Hampshire, where he graduated with a BS in English and journalism.

Donald HallDonald 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 cocre-ated a complex statistical model that helps firms increase their valuation before a liquidity event. Before turning to finance, He was a success-ful 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 com-mercial 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.

35


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-questions-social-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/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 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-billion-doesnt-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-victor-hugo-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/hedge-funds/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-latams-growing-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-partners-on-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-lv-pacific-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-of-integration-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 •

36

2 Ibid. • 3 Douglas Elliman Real Estate, “2012 Elliman Report.” Elliman Report, December 2012. http://www.elliman.com/pdf/6bd01099be8a9cbdbfe233b9c0f68bfbbe59cc74 • 4 Connor Dougherty, “Home Prices Help Advance Economy’s Slow Recovery.” Wall Street Journal, January 29, 2013. http://online.wsj.com/article/SB10001424127887323829504578271653019114288.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/hydraulic-fracturing-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=irol-newsArticle&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-in-failure-to-disclose-wells.html (accessed April 06, 2013)

the financial service industry’s use of technology: 1 Gartner Report. http://www.financialexecutives.org/eweb/upload/FEI/Gartner.pdf • 2 Fidelity Investments. http://www.fidelity.com/inside-fidelity/institutional-brokerage/fidelity-to-introduce-sophisticated-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

the impact of the debt ceiling is unclear: 1 http://www.forbes.com/sites/afontevecchia/2013/03/08/stocks-at-record-highs-reflect-market-confidence-in-president-obama-and-gop-compromise-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-the-stock-market-

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

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-in-real-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-Regulatory-Capital-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-Regulatory-Capital-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-wall-street-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-dodd-frank-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-qualified-mortgage-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/ten-questions-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-is-speed-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-b050-00144feabdc0.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.

37


http://www.nytimes.com/2013/01/31/business/economy/us-economy-unexpectedly-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/daily-stock-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-jobs-in-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/real-estate/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-extends-housing-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/2013-02-01/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.

carroll school of management

Documents

Boston College Financial, Summer 2013