Enron suit: A new tempest for Citi?

twist twist

A $20 billion claim charges the bank helped the firm manufacture financial statements. Bethany McLean investigates.

By Bethany McLean, Fortune editor-at-large

(Fortune Magazine) -- "When Enron blows up, will it be worse than Long-Term Capital?"

So wrote one Citigroup banker to another in April 2001, some seven months before Enron's bankruptcy. That e-mail is, of course, a vivid reminder of two big blowups that rocked the capital markets. But -- surprise! -- it's not just a remembrance of things past.

The e-mail is also part of a series of lawsuits filed against Citi after Enron's bankruptcy, one of which is supposed to go to trial this spring, in which Enron -- or what remains of it -- is seeking more than $20 billion from Citi. In the inflated numbers, the aggressive posturing, and the mind-numbing complexity, the lawsuit itself is totally Enronesque. The funny thing, though, is that this time around it's not clear which actor is playing Enron.

Let's get this out of the way first: Yes, Enron still exists! But it's called Enron Creditors Recovery Corp., it has just 36 employees, and it exists for one reason: to pay creditors. To date, those creditors have gotten 36 cents on the dollar, double the original estimate, which Enron has paid by selling assets such as pipelines and power plants -- and extracting money from Wall Street banks that, like Citi, helped Enron fool the world.

The 'Mega Claims' suit

This campaign against Wall Street began in 2003, when Enron filed a suit that it aptly called Mega Claims against 11 banks, alleging that they helped manufacture its financial statements. Nine of the 11 settled, paying what Enron says is $1.7 billion in cash (some of this was payment for claims the banks took back) and giving up almost $1 billion more in claims. A small case remains against Deutsche Bank -- and a big one remains against Citi. "We believe the suit is without merit, and we intend to defend against it vigorously through the courts," says Citi.

The Mega Claims case is separate from the lawsuit by Enron's shareholders that Citi settled in 2005 for $2 billion to "put a difficult chapter in our history behind us," as then-CEO Chuck Prince put it. Oops. It appears that Citi may have settled the wrong case, because last spring an appeals court sidelined the shareholders' suit. It is currently awaiting a relevant Supreme Court decision.

But Enron itself has a shot against Citi, thanks partly to provisions in bankruptcy law. Mega Claims has its genesis in the 4,235 pages of analysis produced by the Enron bankruptcy examiner, who concluded that Citi helped Enron "produce materially misleading financial statements."

For instance, Citi, which averaged a stunning deal a month with Enron from 1997 through the company's bankruptcy, helped Enron improperly record more than $5 billion in cash flow from operations and understate its debt by billions. As a result, Enron alleges that Citi knew the company's real condition ("When Enron blows up ...").

Karma on Wall Street?

And so Enron argues that Citi should return what it says were $3 billion of payments from Enron to Citi in the years before Enron's bankruptcy. Enron also argues that Citi should have to fill the $18 billion gap between what other innocent creditors are being paid and what they are owed. (This number is obviously out of whack with what the other banks paid.)

The most Enronesque part of the lawsuit has to do with the billions that Citi lent Enron. In the late 1990s, Citi began to get nervous about its exposure to Enron. So Citi crafted some fiendish structures under which, in the event of an Enron bankruptcy, third-party investors -- who believed such a thing was highly unlikely -- would step into its shoes as Enron's creditors.

Not only did those investors end up with Enron's debt, but they wound up with Enron debt that may be worthless because of a concept known as "equitable subordination," under which a bankruptcy court can penalize a creditor's misconduct by making sure that the creditor is paid last.

It appears that Citi knew that was a possibility. A few days before Enron's bankruptcy, one Citi executive wrote, "Remember the risk is equitable subordination.... Think 'jammed to the bottom of the pile.'"

Today Enron argues that what it says are $5 billion of original Citigroup claims can indeed be jammed to the bottom of the pile. Citi says that because third parties now hold the claims, those claims have been cleansed of any bad acts that may have occurred. (Call it claims laundering.) But Citi still has to care, because it's also being sued by those third parties, who want to force Citi to pay if Enron doesn't.

This issue is at the cutting edge of bankruptcy law. Judge Arthur Gonzalez, who is overseeing Enron's bankruptcy, ruled that the claims should be subordinated. Citigroup and a current holder of a small claim appealed Gonzalez's decision to the district court, and in August, in a closely watched decision, Judge Shira Scheindlin ruled that claims were subject to different sorts of treatment based on how the holders acquired them. It's still unclear what her decision means for the bulk of the original Citi claims.

Of course, all this couldn't come at a worse time for Citi (Charts, Fortune 500). Maybe the real question is, Could there be such a thing as karma, even on Wall Street?

Gulf Currencies: Time to break free

unpegging from the dollar seems to be the flavour of the decade for monetary policy makers; after emerging economies its is time for the Gulf.

The Middle East's oil exporters should end their currencies' peg to the dollar.

IN THE past week Iran's president, Mahmoud Ahmadinejad, has damned it as a “worthless piece of paper” and China's premier, Wen Jiabao, has moaned that it is causing his country “big pressure”. The dollar's relentless decline—it hit a new low of $1.49 against the euro on November 21st—is prompting jibes from America's critics, jangling investors' nerves and giving policymakers headaches.

Nowhere are the dilemmas more acute than in the Gulf, where virtually all the oil-rich states peg their currencies to the greenback. The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation. When the Gulf states meet on December 3rd in Qatar, they should agree to loosen their ties to the dollar.

The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff.

Soaring oil prices have brought the Gulf Arabs huge riches. Their real exchange rates, as a result, ought to rise. The simplest way to do that is for the currency to strengthen, but the peg prevents nominal appreciation. Worse, the dollar itself has been falling. The result is rising domestic inflation. Some smaller Gulf economies now have inflation rates of around 10%.

What is to be done? The two most widely discussed options are to revalue or to shift to a currency basket (which Kuwait has already done). By repegging their currencies to the dollar at a higher rate, the Gulf states would alleviate some of today's inflationary pressure. But they would not address the underlying mismatch between any oil exporter and a dollar peg. Switching the peg to a basket of currencies that included, say, the euro and yen as well would give the Gulf states a bit more protection against oil-price swings, but it is hardly a perfect fit. Since most big currencies belong to oil importers, the Gulf States would still be linking their currencies to monetary conditions that may not suit them.

Eventually, the currency pegs should be abandoned. After all, developed economies that are big commodity exporters, such as Norway, allow their currencies to float. In recent years many emerging economies have shifted from exchange-rate pegs to a “managed float”. Instead of aiming for an exchange rate, their central banks have an inflation target. If the Gulf states move to a single currency, as they plan to in the next few years, that currency should surely float. But floating is not feasible in the short-term. These countries have no history of independent monetary policy and few institutions to conduct it.

Look beyond a basket

For the moment, the Gulf states are stuck with a currency peg. But they could do better than the dollar. One intriguing idea is to include the oil price as part of a basket that includes the leading currencies (see article). This would ensure their currencies absorbed some of the impact of oil-price swings.

A big uncertainty is what such a shift would mean for the dollar. In the short term, the effect on the Gulf states' appetite for greenbacks would not be dramatic, since the dollar would have a big weight in any basket. And there should not be a sudden sale of the oil exporters' dollar reserves. The worry is that the end of the Gulf states' dollar peg would send jittery investors into a panic. That risk is real. But with oil prices rising and the dollar falling, the dangers of inaction are greater. The Gulf states need to get rid of their dollar peg now.

Northeren Rock: Pulling the plug

The market has said what it thinks of Northern Rock. The British government should listen

Getty Images

EVERY banker knows John Paul Getty's dictum: “If you owe the bank $100 that's your problem. If you owe the bank $100m, that's the bank's problem.” What then of a bank that owes taxpayers some £24 billion ($49 billion), with another £18 billion or so of deposits underwritten by the public purse? Northern Rock, it seems, is everyone's problem.

The bank, once Britain's fastest-growing mortgage lender, is now a wreck. Having turned to the Bank of England for an emergency bail-out in August, it is unable to repay its loans unaided. Its debt to the central bank is growing. A mortgage book that was the envy of the industry looks less robust by the day. Its share price plummeted this week to less than £1, down from more than £12 at the beginning of the year.

The government finds itself in a deeply unenviable position. It is propping up Northern Rock's liabilities, yet the bank's assets belong to its shareholders. European rules prohibiting state aid to industries require ministers to cut the lifeline by March, or come up with a plausible reason not to. The Treasury is desperately casting around for buyers to take the bank and its problems off official hands, but none of the financial world's best and brightest is willing to assume full responsibility for it. All bidders so far have valued the bank well below even its current market capitalisation; all have asked for public-sector credit lines or loans.

There can be no good ending to this sorry saga, which had its origins in slack supervision, bad central-bank calls and a panic-stricken rescue that left offending bank bosses in charge for too long. But some outcomes are better than others.

Any solution must have two main goals in mind. The first is maintaining the stability of the financial system. For all that the first panic of the credit crunch seems past, there are too many uncertainties abroad to ride rough-shod over fairly fragile sentiment. The second is to get the taxpayer off the hook as fast and as thoroughly as possible. Depositors are protected by the guarantee the government has extended. It is hard not to feel sorry for the 145,000 retail investors who still hold Northern Rock stock; but they are entitled to no such guarantees and they must be aware that share prices go down as well as up.

There are three broad options confronting Alistair Darling, the chancellor of the exchequer, who will, in the end, decide Northern Rock's fate. The first is to sell the bank. The main bidders propose pumping more capital into Northern Rock, organising private lines of credit, repaying part of the government's loan quickly and keeping at least some jobs. Such a deal would annoy the bank's shareholders, who would be bought out for some variation of a pittance; but if Mr Darling could find a private-sector buyer with a firm promise to repay taxpayers quickly, it would be a tidy solution.

The problem is that no such private-sector buyer seems to exist; everybody relies on Mr Darling underwriting the deal for a considerable amount of time. Such a subsidised sale would give the bank's new owners most of the upside, should gains emerge, while leaving the taxpayer with most of the risk, if losses ensued instead. This asymmetry is more than galling: it might well create a perverse incentive for the bank's new owners to gamble even more recklessly than its old ones. And other banks would rightly complain of unfair competition.

A second option is to force the bank into bankruptcy. This too holds few attractions. Deposits would most likely be frozen for weeks or even months. News of savers struggling to get their money back could spark runs on other banks. In the resulting firesale, Northern Rock's assets would probably fetch less than they are worth. And administration would trigger the winding-up of Granite, a vehicle that holds half the bank's mortgages as collateral against bonds issued. If it is liquidated, its cash would be used to pay those bondholders first. Some £7 billion in extra assets that it holds could be tied up for years.

Take it over

This newspaper has, to put it mildly, never been a fan of nationalisation. But with Northern Rock this increasingly looks like the least bad option from a taxpayer's point of view (unless a credible buyer appears). And, in any case, the damage is half-done: in effect the state already owns a chunk of it.

Were the government a distressed-debt hedge fund, it would be trying to assume control, squeeze out existing shareholders and get back the money it is owed. State control, with a view not to running the bank (a terrifying thought) but to running it down, would allow value to be extracted for taxpayers through the orderly sale of assets. Bankers could take some comfort from the government's ability to pace disposals according to the mood of the markets. And nationalisation would let the state retain any future gains by going slowly—or even entering into a private-sector partnership—in the somewhat unlikely event that credit markets, house prices and Northern Rock's reputation recovered soon.

To be sure, nationalisation would be messy. Shareholders might well sue. The lesson from other crises (France, Mexico, Sweden, Japan and so on) is that emergency state ownership should be brief and at arm's length; Mr Darling might meddle, keeping unprofitable parts of the business open to safeguard jobs in the relatively poor (and Labour-voting) north-east. Nevertheless, nationalisation looks the best choice of a bad lot, for it aligns risks and rewards most closely and keeps control in the hands of those who have most invested. But there should be no illusions that it is anything but a mercy killing.

America's vulnerable economy

Recession in America looks increasingly likely. Can booming emerging markets save the world economy?

IN 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”. In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started. Today, most economists do not forecast a recession in America, but the profession's pitiful forecasting record offers little comfort. Our latest assessment (see article) suggests that the United States may well be heading for recession.

Granted, GDP grew by a robust 3.9%, at an annual rate, in the third quarter. Granted also, revisions may well push this figure up. But that was the past. More timely signs suggest that the economy could stall in this quarter. By early next year, output and jobs could be shrinking. The main cause is the imploding housing market. Experts said that house prices could never fall nationwide. But fall they have, by 5% in the past 12 months. Residential investment has collapsed, but a glut of unsold homes means that prices have much further to drop. Americans' spending is likely to be dented much more by a fall in house prices than it was in 2001 by the stockmarket's collapse. With house prices lower and credit conditions tighter as a result of the subprime crisis, households can no longer borrow against capital gains to support their spending.

Dearer oil is set to squeeze households further (this week's drop in crude prices notwithstanding). Consumer confidence has already fallen sharply. It cannot be long before consumer spending stumbles, which in turn would hurt companies' profits and investment. The weak dollar will boost exports, but at only 12% of GDP, exports are too small to make up for a weakening of consumer spending, which accounts for 70%.

I want to break free

Will an American recession drag the rest of the world down with it? The economies of Europe and Japan rebounded strongly in the third quarter, but look likely to slow down. Although both should be able to keep chugging along, neither is likely to set any great pace. Strengthening currencies will hurt exporters in both places. Europe's own housing hotspots are cooling, and some of its banks have been sideswiped by America's subprime ills.

The best hope that global growth can stay strong lies instead with emerging economies. A decade ago, the thought that so much depended on these crisis-prone places would have been terrifying. Yet thanks largely to economic reforms, their annual growth rate has surged to around 7%. This year they will contribute half of the globe's GDP growth, measured at market exchange rates, over three times as much as America. In the past, emerging economies have often needed bailing out by the rich world. This time they could be the rescuers.

Of course, a recession in America would reduce emerging economies' exports, but they are less vulnerable than they used to be. America's importance as an engine of global growth has been exaggerated. Since 2000 its share of world imports has dropped from 19% to 14%. Its vast current-account deficit has started to shrink, meaning that America is no longer pulling along the rest of the world. Yet growth in emerging economies has quickened, partly thanks to demand at home. In the first half of this year the increase in consumer spending (in actual dollar terms) in China and India added more to global GDP growth than that in America.

Most emerging economies are in healthier shape than ever (see article). They are no longer financially dependent on the rest of the world, but have large foreign-exchange reserves—no less than three-quarters of the global total. Though there are some notable exceptions, most of them have small budget deficits (another change from the past), so they can boost spending to offset weaker exports if need be.

This does not mean emerging economies will grow fast enough to make up for the whole of a fall in America's output. Most of them will slow a bit next year: for instance, China's growth rate may dip to “only” 10%. So global growth will ease—which, after five years at an average of almost 5%, close to its fastest pace ever, it needs to do. But thanks to the vigour of the new titans, it will stay above its 30-year average of 3.5%.

A tale of two prices

The rising importance of the world's new giants will not only boost growth. It will also shift relative prices, notably those of oil and the dollar. And the consequences of this will be less comfortable for developed countries, especially America.

The oil price has risen mainly because of strong demand in emerging economies, which have accounted for as much as four-fifths of the total increase in oil consumption in the past five years. In past American recessions the oil price usually fell. This time it is likely to hold up. That will not only hurt the finances of Western consumers, but may also make the jobs of their central bankers harder, by combining inflationary pressure with economic slowdown.

The enfeebled dollar—lately in sight of $1.50 to the euro—would be weaker still without enormous purchases by central banks in emerging economies. This support is now waning. China and others are putting a smaller share of increases in reserves into the American currency. And Asian and Middle Eastern countries with currencies linked to the dollar are facing rising inflation, but falling American interest rates make it harder to tighten their own monetary policy. They may have to let their currencies rise against the sickly greenback, meaning they will need to buy fewer dollars. More important, as international investors wake up to the relative weakening of America's economic power, they will surely question why they hold the bulk of their wealth in dollars. The dollar's decline already amounts to the biggest default in history, having wiped far more off the value of foreigners' assets than any emerging market has ever done.

The vigour of emerging economies is good news for the world economy: for its growth, it has much less need of a strong America. The bad news for America is that this, in turn, may mean that the world also has less need of the dollar.

Fannie Mae's fuzzy math

somebody's cooking again!

The mortgage lender has quietly changed the way it calculates its bad loans -- and it could be camouflaging steep credit losses, writes Fortune's Peter Eavis.

By Peter Eavis, Fortune senior writer

November 14 2007: 1:03 PM EST

(Fortune) -- Investors might want to take a closer look at Fannie Mae's latest earnings report. Lost in the unsurprising news of the mortgage lender's heavy losses was a critical change in the way the company discloses its bad loans -- a move that could mask that credit losses that are rising above levels that the company predicted just three months ago.

Without the change in disclosure, an important yardstick for credit losses that Fannie Mae (Charts) provides to investors would have looked much worse than it did in financials filed last week.

Fannie Mae's potentially misleading disclosure comes at a crucial time for the company. Fannie Mae was severely penalized last year for overstating earnings and for a lack of oversight. As part of its punishment, the amount of home loans that Fannie Mae can make was limited.

But now influential members of Congress, including Senator Charles Schumer, want Fannie Mae's watchdog, the Office of Federal Housing Enterprise Oversight (OFHEO), to temporarily lift the portfolio limits on the company and its rival Freddie Mac. Legislators want both lenders to buy more subprime mortgages to help stave off foreclosures.

Fannie Mae already holds a substantial amount of risky mortgages in its $2.4 trillion mortgage book -- and the recent shift in how it discloses a much-watched credit yardstick disguises just how quickly bad loans may be rising.

If that's the case, Fannie Mae will face a new barrage of questions about its bookkeeping.

Fannie Mae controller David Hisey responds that the change in how its loss numbers were presented makes them "more transparent, not misleading."

How the Wall Street money machine broke down

But Fannie Mae's numbers effectively make its credit look better than it is.

It all comes down to what's known as the credit loss ratio -- a measure that Fannie Mae has consistently provided to investors to help them assess the credit quality of its mortgages. The credit loss ratio expresses bad loan losses as a percentage of Fannie Mae's loans.

In August, Fannie Mae predicted its credit loss ratio would be 0.04-0.06 of a percentage point for all of 2007. (Wall Street generally refers to percentages in basis points, which each equal one hundredth of a percentage point. In Fannie Mae's terminology, then, its 2007 loss ratio estimate is four to six basis points.)

A range of four to six basis points may not sound like a big deal for an institution involved in mortgages, but for Fannie Mae it is the norm.

What matters is if Fannie Mae goes above that range. And Fannie Mae appears to have already done that this year. But its disclosure change makes that worrying development very hard to see.

Here's why: Last week, as part of its earnings report, Fannie Mae revealed that the company had changed the way it calculates the credit loss ratio. Under the new method, Fannie Mae's annualized credit loss ratio was just 4 basis points in the first nine months of the year.

At first glance, four basis points looks to be at the low-end of Fannie Mae's full-year forecast. Problem is, because the company is using a new methodology, the previous estimate no longer makes sense to use.

So what would have happened if the company had compared apples to apples -- and stuck with the old method of calculating its loss ratio?

Under the previous method, Fannie Mae would have been well outside of its range. The company would have reported an annualized loss ratio of 7.5 basis points in the first nine months of this year.

Uh-oh. It's Enron all over again

What exactly caused the change -- and how did it lead to a reduction in the credit loss ratio?

In its third quarter financial statements, Fannie Mae started to break out credit losses taken to fulfill an accounting treatment called SOP 03-3, which the company said it adopted at the start of 2005.

These SOP 03-3 losses were previously included in its credit loss ratio calculation, but Fannie Mae last week removed them from that calculation, causing its loss ratio to look much lower.

The company said it made the change to add transparency to its loss numbers and to show a more cash-based reflection of credit losses.

In a statement, Fannie Mae spokesman Brian Faith said that the forecast of four to six basis points was "predicated on our estimation of what our realized losses would be for the year."

What does realized losses mean? When asked that, Faith referred to Fannie Mae's most recent quarterly filing. There, realized losses appear to be defined as losses calculated under the new method. In other words, Faith appears to be suggesting that the 2007 forecast was always based on the new method of calculation.

Why is that hard to believe? When the company issued that range in August, it expressed all its published credit loss ratios under the old method. And on an August conference call, when discussing the full-year range of four to six basis points, Fannie Mae executives did not mention any change in calculation of the ratio.

Management acknowledges that credit losses are mounting. During an analyst call last week, Fannie Mae CEO Daniel Mudd warned that the company's loss ratio could rise to eight to 10 basis points in 2008, due to a worsening housing market. It's not clear whether that forecast is based on the old or new methodology.

The company may already be exceeding that 2008 guidance. Based on the old methodology for calculating the loss ratio for the third-quarter alone, the company's annualized loss ratio is already at 14 basis points.

If so, Fannie Mae's mounting losses are disturbing.

So what could a soaring loss ratio mean for Fannie Mae? Consider these numbers: At Sept. 30, Fannie Mae had exposure to $74 billion of loans with a FICO credit score below 620. Loans scored below 620 are generally classified as subprime. In addition, Fannie Mae has exposure to $196 billion of Alt-A mortgages, home loans for which the borrower doesn't have to submit complete documentation for basic criteria like income.

At the same time, Fannie Mae has only $40 billion of capital.

Worst-case, credit losses from high-risk loans like subprime and Alt-A could eat away at that capital and leave the mortgage giant on an extremely weak financial footing.

RUNNING FAST: Technology in India and China

India's billion-strong population cuts both ways. Whenever an Indian demographic appears as a numerator, the resulting number looks big. But whenever its population is in the denominator, the number looks small. It is like looking at the same phenomenon from opposite ends of a telescope. As of now, India matters more to technology than technology does to India.

TOWARDS the end of the 11th century, while tardy Europeans kept time with sundials, Su Sung of China completed his masterpiece: a water clock of great intricacy and accuracy. Standing almost 12 metres (40 feet) tall, Su's “Cosmic Engine” wavered, it is said, by only a few minutes in every 24 hours. From twin tanks filled by servants, a steady flow of water was cupped and spilled by a series of buckets mounted on a wheel. The rotation of the wheel turned the clock, as well as an astronomical sphere and globe that charted the movement of the sun, moon and planets. Drums beat 100 times a day; bells chimed every two hours. A replica, painstakingly built with contemporary methods, now turns in Taiwan's National Museum of Natural Science.

Clockmaking was only one scientific endeavour in which China and India comfortably led the world before the 15th century. China outstripped Europe in its understanding of hydraulics, ironsmelting and shipbuilding. Its machines for ginning cotton, spinning ramie and throwing silk seemed to lack only a flying shuttle and a drawbar to match the 18th-century contraptions that launched Britain's Industrial Revolution. Clean your teeth with a toothbrush, rebuff the rain with a collapsible umbrella, turn a playing card, light a match, write, pay—or even wipe your behind—with paper, and you register a debt to China's powers of invention.

India's genius, then as now, was in software not hardware. Its ancient civilisations ushered in a “mathematical revolution” from the fifth century, when Aryabhata devised something like the decimal system. In the seventh century Brahmagupta explained that a number multiplied by zero was zero. By the 15th century, Madhava had calculated pi to more than ten decimal places.

After the 15th century, however, the technological clock stopped in both countries, even as it accelerated in Europe. This peculiar loss of momentum, noted Joseph Needham, a great historian of Chinese science, takes some explaining. Why, he asked, did the science of Galileo emerge “in Pisa but not in Patna or Peking”?

In his book “The Lever of Riches”, Joel Mokyr settles on a simple explanation for China's technological stagnation: the country's imperial state lost interest. Its purposes were better served by continuity than by progress, and there was no rival source of power and patronage to pick up the threads it dropped. Roddam Narasimha of India's National Institute of Advanced Studies reaches a similar conclusion for India. “Up to the 18th century, the East in general was strong and prosperous, the status quo was comfortable, and there was no great internal pressure to change the global order,” he writes.

That diffidence no longer hampers either state. Both China and India are now restless with technological ambition. China's government does not have the luxury of choosing between progress and stability; it cannot enjoy social peace without economic advance. For the past 30 years it has tried to turn the clock forward. By 2015 its research scientists and engineers may outnumber those of any other country. By 2020 it aims to spend a bigger share of its GDP on research and development (R&D) than the European Union.

India, for its part, surveys the future with uncharacteristic optimism. Its technological confidence has grown immeasurably thanks to the success of its software and IT firms. The heirs to Aryabhata and Brahmagupta, India's digital ambassadors have won acclaim for their mastery of ones as well as zeros.

But even as India's technological powers make a splash in the world, they stir only the surface of its own vast society. India produces more engineering graduates than America. But it has only 24 personal computers for every 1,000 people, and fewer than three broadband connections. India's billion-strong population cuts both ways. Whenever an Indian demographic appears as a numerator, the resulting number looks big. But whenever its population is in the denominator, the number looks small. It is like looking at the same phenomenon from opposite ends of a telescope. As of now, India matters more to technology than technology does to India.

This is a pity. India and China still have more to gain from the adoption and assimilation of technology than from invention per se. Some of their best minds are adding generously to the world's stock of knowledge, but the more urgent task for the countries themselves is to make wider use of know-how that already exists. Indeed, the World Bank has calculated that India could quintuple the size of its economy if it only caught up with itself—that is, if the mediocre firms in its industries closed the gap with the best. Both countries miss out when policies to promote invention, such as China's push for “indigenous” innovation or India's recent patent laws, serve to stymie diffusion.

A year in China, foreign residents say, is like ten years outside. Its clock is already turning rapidly. But the cogs and levers that drive technological progress are as intricate and delicate as Su Sung's mechanism. China's government is in danger of trying to do too much. Its monumental efforts to educate and train have filled the tanks of its innovation engine. Now it is time for it just to let the water flow.

Google Inc: Letter from the Founders

Every year the annual report of Google carries a letter from its founders charting out the Google vision. A good source of data for conspiracy theorists, it makes a good reading on where the information powerhouse is headed (it has moved beyond being just a search giant). Are the founders attempting something like the Buffet Annual letters? Not there yet.



Introduction

There are few things as powerful as human passion. On the Internet, we see it in blogs, videos, and social networks, through many voices with a story to tell, eager to be heard. Over the past year, there have been many developments at Google I would like to share with you – products, partnerships, and milestones. There are many feature lists, statistics, and technical accomplishments behind them. However, what really inspires me are the words of the people whose lives we touch. While in the past Larry and I have taken turns writing this letter, this year I would like to give a voice to these people so you can hear just as I do how Google affects their lives.

Search

Search remains the heart of Google. Every day, millions of people search on Google for information either for themselves or someone close to them - information that can help their careers, their education, or their health. Sometimes it is just a casual curiosity that sends them searching, but at other times, their need for information can be critical – and what they find can even save a life. That is why we work so hard to provide the best possible information for every query, on any topic, in any language, in any country.

I found some minor swelling after feeling minor pain over a couple of days. A Google search brought up several pages with links to articles, all pointing to the same type of cancer… Without Google I would have ignored and possibly forgotten about the incident until it would have been too late. Google also helped me find the doctor who checked me out the very next day, and who organized surgery for the very same day he identified the cancer. It took me a long time to write and express my thanks to all of you who are working there. You are life savers!
- PETER MACKENZIE

Our search must also work well for different levels of expertise. Sometimes it is patients who seek medical information on Google, but other times it is doctors themselves. To go more deeply into technical fields, we have developed Google Scholar™, the most comprehensive search for scholarly work. And we also launched Google Patent Search as well as News archive search, which adds nearly 200 years of newspaper archives to Google News™. In addition, information providers and individuals can now help us improve search within their fields of expertise by creating Custom Search Engines on their own sites that provide more specific search results related to their interests.

Like many people on the Internet, I use Google so many times daily that I hardly remember a time without it… Recently, I had a similar realization while using Google Scholar to search the medical literature. Potentially, Google Scholar can instantly direct you to the most important papers in any field anywhere you can access the Internet, and many of these papers are now available online. I use it at least several times weekly and sometimes daily… A seventy year old woman with neurofibromatosis came to me with severe hypertension. I was initially concerned that she had a pheochromocytoma, which is associated with neurofibromatosis. To look for other associations, I searched [“hypertension and neurofibromatosis”] in Google Scholar, which revealed that renal artery stenosis from vascular neurofibromas was also possible. We looked, and that’s what she had… A second patient was referred to me complaining that he had stopped sweating three months ago. I’d never seen anything like this before. So I searched Google Scholar, which quickly directed me to the literature on acquired idiopathic generalized anhydrosis, a rare neurologic disorder. I sent him to a neurologist for a skin biopsy, and this confirmed the diagnosis.
- JOSHUA SCHWIMMER, MD

“Aren’t ‘X’ billion pages enough? Who needs more search results?” I hear questions like this often. The answer is, “We all do.” When you are looking for something specific, like a particular person or place, comprehensiveness is the difference between finding a long-lost relative or love, and not.

The first time I used Google… I put in my name to see what would come up on me. Imagine my surprise when I found another 3 women who shared my name… one of the other Una McGurks I found on Google is a survivor of the 1998 Omagh bombing, which was just miles from the farm where my father was born and raised on in Tyrone, Northern Ireland. I ended up planning a trip back to Ireland to find the other women with my name… So, I have Google and global awareness to thank for tracking down 3 long lost relatives who share my unusual name.
- UNA MCGURK


I looked up my first love, whom I had not seen nor spoken to in 22 years, via Google. Long story short - we’re getting married… Thanks Google!
- JOSHUA BYRON

Stories like these help us understand just how important it can be for people to have comprehensive search results. In the past year, we have increased our search index size by billions of documents, leveraging continued infrastructure improvements to our indexing system. This has increased capacity and improved refresh time. We also launched Webmaster Central as the place for webmasters to get information about how Google crawls and indexes websites, and to find tools such as Google Sitemaps™ to direct our crawler more efficiently.

Books

A comprehensive search engine is not restricted to the Internet. Much of the highest quality information in the world may be found in tens of millions of books tucked away in libraries and on publishers’ shelves. These books can be tremendous assets - but only if people know that they exist. Google has embarked on a mission to digitize the world’s books and make them discoverable, simply by searching online.

Book publishers benefit from wider distribution of their books. In 2006, we continued to add to our growing book index. We introduced four new partners to the Library Project, including the University of California, considered the largest research and academic library in the world; University Complutense of Madrid; University of Wisconsin-Madison; and the University of Virginia. Our Partner Program grew with new relationships and expanded agreements and now includes more than 10,000 publishers. Book Search is now available in 9 languages, and next year, there will be more.

Today users can search through millions of books to find popular, obscure, and beloved titles on every topic imaginable. Of course, Google Book Search is not just good for readers. Publishers benefit from increased exposure for their books.

At first, we didn’t understand why all of a sudden we were getting a request for this older title. But when we looked at the reports from Google, we saw that it was one of the most-viewed titles over the past 15 days. Best of all, this book is not an exception. Our e-commerce sales have increased 60% across the board.
- GRACE GUINAND, INTER-AMERICAN DEVELOPMENT BANK

This year we also developed a new look and browsing interface for Google Book Search™ that makes it even easier to use. We’re hearing from readers, researchers, and book lovers around the world that they are locating books more quickly and easily than before.

I was idly trying a search on “roads” to see what sort of a literature would turn up for the period of my dissertation research, 1740-1850. I didn’t expect much. I’ve spent the last two years wandering through the Yale, Harvard, and California libraries, the British Library, Britain’s National Archives, and the immense reserves of North American Inter Library Loan reading every book on London, pavement, or travel I could get my hands on. Surprise. In a single idle search I just added twenty extra full-text books to my list…Hallelujah, Google Books.
- JO GULDI, UC BERKELEY

Video

Sometimes text isn’t the best way to communicate or understand an idea. If you are learning about a sport, an art performance, or a mechanical invention, video can be a far more compelling medium. This is one reason 2006 saw such a dramatic growth in the viewing and sharing of online videos. To this end, we have developed Google Video™ to search video, and this year we acquired YouTube™ – an incredibly dynamic and compelling way for people around the world to share their lives and express themselves.

YouTube has the largest online video audience and offers the most entertaining, original content on the Internet – with a community that continues to grow exponentially month after month. YouTube has struck more than 1,000 partnership deals with content providers looking to participate in this growing creative community – including Universal Music Group, CBS, BBC, Sony Music Group, Warner Music Group, the NBA, and The Sundance Channel.

YouTube users are clearly being entertained by the CBS programming they’re watching as evidenced by the sheer number of video views. Professional content seeds YouTube and allows an open dialogue between established media players and a new set of viewers.
- QUINCY SMITH, PRESIDENT, CBS INTERACTIVE

In addition to professional content, user-generated content is central to the YouTube community experience. As more people capture special moments on video, YouTube empowers them to become the broadcasters of tomorrow. YouTube is a cultural phenomenon, winning the hearts and minds of an increasingly broad demographic. It has democratized the entertainment experience and created a new way for people to communicate across the globe. For example, when Leigh Buckley, a wife and mother from New Hampshire, was diagnosed with leukemia, she and her husband Andrew began chronicling her experience and posting the videos to YouTube. They have received an overwhelming response from people not only wishing her well but also organizing bone marrow drives.

Google is about connecting people with information. Online video is a new genre for connection that engages a new generation.

Local

People use Google products to learn not just about the farthest reaches of the universe but about places closer to home. Google Maps™ has become the #1 mapping site across Europe and #2 in the U.S., and now offers detailed street maps in more than 50 countries. We are pleased that so many developers have used our mapping technology as a platform for further innovation, and proud that more than 30,000 websites use our maps API. Local authorities in London now use the Google Maps API to let residents report problems such as road defects and trash on the streets. Google Maps is also available now on mobile devices and plays an integral role in our partnerships with mobile providers. We expect more and better local products to result from our work in the mobile space.

With more than 200 million unique downloads, Google Earth™ users worldwide are venturing out to explore, understand, and share our planet. Google Earth now covers more than half of the world’s population and a third of the land surface in high resolution. We’ve found that one of the first things users do after launching Google Earth is look at their own home from space. Then they quickly discover that Google Earth lets them search and browse a growing web of geospatial content from community storytelling, 3D buildings, location referenced photos and historic maps to Wikipedia articles, United Nations and European Space Agency content, and even photos and stories from National Geographic and videos from Discovery Networks. Furthermore, Google Earth also enables people with limited resources to better understand the world around them.

We used Google technology to prove to the authorities that the land is fertile [so that the Indian government would compensate us at a higher rate in developing an SEZ (Special Economic Zone)].
- ARUN SHIVKAR

Mobile

We were shaken and quite upset [at learning that one of our newborn twins might require a blood transfusion, which is risky for small babies]. Armed with only a cell phone - and a very low battery - I was able to Google [hemoglobin ‘premature infant’] and found a medical journal article claiming that it’s perfectly normal for preemies to have their hemoglobin levels drop to 7 between the first and third months of life, and apparently this is especially true with twins. [I showed the Google results to the doctors, who eventually concurred that the risky transfusion was not, in fact, necessary.]
- HOWARD, GOOGLE MOBILE USER

In many regions, mobile is often a “first screen” device – the primary way users access information.

Here’s a story that illustrates this global reality:

A Googler was vacationing in Africa recently and happened to be wearing a Google T-shirt. A local approached him, clearly very excited about Google News. Naturally, the Googler asked, “Do you know you can get Google News on your mobile now too?” To which the man replied, “How else would I get it?” Indeed.

We’ve made great strides toward universal accessibility, in no small part because we have forged relationships with some of the most prominent carriers and equipment manufacturers in the world. Motorola, Sony Ericsson, Vodafone, Nokia, Beeline, KDDI, NTT DoCoMo, Bharti Airtel, China Mobile, and Samsung are our partners, and we look forward to growing these relationships.

Our efforts in mobile are helping to drive adoption of the mobile web and create interesting revenue opportunities for our partners, such as the mobile ad pilots that we launched in more than a dozen markets in 2006.

The partnership with Google is making a substantial contribution to the very rapid increase in our customers’ uptake of mobile search. Even more so, the performance of Google’s Mobile Search Ads is greatly exceeding our expectations. We are strongly dedicated to keep developing our world of mobile Internet services through our continuing partnership with Google.
- TADASHI ONODERA, CEO, KDDI

Content, Collaboration, Community

We have worked to expand our offerings that enable users to manage their information – to create content, collaborate on it as a group, and then share it with the world.

Perhaps the most important online collaborative tool is email. Gmail’s introduction in 2004 contributed to a new focus on webmail generally, including a shift from offering storage space in megabytes to gigabytes. Gmail™ has developed substantially, with the introduction of features like Gmail Chat, which brings together email and instant messaging.

I depend on my gmail and gtalk big-time! today, i got a notification that (yipee!) i had new gmail. anyway - it was email promoting a pre-sale for tickets to a huge concert…within seconds, i had checked my gmail, hopped on the ticket buying website, and am now sitting pretty with tickets secured, while the rest of the non-google-users are waiting in a buyers-queue/waiting-room server waiting to purchase… now i have tickets to the hottest show in town for an amazing price, as well as my sister’s birthday present. you’re the BEST!
- EMILY BOUCHARD

For better time management, we offer Google Calendar™ a free online service that we launched this year that makes it easy to keep track of your schedule and share it with friends. Google Calendar fits perfectly with our other online collaboration applications like Gmail and Google Docs & Spreadsheets™ designed for managing and sharing documents. This product combines both ease of use (nothing to install, just use your browser) along with powerful Internet capabilities like collaborative editing, access controls, and content available anywhere you can get to the web.

As I write this right now, other Google employees are editing this document (and making it “flow” - I confess I am difficult to edit).

Products that enable the discovery and sharing of content have become a dynamic force on the Internet. We want to support these activities for all types of information, including photos, documents, and blog content. For example, today we offer Picasa™ photo-organizing software and more recently launched Picasa Web Albums for online photo sharing.

My mother is happy about the ease of using Picasa and finds it a joy working with this service. [She] is not a computer guru, but has learned many ways that Picasa makes photo albums more fun than ever. Color pictures as far back as 1943 are an online testament to how Picasa has now become our family treasure and is bringing our family together. My mother hopes that the whole family will build upon her work and add to a priceless family treasure Picasa has given all of us.
- JAMES HERNANDEZ

Another focus is products that enable users to discover new people and learn more about each other. Orkut™ our experiment with social networking, is now part of the social fabric for the majority of online users in such countries as Brazil and more recently, India.

Finally, in the area of personal publishing for large audiences, we unveiled major updates to Blogger™ and Google Groups™ and introduced Google Page Creator™, which people can use to easily and quickly create professional-looking web pages. Our acquisition of JotSpot, collaborative wiki technology, is another demonstration of our commitment to this space.

Organizations are increasingly sharing these services with all of their users. In 2006, we developed Google Apps for your domain, which includes Gmail, Google Talk™, Google Calendar, Google Docs & Spreadsheets, Page Creator, and the Start Page. Arizona State University (ASU), with 65,000 students, has already implemented Google Apps across the university.

On the day of the announcement [that ASU was adopting Google Apps], students were converting to Gmail for ASU at the rate of 300 an hour… In addition to providing an exciting new service for students… the feat that Google and ASU achieved in the past fortnight displayed a nimbleness that rivals the best of what Silicon Valley can do… The range of technology solutions that Google is putting forward, at the speed and scale that they have proven they can deliver them, is sparking nothing short of a revolution in the IT business…
- ADRIAN SANNIER, CTO, ASU


Advertising

Our goal is to create a single and complete advertising system. Diversity in our advertising and publisher base continues to be central to our business and is important to our long-term success. Advertisers large and small use Google to reach their target audiences easily and get measurable ROI.

Last year we launched the AdWords™ Starter Edition, a simplified version of AdWords that lets users create an account quickly using a one-page sign-up form.

I was up and running in 15 minutes. For somebody like me who isn’t comfortable with the PC, it was quite a revelation.
- COSMO BUONO, BBPIANO.COM

As more and more users look for local information online, we must continue to improve our ability to attract local advertisers. We have launched local business ads, local coupons, and refined local targeting so businesses can target customers right in their neighborhood. This year we partnered with companies like Intuit, Verizon, and AT&T to help us bring more business information online and convert more small businesses into happy Google customers. Small business is big business.

We have also gone beyond text for brand advertisers. Traditionally, video and other rich formats have been used exclusively by large advertisers because of their higher production costs and higher minimum spending requirements. However, our new clickto-play video ad format can serve ads to both large and small advertisers. In fact, video can be the best way for a small business to communicate its offerings in a genuine and personal way.

Since we started advertising our robotic guitar tuner with Google Click-to-Play Video Ads, not only have we seen a dramatic increase in sales, both in the USA and internationally, we’ve also had lots of inquiries from distributors all over the world who want to carry our product. I don’t know of any other advertising that could have had this kind of impact… Now when people bring us exciting products to market, we know that Google’s video ads can be our strongest new tool to help demonstrate and promote those products nationally or even internationally at a very reasonable cost.
- EVAN SHOFRON, ACTION MARKETING

And we’re helping advertisers of all sizes buy and place offline ads more effectively. In January, we acquired dMarc™ Broadcasting to help develop a radio advertising product and now have more than 900 stations in more than 200 metro markets. In addition, more than 100 advertisers and 70 newspapers have participated in significant tests for print advertising. We believe these offline efforts are key to creating a complete ad system. We continue to roll out new pricing and account tools to help online advertisers better manage their campaigns. Last year the ads team launched Position Preference, which allows advertisers to set controls to have bids automatically adjusted to maintain a desired ad-position range. We also released Preferred CPC in beta, which enables advertisers to bid to an average CPC. To help improve conversions, there is now Web Optimizer for doing multivariate testing on landing pages. And for easier, more robust account management, there is AdWords Editor, a client-based application for making offline changes to AdWords accounts and uploading them later.

Effective advertising is just one component of ROI. Once a customer is on an advertiser’s website, it’s important that they find what they are looking for and complete a transaction. Google Analytics™ allows webmasters to easily monitor and optimize the design of their sites to make them as frictionless for customers as possible.

Every new piece of information we get from Google Analytics gives us 10 new ideas that can help our customers find what they need online. Google Analytics helps us prioritize what to try first, and then track success metrics around each change to make sure our assumptions are correct. Google Analytics is key to continuously improving our site and our customer experience.
- MIKE BOLLAND, DISCOUNT TIRE

Once a customer has decided to make a purchase, completing the purchase swiftly and easily is paramount. Google Checkout™ tremendously simplifies the buying process by enabling you to shop across the web with just your Google login. Checkout has done a great job of increasing conversion and driving leads. Initially launched last summer with just a few stores, it has now reached millions of registered users and signed thousands of merchants, including more than 100 of the top 500 online stores.

We always want to give our customers more choice and more convenience when they shop with us, and Google Checkout gives them both. In addition to the positive customer experience Google Checkout offers, we’ve also been very pleased with the benefits for our business. We’re seeing great results as Checkout helps us acquire new customers every day. We’ve appreciated the increased sales as well as the ability to process transactions for free…
- TIM MCCUE, JOCKEY.COM

Early in Google’s development we realized that great search depended on great content. To that end we created Google AdSense™ for content, which now enables thousands publishers to spend their time developing great material instead of having to sell ads themselves.

We’d tried all sorts of affiliate programs and they amounted to nothing… Without the AdSense program, [our] free service would never have been possible.
- ADSENSE PUBLISHER

Global

I’ve mentioned some of our global efforts earlier, but it’s so important to us that I want to call out a few more facts here. Last year we added 44 domains so that Google is now available in 158 domains and more than 100 languages. Google News is now up to 39 editions, with launches in Hebrew, Arabic, and Russian. Gmail added Hebrew and Arabic to reach 40 total languages.

Google Toolbar™ is now available in 42 languages for Internet Explorer (26 for Firefox) and Desktop™ 4 is in 28 languages. And Google Groups 2 came out of beta and is available in over 40 languages. With international sources comprising 43% of Google’s revenue in 2006, we continue to grow our global monetization efforts. AdWords added several additional language/country interfaces, and now supports more than 40 languages. AdSense for search and AdSense for content both added four new languages bringing their totals to 27 and 23 respectively. We also launched electronic fund transfer payments in 9 more countries and piloted a Western Union payment method in China and Malaysia to further extend payments in local currencies.

Our mobile initiatives, critical to worldwide access, also include these firsts: we integrated mobile search and our first syndicated mobile sponsored links with KDDI, Japan’s second-largest mobile carrier; and we partnered with major mobile carriers and global handset manufacturers such as Vodafone and Telefonica.

We’re also making great strides with our awardwinning machine translation system. We want it to vastly improve the web experience for users everywhere. We improved or added several new language pairs, including English to/from Chinese, Arabic, and Russian; we now have over 20 language pairs.

Google is committed to its investment in markets across the globe, and the advances mentioned above bring us closer to our goal of making Google accessible to people in more languages and in more countries – a goal we will continue to pursue in 2007.

Culture

We have worked hard to create and maintain a compelling environment for Googlers. We’re building a culture rooted in transparency, innovation, and scale. Because we aspire to innovate as much on the people side as we do on the product side, we were honored to top FORTUNE’s “100 Best Companies to Work For” list in our first year of eligibility.

None of what we do would happen without a global employee base. In 2006, we hired 4,994 full-time employees, and for the first time, half of our software engineering hires were outside our Mountain View headquarters, including significant increases in China, Russia, India, Brazil, and Europe. Employees outside the U.S. now make up nearly a third of the company, and many of them moved into new offices this year including Beijing, Trondheim, Istanbul, Tel Aviv, Copenhagen, Vienna, Taipei, Warsaw, Haifa, Moscow, St Petersburg, Sydney, Mumbai, Cairo, and Delhi. Having a presence in all these locations attracts Googlers who want to work where they already live, and contributes to local economies.

We have improved our benefits programs to include such things as more doctors on staff and many new cafes in different locations. We expanded our equity refresh program and introduced our Transferable Stock Options program. We launched a range of development programs including EDGE, which helps grow our engineers into better leaders. And we work hard to infuse Google’s culture and principles into every office around the world, empowering employees to make contributions that help drive Google’s overall success.

Working at Google Kirkland is a fantastic opportunity to get a team together and launch great things. We’ve got the advantages of a small environment that makes it easy to know everyone, coupled with Google culture that keeps us connected with Mountain View so we can work with teams there, rather than as an isolated island. This helps us develop search products like Google Webmaster Central, which is improving search quality and making a big impact for all of Google, not just our office.
- VANESSA FOX, GOOGLE KIRKLAND

These initiatives help us scale by attracting amazingly talented people, and then nurturing them as we preserve what’s special about our culture. Whenever we open new offices, we strive to keep things “Googley.”

The office culture is still relatively intimate, even though we’ve grown 200% since the office opened in September(!). The atmosphere is fun and engaging, and my coworkers are smart, funny and overall great people to be around all day. Even though we’re a much smaller office than our Mountain View counterpart, we continue to have that Googley, welcoming feel.
- STEPHANIE DUCHAINE, GOOGLE ANN ARBOR

Our commitment to our employees is matched by a broader sense of responsibility to our user communities worldwide. Specifically, we recognize that access to information is a powerful tool to help identify and solve problems. We are committed to harnessing our resources to help address pressing global needs.

Sustainability is one example. Last fall we kicked off a project to install 1.6 megawatts of solar photovoltaic panels at our Mountain View campus. This project will be the largest solar installation on any corporate campus in the U.S., and we think it’s one of the largest on any corporate site in the world. The amount of electricity that will be generated is equivalent to powering about 1,000 average California homes. We’ll use that electricity to power several of our Mountain View office facilities, offsetting approximately 30% of our peak electricity consumption for those buildings. Our work in this area has just begun and we hope to do much more in the future.

This past year Google.org, our philanthropic arm, got off the ground by building out a leadership team. Among these new hires was Dr. Larry Brilliant, who joined us in March to serve as the head of Google.org. He is a great leader to help Google.org tackle its threefold mission of global health, global wealth, and the environment. While Google.org is ramping up, our existing philanthropic activities are still going strong. Google Grants puts our advertising program to work for charities and nonprofit organizations that don’t always have equal footing in the traditional advertising business. More than 2,100 organizations in 16 countries have now been accepted to run targeted ads to reach their constituencies around the world.

Our current program is a smoking cessation site testing four Web-based methods to quit smoking. We are very appreciative of your support. Over 190,000 Spanish- and English-speaking users looking for help to stop smoking have clicked on to our site from your ads.
- DR RICARDO F. MUÑOZ, UC-SAN FRANCISCO

Since we first became a grantee, website activity has increased by a dramatic 400% and the number of youth we serve has increased by 20%. Our annual budget has increased 20% due in part to increased donor activity and increased community partnerships – both of which are influenced by our sponsored link positioning on Google.
- BRANDE MARTIN, MY FRIEND’S PLACE

This is just a start. When I write this letter in future years, I am optimistic that I can report significant progress on the global challenges that we hope to address through Google.org’s work.


Thank you

We had a remarkable 2006. None of our achievements would have been possible without our passionate users, strong partnerships, and talented employees. As I read back over this letter, what stands out are the individual experiences of the people who use our products. It is an honor to share these pages with a few of them.


Larry Page


Sergey Brin

As oil nears $100, look out below

A discussion on the most intriguing topic of today:



Oil prices are soaring. Having jumped 40% since August, crude prices hit another historic high on November 6, rising to $96.70 a barrel. The factors sparking the $2.72 rally this time: bad weather in the North Sea that could force production cuts, the dollar’s continued fall, more violence in the Middle East, and fears that US crude supplies are low. But is there a sharp fall just ahead? Analysts say that the oil market looks overheated, and a number of factors could puncture the price bubble.

Most important, speculators have played a key role in driving up crude prices this year, and if the trend reverses they’ll get out fast. Certainly, global demand remains strong for now. But a number of factors—technical indicators, an economic slowdown, lower demand— could prompt investors to exit en masse. “Oil prices are in uncharted territory,” says Peter Fusaro, co-founder of the Energy Hedge Fund Centre, which tracks commodities hedge funds. “My worry is that if the market tanks, everyone will want out at the same time.

The market would collapse, and who knows what the bottom is.” Much Trading Remains Opaque Speculators have played a growing role in the oil market in recent years. There are 595 hedge funds that are engaged in at least some energy trading now, more than triple the 180 funds involved just three years ago. Fusaro estimates the assets involved in such trading total more than $200 billion, up more than 60% from the beginning of the year. It’s tough to get a firm handle on the speculation.

A large portion of trading takes place in the unregulated, over-thecounter market. Still, some of the trading in crude oil takes place on the New York Mercantile Exchange (NYMEX), and there the market is approaching a record in terms of the number of crude oil contracts that predict a price rise. Traders have committed to 135,000 contracts— each representing 1,000 barrels of crude—betting that prices will continue to rise. That’s just shy of the record 155,000 contracts reached this summer. Some analysts say that if the number of contracts rises sharply, oil prices could fall. “The exit signal for investors could be breaking through the 150,000 or 160,000 contract barrier,” says Joel Fingerman, president of OilAnalytics.net, an energy consulting firm. “At that point investors could feel they’re using all their bullets.”

For Now, It’s Full Steam Ahead In the meantime, however, investment continues to flood the crude oil market, as well as commodities in general. “The mentality now is very bullish,” says Fingerman. “As long as money keeps flowing in, people will keep buying [oil] as though it’s going to go to the moon.” The optimism has helped the stocks of the oil majors. ConocoPhillips is up nearly 40% over the past year. ExxonMobil, Chevron, British Petroleum and Royal Dutch Shell have posted similar if somewhat smaller gains. Still, some analysts say the psychological impact of $100 oil could mark the beginning of a slip in prices. “The professionals will get out of the market at $98.50 or $98.99,” says Peter Beutel, president of the energy risk management firm Cameron Hanover in New Canaan, Conn. “They’re not going to wait for $100 to materialise.” But is there anything special about the $100 mark? Some experts think not. “The barrier was supposedly $70, $80, then $90, and we’re past that. Why would $100 suddenly cause a reversal?” says Stephen Schork, an energy consultant in Villanova, Pa., and editor of the Schork Report, a daily energy newsletter. “$100 is not the death knell to the bull market.”

A Correction Is Inevitable Beutel says that regardless of the exit signal for investors, the oil market is due for a correction. “Historically speaking, we see that every time there is a sustained vertical [price] rise, there is a 20% correction,” says Beutel, adding that the serious threat of a recession could take 40% off oil prices. “It’s a beautiful thing that people forget: The market moves more quickly on the downside than it does on the upside.” It’s also possible that ballooning oil prices will begin to fall when demand responds to price signals, as it happened in the 1980s. “The uptick in crude hasn’t caused the same drag on the economy as it did 28 years ago,” says Ray Carbone, owner of the trading firm Paramount Options. “But once we’re past all-time highs in oil prices, things could change.”

Courtesy: BusinessWeek

Let it flow

A slightly old article that I had read in CFO Asia on innovations in raising money in Asia.

How global liquidity is driving financial innovation in Asia


By Abe De Ramos, Cesar Bacani

By any measure, US$500 bn is a huge sum. It’s about two-and-a-half times the amount of trade surplus that Asia has with the rest of the world; 40% the size of the global hedge-fund industry; half the amount of foreign-exchange reserves China holds. It is also a powerful sum. George Soros shorted just the equivalent of US$10 bn to bring the Bank of England to its knees in 1992. Yet half a trillion dollars is the amount that turned up for just one initial public offering in Asia last October. ICBC, the largest of four state-owned banks in China, needed to raise US$20 bn to pursue its transformation strategy – already a substantial figure, making it the largest IPO ever – and received a flood of orders from institutional and retail investors. What’s more impressive? Two-thirds of that demand came from investors based in Asia. Think about it: at any given time, there’s at least US$330 bn in capital in the region just waiting to be invested.

This is good news for CFOs. As global financial-market liquidity remains above historical averages, investors are finding their way into almost every asset class available. In the same year, stock markets from Hong Kong to Mumbai to New York approached record highs, and spreads for emerging-market bonds have tightened from 400 basis points last year to around 200 bp this year. Global M&A should also see continued growth, not only as the number of deals multiply, but also as deal sizes bloat. And let’s not forget the amount of oil money sloshing around; Middle Eastern investors have been buying equity stakes while snapping up assets across the globe.

Asian companies have benefited from this surfeit of cash. In Singapore, Avago Technologies issued the largest high-yield and lowest-rated corporate bond from Asia. Lippo Karawaci raised the first property bond out of Indonesia. Agile Property came up with the largest bond transaction from a private Chinese company. Food-and-beverage maker San Miguel executed the first true leveraged-buyout deal in the Philippines. But all this hardly means that funds are available on tap. As uncertainties over global economic imbalances grow, so do the financial risks that can affect investor appetite. To be sure, the money is there; investors just need to be convinced that the risks they take are packaged properly, and that the upside potential is evident.

So far, CFOs, financial advisors, and regulators in Asia have responded with gusto, and 2006 might just be remembered as a year of landmark transactions for the Asian capital markets – at least based on the deals that vied for CFO Asia’s seventh annual Deals of the Year awards. This time, we picked transactions that were outstanding, not mainly for their impressive size or flawless execution, but for their innovation, creating new funding avenues, and even changing the dynamics of their sectors altogether. Given the abundant liquidity in the market, CFO Asia predicts that the flow of meaningful deals will continue in 2007. Our boldest view: CFOs should brace themselves for hostile takeovers, as private-equity managers become more aggressive in finding opportunities to grow their funds.

Jason Rynbeck, head of Asia M&A at ABN Amro, shares our view. Previously, private-equity funds tended to strike cozy relationships with business families and made an investment as part of the generational change in the business or to provide extra funding for expansion or working capital. Now, Asian companies have become so disciplined with their financial management that they have more money than they know what to do with. In the meantime, private-equity funds are continuing with their hunt, and if their ability to inject capital were to become less in demand, they will likely use their resources to go for the best assets in the market – whether welcomed or not. Rynbeck puts the size of private-equity funds in the region at US$15 bn to US$20 bn; add the debt load that accompany these deals and the amount could easily reach four or five times that value.

“The nature of transactions will change,” says Rynbeck. “Private equity will start thinking a bit more creatively on how they can participate in transactions by companies. Things will move toward a more aggressive, Carl Icahn-type stance. You will see more hostile bids.” Next month, CFO Asia will publish a list of what we think are potential M&A targets in the region. For now, we present the ten most outstanding deals of 2006 – all inspired by innovation, and made successful by global liquidity. – ADR

ICBC’S US$21.9 BN IPO
Financial advisors: Merrill Lynch, Credit Suisse, Deutsche Bank

This deal had the word ‘success’ written all over it. In October, the Industrial and Commercial Bank of China (ICBC) raised US$21.9 bn in equity, easily becoming the world’s largest initial public offering. The deal cemented China’s stature in the global capital markets, thanks to the unprecedented demand for the IPO.

With an order book of US$500 bn, ICBC was an eye opener on how much liquidity exists in the market and how much money can pour into a single transaction. The international tranche was oversubscribed 40 times, and the retail tranche 78 times – one in seven Hong Kong residents subscribed to the deal. And in a classic measure of IPO pricing accuracy, ICBC’s Hong Kong-listed shares rose 14% on the first day of trading.

The long-term significance of the deal, however, lay in its other landmark achievement: being the first IPO to have concurrent listing in Hong Kong and Shanghai. Prior to ICBC, the best of the mainland companies typically listed first in Hong Kong, and then in Shanghai two or three years later. That put mainland investors at a disadvantage; not only were they not able to capture the upside potential of the first listing, but the pricing of the subsequent domestic listing had been subject to so much volatility. The Chinese government had been meaning to lay the groundwork for concurrent listing with identical pricing in recent mainland-company IPOs, but the market conditions and the determination of the regulators finally aligned for the ICBC issue. “There is a symbolic value in the concurrent listing: to demonstrate that China cares about domestic investors,” says Bing Wang, director at Merrill Lynch in Hong Kong.

To achieve such listing, the IPO broke new regulatory ground. For example, the different disclosure standards for Shanghai’s A-share and Hong Kong’s H-share prospectus regimes meant that lead managers had to obtain waivers and follow just one standard. To achieve identical pricing, lead managers had to carefully balance demand and supply on the international and domestic markets. Overcoming these issues cleared the way for a higher, albeit farther, goal – achieving the fungibility of shares in the two distinct markets. “If you look at it with a long-term view, a concurrent A- and H-share offering is a clear first step towards a unification of both markets,” says Carlos Oyarbide, head of financial institutions group at Credit Suisse.

The deal was attractive on its own merits. ICBC is China’s largest bank with a leading position in corporate and retail segments. It also pre-dates its peers China Construction Bank and Bank of China in terms of internal reforms, having doubtful loans of only 12% compared with 13% and 17% for the others, respectively. It has a lower cost-to-income ratio, and a higher fee income to operating income ratio. “Getting this deal done successfully was no longer just a matter of being a China play; investors recognized the superiority of the bank, in terms of its franchise and fundamentally, its management,” says Oyarbide. – ADR

CATHAY PACIFIC’S HK$8.2 BN
ACQUISITION OF DRAGONAIR
Financial advisors: ABN Amro, Merrill Lynch

The headlines make it sound like a simple transaction: Hong Kong flag carrier Cathay Pacific acquires shares in Chinese-owned Dragonair that it did not already own. Beneath this HK$8.2 bn acquisition, however, is a unique web of cross-shareholdings involving five different parties, the untangling of which was made complicated by forces both commercial and political. But with dogged determination and a keen eye on value creation, Cathay and Air China, parent company of Dragonair, effected one of the most meaningful M&A transactions the Asian aviation sector has ever seen; it would create two of the most competitive carriers in the world, and potentially change the playing field for all airlines with interest in air traffic in the region.

The complicated shareholding structure among the airlines and their shareholders meant the execution of the M&A was not going to be simple. Cathay Pacific wanted to gain control of the strategic China network that Dragonair had at a reasonable price. Air China and CNAC wanted to dispose of their Dragonair shares at a premium to its standalone value while obtaining equity interest in Cathay. Swire Pacific wanted to maintain its dominant shareholding in Cathay, while CITIC Pacific would only reduce, not let go of, its shares in Dragonair. Through a series of share sales and purchases (see chart, left), the working out of these interests met with the stock market’s approval; share prices of all the parties went up following the deal’s completion.

Analysts have long held that full ownership of Dragonair made perfect sense for Cathay Pacific. Why it couldn’t do so sooner, apart from the web of ownership, rested on political considerations. Cathay is majority owned by Swire Pacific, a Hong Kong conglomerate with a largely British identity. The Chinese government was wary of giving the quasi-foreign carrier access to its domestic route, maintaining that mainland carriers should benefit first and foremost. On the other hand, Cathay had an excellent network that Air China could tap into, and one that it could not build on its own. In the end, the most obvious solution won, resulting in an operational agreement that gives each party unhampered access to each other’s networks.

Under the agreement, Air China and Cathay Pacific will have reciprocal sales representation; code share arrangements for all passenger services between Hong Kong and mainland China; business cooperation in marketing, engineering, and ground handling among others; and a possible air cargo joint venture. The arrangement fills gaps in each others’ operations, giving each a competitive advantage over other Chinese airlines and foreign carriers that fly into China and wish to expand there.

The result? Competitors are now trying to catch up – the mainland, after all, is the world’s fastest growing aviation market – and some are now exploring possible deals. “This deal was transformational not just in Asia but also globally,” says Kalpana Desai, head of M&A at Merrill Lynch, which advised Air China. “It not only transformed the Chinese aviation sector, but it also made the entire airline sector around the world ask what are the implications of the transaction.” – ADR

MOBILINK’S US$250M BOND ISSUE
Financial advisors: ABN Amro, Deutsche Bank

While the growth story of Pakistan remained overshadowed by its larger neighbor, investors in its stock market have been richly rewarded over the last five years as the local stock index grew more than five-fold since 2001. Few domestic companies, however, had been known to bond investors overseas as none had dared to tap the international debt market. That changed in November when Pakistan Mobile Communications, or Mobilink, raised US$250m of seven-year debt from enthusiastic investors across Europe, Asia and the US. As the first-ever corporate bond issue out of Pakistan, Mobilink paved a new funding avenue for CFOs in the country.

Jointly led by ABN Amro and Deutsche Bank, Mobilink didn’t take a page out of the structures done previously for similar credits such as Excelcomindo of Indonesia. For one, the company had a credit rating three notches lower than its peers, thanks to a capital structure that had a debt-to-equity ratio approaching four times. Likewise, it refused to restrict dividend payments to its parent, Egypt’s Orascom, which owned telecom assets from Italy to Nigeria. “There was a lot of cash expected from this company, which was a concern for investors,” says a banker who worked on the transaction. What Mobilink had going for it was a 55% market position that generated not only consistent revenue growth, but also exceptional cash flow and profits.

Mobilink’s strong underlying credit and the deal’s rarity value allowed the lead managers to try a novel way of hitting the right cost of funds for Mobilink – blindsiding investors by keeping the order books firmly closed. “We let investors tell us what they thought the credit was worth, without talking up the deal in any way,” says the banker. As such, initial pricing interest ranged from 8.5% to 12%, and succeeding investor meetings established that many investors were comfortable with 9%. An overwhelming demand ultimately set the price at 8.625%, well below what Mobilink was prepared to pay for.

The biggest challenge Mobilink and its lead managers faced was putting the deal together. As a trailblazer, the deal practically wrote the regulations that took the State Bank of Pakistan a year to finalize and approve. “It was a case of educating the regulator as to how a corporate bond deal works, such as what constitutes a covenant package or what kind of collateral can be pledged,” says the banker. On several occasions, the central bank would come back with letters approving certain aspects of the transaction, but would get wrong their intent, leading advisors to return to the drawing board. The regulators, for their part, responded with an eagerness that could eventually bring more Pakistani companies to the international capital markets. – ADR

PRIVATIZATION OF MUMBAI AND DELHI AIRPORTS
Financial advisor: ABN Amro

The privatization of the Delhi and Mumbai airports represents the triumph of economic sense over retrograde populism in a country that needs it most. Transferring control of state assets to private, especially foreign, hands has never appealed to popular sentiment, but the deal’s success gave India a model for future public-private partnerships. India is one of the world’s fastest-growing aviation markets, but carriers are constrained by a chronic lack of runways and parking spaces in the two major hubs, which already account for over 50% of traffic.

It took two years to sell the airports in a bidding that attracted 11 consortia. For a 30-year concession, a South African-Indian consortium will develop and manage the Delhi airport, while a German-Malaysian-Indian group will take care of Mumbai. The cost of developing each was placed at US$2 bn over 20 years. Each consortium will have a 74% stake in its joint venture with the Airport Authority of India (AAI), which takes up the balance.

One of the challenges of the deal was to get the government to agree on what it wanted to accomplish and how much it was willing to share in terms of capital expenditure and revenues. “Getting a common understanding of what the objectives are and presenting this in a package to get buyers interested is challenging,” says Jason Rynbeck, head of M&A for Asia at ABN Amro. In the end, the bidding required that financial consideration include a modest initial payment, plus an annual fee to AAI, set as an annual share of total revenues, which aligns the economic interests of the joint-venture partners. This eventually amounted to 37.7% for Mumbai, and 45.99% for Delhi.

To build competitive tension, participants were required to bid for both assets. They also had to submit a technical bid disclosing their track record and development plans, out of which they were scored up to 100 points. Passing the minimum score then gave them the key to submit financial bids.

The deal didn’t go without a glitch. The high qualifying standards meant only one consortium met the minimum score of 80 points, forcing the government to bring it down to 50. A local company that lost its bid challenged the legality of the sale. The case ended in failure in less than three months. The airports also ground to a halt for days due to union strikes, but the government prevailed upon them after a meeting. Now, the government is ever more determined to privatize 40 smaller airports, while India’s railway monopoly is considering doing the same for a number of terminals. “The success of the deal triggered a thought process in the government,” says Manikkan Sangameswaran of ABN Amro in Mumbai. “Imagine what it could do for healthcare and education.” – ADR

BRAC’S US$180M SECURITIZATION
Financial advisors: Citigroup, RSA Capital

In a year when the Nobel Foundation recognized the role of micro-finance in promoting peace in impoverished nations, the securitization of US$180m in BRAC (Bangladesh Rural Advancement Committee) loans in Bangladesh becomes a more meaningful endeavor for the non-profit organization. Completed in September, the deal brought innovation to funding for the poor, introducing a commercial transaction that may be replicated in countries where micro-credit exists.

BRAC focuses on poverty alleviation and empowerment of women, who make up 99% of its borrowers. Funding is given to village organizations that undertake a project, with the aim of helping members become self-sustaining. About 65% of its loans are for the extremely poor who borrow from US$50 to US$100, while the rest go up to US$500. Loans are usually given a one-year tenor and have an average life of six months. Last year, BRAC extended loans worth US$500m, up from US$440m in 2004. The securitization program allows it to raise US$180m over six years – equivalent to about 7% of its annual funding needs – enough to extend credit to 1.2m members.

The deal is customized to the loan profile of BRAC. Each year, it only raises US$30m, divided into two tranches of US$15m every six months. Each tranche is split into four sub-tranches, and for the first year of the securitization program, each sub-tranche has been allotted to specific investors: US$5m to the Dutch lender FMO; US$5m to Citibank (Dhaka) guaranteed by FMO and KfW of Germany; US$3m to Citibank without guarantee, and US$2m to local banks. These are renegotiable in succeeding years, which may further diversify the investor base. “Their objective is to reduce dependence on donor grants,” says a Citigroup banker in Mumbai, “Now they can get capital-market financing for their initiatives.”

BRAC commissioned a software program developed in Boston to go through the volume of its loan portfolio – at US$100 per loan, borrowers are in the millions – and identify a pool of non-delinquent loans to back the securitization. As BRAC’s collection efficiency reached 99% for the last three years, the Credit Rating Agency of Bangladesh gave AAA ratings to all tranches, which are priced with a spread against the 182-day Bangladesh Treasury-bond rate. On average, funding costs for BRAC amounted to 12% – 200 basis points lower than its average cost of funds from traditional sources such as bank loans.

As the first issuer of securitization in Bangladesh, BRAC and its advisors spent close to a year working with regulators on deal structure, allowing for stamp duty exemptions and accommodating future adjustments in loan tenors. As such, the deal not only paves the way for similar ones in Bangladesh, but in other developing nations as well. “We are in active discussion with other microfinance groups around the world, and we’re trying to replicate this in Eastern Europe and Latin America,” says John Dahl, head of securitization at Citigroup in Hong Kong. – ADR

STANDARD CHARTERED’S US$1.2 BN ACQUISITION OF HSINCHU
Financial advisors: Credit Suisse, Morgan Stanley

In March this year, Craig Liu, vice president for Taiwan at Credit Suisse, happened to sit beside Wu Chih-Wei, president of Taipei-listed Hsinchu International Bank, on a train ride from Hong Kong’s airport to town. Liu had been in regular contact with Wu regarding strategic issues for the mid-sized bank, but all of Credit Suisse’s M&A proposals were turned down. On the train, Liu tried again. He mentioned Britain’s Standard Chartered as a good fit for Hsinchu. This time, Wu signaled interest. Seven months later, Standard Chartered paid US$1.2 bn for nearly all of Hsinchu’s shares.

It was the first-ever acquisition by a foreign financial institution of a bank in Taiwan. Advised by Morgan Stanley, Standard Chartered paid a record price-to-book multiple of 2.3 times, higher than the average of the seven prior domestic acquisitions, and 34% more than Hsinchu’s closing price on the day prior to the announcement. Morgan Stanley declines to comment on the steep price, but some analysts note that seen as a p/e multiple of 2005 earnings, the purchase price is reasonable at 12.7 times.

For Standard Chartered, US$1.2 bn bought 83 branches (it had exactly three before the acquisition) and a commanding market share in Hsinchu, which is home to many of Taiwan’s technology companies. The British bank aims to leverage on this platform to introduce and cross-sell wealth management and other products, and to offer Taiwan corporates financing in China. As a Taiwan bank, Hsinchu could not follow its clients on their mainland forays, a constraint that does not apply to international banks.

For Hsinchu, selling out to Standard Chartered was better than being absorbed by a local bank that could have fired many of its 3,391 employees and its management team. Wu and other senior managers will continue to run Hsinchu, as Standard Chartered had indicated that it sees Hsinchu’s staff as a valuable resource that can be tapped for its own expansion in China.

Taiwan is potentially a winner too. Regulators in Asia’s fifth-largest economy and fourth-biggest banking revenue pool have been signaling their readiness to allow foreigners into the banking sector as a way of consolidating a fragmented industry and strengthening it for global competition. Now that Standard Chartered has blazed the trail, there is renewed interest in cross-border M&A in Taiwan. “There are 43 banks here, and we’re talking to a significant number of them,” says Credit Suisse’s Liu. – CB

AYALA’S PESO CORPORATE HYBRID
Financial advisor: HSBC

In the Philippines, Ayala’s treasury department prides itself on being a pioneer of financial instruments as the diversified conglomerate seeks to help develop the local capital markets. In 2004, it issued a first-ever 7-bn-peso, five-year corporate bond priced at only 20 to 25 basis points above the benchmark. In 2005, its two transactions totaling 7.2 bn pesos were priced 9% inside the benchmark – again a first, since local corporate issues have always been priced at a premium to the benchmark.

“This year, we asked ourselves what we can introduce to the market that was novel and a win-win solution for issuers and investors,” recounts Ramon Opulencia, Ayala’s treasurer. The answer: a peso-denominated corporate hybrid bond (known as a perpetual preferred share) that would be the first-ever local-currency hybrid in Asia, and one that neatly deals with a new wrinkle caused by the adoption of International Financial Reporting Standards (IFRS) in the Philippines. Previously, under local GAAP, preferred shares with a mandatory redemption were treated as equity, and the dividends accounted for after the net income line. Now, under IFRS, these preferred shares must be treated as debt and their dividends accounted for as interest, affecting not only net income but also the ratio of equity to debt and, potentially, a company’s credit rating.

Technically, says Opulencia, Ayala does not need to issue perpetual preferred shares because its balance sheet is strong enough to accommodate the IFRS rule. As well, any change in financial ratios makes no difference since the company has no creditor covenants. After piling up US$1 bn in dollar-denominated debt in the early 1990s, Ayala has deleveraged down to US$550m, in part as a response to the Asian financial crisis that saw a blow-out in the peso-dollar exchange rate. Opulencia’s strategy now is to source pesos from the local market, despite Ayala’s ablity to raise US$100m offshore “in two to three weeks”.

Ayala asked advisor HSBC to structure the hybrid such that it would be treated as equity even as it retained debt characteristics. That meant making the instrument permanent – no mandatory redemption, deeply subordinated, and with the option of deferring payment of dividends without the issuer being declared in default. Ayala also demanded tight pricing. Accordingly, the hybrid was priced flat against the benchmark, which didn’t deter investors whose demand encouraged Ayala to nearly double its issue to 5.8 bn pesos.

The keen investor interest may be due in part to Ayala’s sterling reputation, along with the instrument’s tax efficiency. As equity, the perpetual preferred share’s income is not taxed if the investor is a resident corporate, and taxed only 10% if a resident individual. In the Philippines, a 20% withholding tax is imposed on public corporate debt issues and on Treasury bills issued by the government. HSBC believes that the success of the Ayala hybrid will open up new funding alternatives, not only for Philippine borrowers, but also for other Asian corporates.

“The transaction underscores the value of an issuer’s home market as a viable source of non-dilutive equity,” says the bank, adding that “the improved capital efficiencies and strengthened credit ratios achieved through this domestic transaction could well prove to be of strategic value when volatility strikes the global bond market.” Maybe so, although issuers that are less well regarded than Ayala and those in markets that have little or no room for tax arbitrage may have to be priced much less tightly. – CB

GZI’S REAL ESTATE INVESTMENT TRUST
Financial advisors: Citigroup, HSBC, DBS

In the long list of investment firsts involving China, the first real estate investment trust (REIT) offered abroad is among the most notable. It wasn’t too long ago that all land and property in China were owned and controlled by the communist government. So when four commercial buildings in booming Guangzhou province were placed in the hands of private-sector – and foreign – investors, the transaction was bound to make people sit up and take notice. And buy. GZI REIT’s initial public offering last December was 177 times oversubscribed, with the Hong Kong tranche covered 496 times.

This is all the more remarkable because other IPOs were also jockeying for investors’ attention at that time. Link REIT, the controversial vehicle set up by the Hong Kong government to manage 180 commercial properties and car parks, was listed a month before GZI. Prosperity REIT, which owns seven office and industrial buildings in Hong Kong, went public a week before GZI. A mainland real estate developer, Agile Property, launched its IPO a day after Prosperity. All were multiple times oversubscribed.

Timing was certainly a factor for the deal’s success, and advisors Citigroup, HSBC, and DBS had gone on an accelerated marketing campaign to catch the wave. The roadshow schedule took GZI REIT executives to Hong Kong, Singapore, Amsterdam, and London in seven days, in addition to conference calls to investors in Australia and the US. In the meetings, the Chinese reps touted the REIT’s strong asset portfolio, implied yield of 6.54%, and potential gains from an appreciating renminbi. GZI REIT also secured a five-year right-of-first refusal agreement to acquire properties from Hong Kong-listed Guangzhou Investment, the investment arm of the Guangzhou municipal government.

Subsequent events have put a crimp on investor appetite for REITs. A year after GZI, no other mainland REIT has come to market. Beijing’s crackdown on real property investments to cool the economy is one reason. Another is a new rule that imposed heavy taxes on the transfer of property ownership offshore.

At one point, GZI REIT’s stock price fell 7% to HK$2.85 on the news, compared with the IPO price of HK$3.075. But the stock has since recovered, and closed at HK$3.21 on December 8. If nothing else, GZI REIT has proven that there is enormous overseas appetite for income-producing properties in China, and more important, the prospect of acquiring more real estate assets. The austerity measures are surely short term, and regulators may yet be persuaded to relax their anti-offshore ownership stance. At least, the first REIT step has been taken. – CB

CNPC AND OVL’S JOINT ACQUISITION OF PETRO-CANADA’S SYRIAN ASSETS
Financial advisor: Citigroup

The rise of China and India has the potential to create one of the most exciting economic rivalries of this century, but in at least one area, the two rising superpowers are finding that cooperation might actually work in their favor. With rising energy needs to support their thriving economies, both countries have mandated their state-run energy firms to be acquisitive, and have often found themselves competing against each other for the same overseas assets. The joint acquisition by China National Petroleum (CNPC) and OVL, the international unit of India’s Oil and Natural Gas (ONGC), of the Syrian assets of Petro-Canada last December, was the first of what could be numerous opportunities for them to work together – and fuel their growth in friendlier terms.

Fresh from a bidding war over assets of PetroKazakhstan in July last year, leaders of both countries acknowledged in a meeting at the Great Friendship Hall in Beijing in December that bidding each other out was not always the best way to go. Behind the scenes, CNPC had been working with Citigroup to acquire a stake in the Syrian assets operated by Shell. Recognizing ONGC as a likely competitor once again, bankers broached the idea of a joint bid to CNPC, a proposal that was quickly, surprisingly, welcomed by both parties. To avoid tension in pricing their bid, Citigroup made presentations of the assets’ production profile, operating and capital expenditure, and discount rates. “Once you’ve agreed on those parameters, it will be difficult to have too much variation in terms of valuation,” says a Citigroup banker in Hong Kong.

The deal was an easy win and a good start for M&A cooperation between the two countries: Their joint venture did not entail an operating agreement, and at €484m, the all-cash transaction was a small enough risk compared to the potential benefits. “It was a perfect asset because they could learn about each other without having to agree on Day One about facilities management, drilling schedules, and the like,” the banker adds. The assets made a significant addition to CNPC’s and ONGC’s reserves, and strengthened their relationship with the government of an oil-rich country.

Equally important, the deal set a precedent for future cooperation between Chinese and Indian companies in the energy sector. And it didn’t take long for a second deal to happen. Last August, Sinopec and ONGC agreed to acquire a 50% stake in Omimex of Colombia for US$800m. The deal brought the cooperation between the two countries to a new level, as they will take on the role as operator of the assets.

To be sure, the two deals are minuscule in value compared with what both are capable of spending, and analysts believe that for big-ticket acquisitions such as PetroKazakhstan, players from both countries would prefer to go it alone, and possibly engage in another bidding war. But opportunities like that don’t come very often; in the meantime, both countries can take comfort in the fact that by working together, at least in smaller deals, they could get better value for their money. – ADR

KHAZANAH’S US$750M ISLAMIC EXCHANGEABLE BOND ISSUE
Financial advisors: HSBC, UBS, CIMB

In a move that takes advantage of the amount of oil money sloshing around the region, Khazanah Nasional, the investment arm of the Malaysian government, issued the world’s first exchangeable Islamic bond in September, providing a benchmark for an innovative form of financing for companies in Islamic states. Khazanah raised US$750m in debt exchangeable for shares in Telekom Malaysia, a deal that also became the largest equity-linked issue out of the country. In doing so, Malaysia put its foot forward in the race among Islamic nations to become the center for Shariah-compliant financing in Asia.

Selling a new instrument, advisors to the deal faced the immediate challenge of investor education. Investors in the Middle East, who would take up one-third of the issue, were generally unfamiliar with the equity aspect of Islamic debt known as sukuk, which takes into consideration the fact that charging of interest is forbidden under Shariah law. On the other hand, traditional convertible-bond investors in the US and Europe, who bought the rest of the issue, had the opposite concern. This presented complications in structuring and pricing the deal.

In a traditional sukuk, the ultimate borrower creates a special-purpose vehicle (SPV) that then becomes the technical borrower. The borrower then transfers physical assets to the SPV and enters into an arrangement similar to a sale-and-lease-back agreement. The lease payments that the borrower makes to the SPV are then used to finance the coupon payments of the sukuk. For Khazanah’s exchangeables, the transaction is backed up not by a lease agreement but by Telekom shares transferred to the SPV. The dividend income on those shares is then used to pay the coupon. But because dividends are not guaranteed, the risk for investors increased. “So we had a number of features in the structure that maximized the likelihood that the coupons will get paid,” says Tom Lanners at HSBC in Hong Kong.

First among the solutions was to fix the coupon at roughly half the forecast level of the dividend; this way, even if Telekom were to halve its dividend, it would still have enough to cover the coupon obligations. Second, the advisors created a sinking-fund concept, where if there were more than enough dividends to cover the coupon payments early on, the surplus would be put into a fund to pay future coupons. Third, advisors made coupon payments cumulative, so that if there weren’t enough funds to pay the coupon early on, they would still be payable at the point in the future when funds became sufficient. This was a time-consuming process because each Islamic investor had its own Shariah board, and each could have its own interpretation.

As investors have become more aware of the structure, Lanners adds that other Islamic-country corporates can now follow suit. “There is a lot of money among Islamic investors,” he says. “And if you come with an Islamic issue, then you will have access to investors that you otherwise wouldn’t have been able to tap.” – ADR