FINANCE: OTC and CDS

Some interesting information:

Structured Finance

OTC's are over the counter security sales.

CDS - credit default swaps: Time article & Businessweek

Bank of International Settlements

SWAPs in general

CDS's were made legal by the Commodity Futures Modernization Act of 2000. Which is apparently something Phil Gramm is still pretty proud of, according to the NYTimes...

In November 1999, senior Clinton administration officials, including Treasury Secretary Lawrence H. Summers, joined by the Federal Reserve chairman, Alan Greenspan, and Arthur Levitt Jr., the head of the Securities and Exchange Commission, issued a report that instead recommended legislation exempting many kinds of derivatives from federal oversight.

Mr. Gramm helped lead the charge in Congress. Demanding even more freedom from regulators than the financial industry had sought, he persuaded colleagues and negotiated with senior administration officials, pushing so hard that he nearly scuttled the deal. “When I get in the red zone, I like to score,” Mr. Gramm told reporters at the time.

Finally, he had extracted enough. In December 2000, the Commodity Futures Modernization Act was passed as part of a larger bill by unanimous consent after Mr. Gramm dominated the Senate debate.

“This legislation is important to every American investor,” he said at the time. “It will keep our markets modern, efficient and innovative, and it guarantees that the United States will maintain its global dominance of financial markets.”

But some critics worried that the lack of oversight would allow abuses that could threaten the economy.

Frank Partnoy, a law professor at the University of San Diego and an expert on derivatives, said, “No one, including regulators, could get an accurate picture of this market. The consequences of that is that it left us in the dark for the last eight years.” And, he added, “Bad things happen when it’s dark.”

In 2002, Mr. Gramm left Congress, joining UBS as a senior investment banker and head of the company’s lobbying operation.

That does seem a bit corrupt, doesn't it?

I've been wondering for a while why Banks and pension funds bought CDOs (especially the "toxic waste" - why would anyone buy something with that nickname?). This is an interesting bloomberg article on that point...

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Darrell Duffie, a professor of finance at the Stanford Graduate School of Business in Stanford, California, says he's concerned about public pension trustees' getting their CDO education from the banks that are selling the investment.

FINANCE: Basel II Notes and Thoughts

From RISK Net article:

One of those ideas would be to detach capital requirements from risk levels. Because risk is lowest at the peak of a business cycle, regulatory capital under Basel II should also be low, meaning there would be little constraint on a bank's ability to pile on risk - potentially exacerbating the pain of the next downturn, say critics. Conversely, at the market's nadir, risk would appear to be high, and capital requirements would also be high - biting into the industry's ability to lend and prolonging the slump. In short, the rules are seen as being pro-cyclical.
...
The devil, of course, is in the detail - and Oliver Wyman's Kuritzkes says there is precious little detail: "There's a lot of easy talk about through-the-cycle PDs but, to my knowledge, no one has come up with a rigorous way to evaluate these dynamic time effects." There is also a trade-off to be made, he says. One of Basel II's main aims was to curb regulatory capital arbitrage, in which banks took advantage of the old regime's insensitivity by retaining more risk (and its associated higher returns) without having to hold an appropriate level of capital. Tying capital more closely to the underlying risk of an asset was supposed to curb this behaviour - but a through-the-cycle approach would again open the possibility that risk levels at certain points in time could become decoupled from capital requirements.
...
The current credit crisis has come close to making disintermediation a dirty word - short-hand for the process through which exposure to US subprime mortgage loans was originated by banks but ended up distributed around the financial system, spooking investors and causing global panic. "It's bound to cause the originate-to-distribute model to be queried," says Charles Goodhart, director of the regulation and financial stability programme at the London School of Economics (LSE), and a former member of the Bank of England's rate-setting committee.

But this is a tricky issue. Although there is widespread acceptance that banks have embraced the originate-to-distribute model, not everyone thinks that is the same thing as disintermediation - while risk was distributed, much of it remained within the banking industry, they argue. And there is also little agreement on the extent to which the Basel Accord is to blame.

ECONOMY: Krugman Editorial on Likelihood of a Recovery

Easily the most intelligent assessment I've seen of the current economic situation. Unfortunately, it doesn't paint a very nice picture...

Life Without Bubbles

By PAUL KRUGMAN

Whatever the new administration does, we’re in for months, perhaps even a year, of economic hell. After that, things should get better, as President Obama’s stimulus plan — O.K., I’m told that the politically correct term is now “economic recovery plan” — begins to gain traction. Late next year the economy should begin to stabilize, and I’m fairly optimistic about 2010.

But what comes after that? Right now everyone is talking about, say, two years of economic stimulus — which makes sense as a planning horizon. Too much of the economic commentary I’ve been reading seems to assume, however, that that’s really all we’ll need — that once a burst of deficit spending turns the economy around we can quickly go back to business as usual.

In fact, however, things can’t just go back to the way they were before the current crisis. And I hope the Obama people understand that.

The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either.

To be more specific: the severe housing slump we’re experiencing now will end eventually, but the immense Bush-era housing boom won’t be repeated. Consumers will eventually regain some of their confidence, but they won’t spend the way they did in 2005-2007, when many people were using their houses as ATMs, and the savings rate dropped nearly to zero.

So what will support the economy if cautious consumers and humbled homebuilders aren’t up to the job?

A few months ago a headline in the satirical newspaper The Onion, on point as always, offered one possible answer: “Recession-Plagued Nation Demands New Bubble to Invest In.” Something new could come along to fuel private demand, perhaps by generating a boom in business investment.

But this boom would have to be enormous, raising business investment to a historically unprecedented percentage of G.D.P., to fill the hole left by the consumer and housing pullback. While that could happen, it doesn’t seem like something to count on.

A more plausible route to sustained recovery would be a drastic reduction in the U.S. trade deficit, which soared at the same time the housing bubble was inflating. By selling more to other countries and spending more of our own income on U.S.-produced goods, we could get to full employment without a boom in either consumption or investment spending.

But it will probably be a long time before the trade deficit comes down enough to make up for the bursting of the housing bubble. For one thing, export growth, after several good years, has stalled, partly because nervous international investors, rushing into assets they still consider safe, have driven the dollar up against other currencies — making U.S. production much less cost-competitive.

Furthermore, even if the dollar falls again, where will the capacity for a surge in exports and import-competing production come from? Despite rising trade in services, most world trade is still in goods, especially manufactured goods — and the U.S. manufacturing sector, after years of neglect in favor of real estate and the financial industry, has a lot of catching up to do.

Anyway, the rest of the world may not be ready to handle a drastically smaller U.S. trade deficit. As my colleague Tom Friedman recently pointed out, much of China’s economy in particular is built around exporting to America, and will have a hard time switching to other occupations.

In short, getting to the point where our economy can thrive without fiscal support may be a difficult, drawn-out process. And as I said, I hope the Obama team understands that.

Right now, with the economy in free fall and everyone terrified of Great Depression 2.0, opponents of a strong federal response are having a hard time finding support. John Boehner, the House Republican leader, has been reduced to using his Web site to seek “credentialed American economists” willing to add their names to a list of “stimulus spending skeptics.”

But once the economy has perked up a bit, there will be a lot of pressure on the new administration to pull back, to throw away the economy’s crutches. And if the administration gives in to that pressure too soon, the result could be a repeat of the mistake F.D.R. made in 1937 — the year he slashed spending, raised taxes and helped plunge the United States into a serious recession.

The point is that it may take a lot longer than many people think before the U.S. economy is ready to live without bubbles. And until then, the economy is going to need a lot of government help.

RETAIL: Science of Shopping

Interest economist article about the science of retailing.

The way the brain buys

Dec 18th 2008 | BASINGSTOKE, ENGLAND
From The Economist print edition

Retailers are making breakthroughs in understanding their customers’ minds. Here is what they know about you

IT MAY have occurred to you, during the course of a dismal trawl round a supermarket indistinguishable from every other supermarket you have ever been into, to wonder why they are all the same. The answer is more sinister than depressing. It is not because the companies that operate them lack imagination. It is because they are all versed in the science of persuading people to buy things—a science that, thanks to technological advances, is beginning to unlock the innermost secrets of the consumer’s mind.

In the Sainsbury’s in Hatch Warren, Basingstoke, south-west of London, it takes a while for the mind to get into a shopping mode. This is why the area immediately inside the entrance of a supermarket is known as the “decompression zone”. People need to slow down and take stock of the surroundings, even if they are regulars. In sales terms this area is a bit of a loss, so it tends to be used more for promotion. Even the multi-packs of beer piled up here are designed more to hint at bargains within than to be lugged round the aisles. Wal-Mart, the world’s biggest retailer, famously employs “greeters” at the entrance to its stores. Whether or not they boost sales, a friendly welcome is said to cut shoplifting. It is harder to steal from nice people.

Immediately to the left in Sainsbury’s is another familiar sight: a “chill zone” for browsing magazines, books and DVDs, tempting impromptu purchases and slowing customers down. But those on a serious mission will keep walking ahead—and the first thing they come to is the fresh fruit and vegetables section.

For shoppers, this makes no sense. Fruit and vegetables can be easily damaged, so they should be bought at the end, not the beginning, of a shopping trip. But psychology is at work here: selecting good wholesome fresh food is an uplifting way to start shopping, and it makes people feel less guilty about reaching for the stodgy stuff later on.

Shoppers already know that everyday items, like milk, are invariably placed towards the back of a store to provide more opportunity to tempt customers. This is why pharmacies are generally at the rear, even in “convenience” stores. But supermarkets know shoppers know this, so they use other tricks, like placing popular items halfway along a section so that people have to walk all along the aisle looking for them. The idea is to boost “dwell time”: the length of time people spend in a store.

Traditionally retailers measure “footfall”, as the number of people entering a store is known, but those numbers say nothing about where people go and how long they spend there. But nowadays, a ubiquitous piece of technology can fill the gap: the mobile phone. Path Intelligence, a British company working with the Massachusetts Institute of Technology, tracked people’s phones at Gunwharf Quays, a large retail and leisure centre in Portsmouth—not by monitoring calls, but by plotting the positions of handsets as they transmit automatically to cellular networks. It found that when dwell time rose 1% sales rose 1.3%.

Having walked to the end of the fruit and vegetable aisle, Basingstoke’s hard-core shoppers arrive at counters of prepared food, the fishmonger, the butcher and the deli. Then there is the in-store bakery, which can be smelt before it is seen. Even small supermarkets now use in-store bakeries. Mostly these bake pre-prepared items and frozen dough, and they have boomed even though central bakeries that deliver to a number of stores are much more efficient. They do it for the smell of freshly baked bread, which makes people hungry and thus encourages people to buy not just bread but also other food, including frozen stuff.

Most of the information that shoppers are bombarded with is visual: labels, price stickers and advertising. But the wafting bread aroma shows smell can usefully be stimulated too, says Simon Harrop, chief executive of BRAND sense agency, a British specialist in multi-sensory marketing. In the aisle by the laundry section he suggests introducing the smell of freshly laundered sheets. Even the sound of sheets being folded could be reproduced here and contained within the area using the latest audio technology. The Aroma Company, which Mr Harrop founded, has put the smell of coconut into the shops of Thompson, a British travel agent. Some suntan oils smell of coconut, so the scent is supposed to remind people of past holidays. The company even infuses the fresh smell of citrus into a range of clothing made by Odeur, a Swedish company. It can waft for up to 13 washes.

Such techniques are increasingly popular because of a deepening understanding about how shoppers make choices. People tell market researchers and “focus groups” that they make rational decisions about what to buy, considering things like price, selection or convenience. But subconscious forces, involving emotion and memories, are clearly also at work.

Scientists used to assume that emotion and rationality were opposed to each other, but Antonio Damasio, now professor of neuroscience at the University of Southern California, has found that people who lose the ability to perceive or experience emotions as the result of a brain injury find it hard or impossible to make any decisions at all. They can’t shop.

Oh, that’s what I want

Researchers are now exploring these mechanisms by observing the brain at work. One of the most promising techniques is functional magnetic resonance imaging (fMRI), which uses a large scanner to detect changes in the blood flow in parts of the brain that correspond to increases or decreases in mental activity. People lying inside the scanners are shown different products or brands and then asked questions about them. What they say is compared with what they are thinking by looking at cognitive or emotional activity. The idea is that if, say, a part of the brain that is associated with pleasure lights up, then the product could be a winner. This is immensely valuable information because eight out of ten new consumer products usually fail, despite test marketing on people who say they would buy the item—but whose subconscious may have been thinking something different.

“We are just at the frontier of the subconscious,” says Eric Spangenberg, dean of the College of Business at Washington State University and an expert on the subtleties of marketing. “We know it’s there, we know there are responses and we know it is significant.” But companies commissioning such studies keep the results secret for commercial reasons. This makes Dr Spangenberg sure of one thing: “What I think I know, they probably know way more.”

We are just at the frontier of the subconscious

Retailers and producers talk a lot about the “moment of truth”. This is not a philosophical notion, but the point when people standing in the aisle decide what to buy and reach to get it. The Basingstoke store illustrates some of the ways used to get shoppers’ hands to wobble in the direction of a particular product. At the instant coffee selection, for example, branded products from the big producers are arranged at eye-level while cheaper ones are lower down, along with the supermarket’s own-label products.

Often head offices will send out elaborate plans of where everything has to be placed; Albertsons, a big American supermarket chain, calls these a “plan-a-gram”. Spot-checks are carried out to make sure instructions are followed to the letter. The reason for this strictness is that big retailers demand “slotting fees” to put suppliers’ goods on their shelves, and these vary according to which positions are considered to be prime space.

But shelf-positioning is fiercely fought over, not just by those trying to sell goods, but also by those arguing over how best to manipulate shoppers. Never mind all the academic papers written on how best to stack shelves, retailers have their own views. While many stores reckon eye-level is the top spot, some think a little higher is better. Others charge more for goods placed on “end caps”—displays at the end of the aisles which they reckon to have the greatest visibility (although some experts say it all depends on the direction in which people gyrate around a store—and opinion on that is also divided). To be on the right-hand-side of an eye-level selection is often considered the very best place, because most people are right-handed and most people’s eyes drift rightwards. Some supermarkets reserve that for their own-label “premium” goods. And supermarkets may categorise things in different ways, so chapatis may not be with breads, but with ready-meals of the Indian variety. So, even though some suppliers could be paying around $50,000 per store a year for a few feet of shelf space, many customers still can’t find what they are looking for.

Technology is making the process of monitoring shopper behaviour easier—which is why the security cameras in a store may be doing a lot more than simply watching out for theft. Rajeev Sharma, of Pennsylvania State University, founded a company called VideoMining to automate the process. It uses image-recognition software to scan the pictures from security cameras of shoppers while they are making their selections. It is capable of looking at the actions of hundreds of thousands of people. It can measure how many went straight to one brand, the number that dithered and those that compared several, at the same time as sorting shoppers by age, gender and ethnicity.

VideoMining analysed people in convenience stores buying beer. Typically it would take them two minutes, with the majority going straight to one brand. “This shows their mind was already made up; they were on autopilot,” says Dr Sharma. So brewers should spend their marketing money outside, not inside, the store. The analysis can also help establish the return on investment to a new advertising campaign by showing what proportion of beer-buyers can be persuaded to consider rival brands. Another study in a supermarket some 12% of people spent 90 seconds looking at juices, studying the labels but not selecting any. In supermarket decision-making time, that is forever. This implies that shoppers are very interested in juices as a healthy alternative to carbonated drinks, but are not sure which to buy. So there is a lot of scope for persuasion.

Reducing the selection on offer might help too. Cassie Mogilner of Stanford University and her colleagues found in a study that consumers like unfamiliar products to be categorised—even if the categories are meaningless. In a study of different coffees they found people were more satisfied with their choice if it came from a categorised selection, although it did not matter if the categories were marked simply A, B and C, or “mild”, “dark roast” and “nutty”.

Despite all the new technology, simply talking to consumers remains one of the most effective ways to improve the “customer experience”. Scott Bearse, a retail expert with Deloitte Consulting in Boston, Massachusetts, has led projects observing and quizzing tens of thousands of customers about how they feel about shopping. It began when a client complained that he had mountains of data on the one in four people that entered his store and bought something, but knew hardly anything about the vast majority who left without making a purchase. The “customer conversion” rate varies between types of store: it could be around 20% in some department stores but reach almost 100% in a grocery. And within the same store the conversion rate will vary in different sections.

People say they leave shops empty-handed more often because they are “unable to decide” than because prices are too high, says Mr Bearse. Working out what turns customers off is not difficult, yet stores still struggle with these issues: goods out of stock, long queues at the checkouts and poor levels of service. Getting customers to try something is one of the best ways of getting them to buy, adds Mr Bearse. Deloitte found that customers using fitting rooms convert at a rate of 85% compared with 58% for those that do not do so.

Often a customer struggling to decide which of two items is best ends up not buying either. A third “decoy” item, which is not quite as good as the other two, can make the choice easier and more pleasurable, according to a new study using fMRI carried out by Akshay Rao, a professor of marketing at the University of Minnesota. Happier customers are more likely to buy. Dr Rao believes the deliberate use of irrelevant alternatives should work in selling all sorts of goods and services, from cable TV to holidays.

The notion of shoppers wearing brain-scanning hats would be ridiculous

A lack of price tags is another turn-off, although getting that right will become crucial with the increasing use of Radio Frequency Identification (RFID) tags. These contain far more information than bar codes and can be scanned remotely. People have been predicting for years that they would shortly become ubiquitous; but, with costs continuing to fall, they eventually will. Tills will then become redundant, because everything shoppers put in their trolleys will be automatically detected and charged to their credit cards.

The basic mechanisms to do this are already in place. A store or loyalty card can be fitted with an RFID tag to identify customers on arrival. A device on the trolley could monitor everything placed in it, check with past spending patterns and nudge customers: “You have just passed the Oriels, which you usually buy here.”

Mind over matter

Technology will also begin to identify customers’ emotions. Dr Sharma’s software has the potential to analyse expressions, like smiles and grimaces, which are hard to fake. And although fMRI scanners presently need a crane to move, something that provides a similar result might one day be worn on your head. Researchers believe it is possible to correlate brain patterns with changes in electrical activity in the brain, which can be measured with electroencephalography (EEG) using electrodes placed on the scalp. Small EEG machines are already available, especially for computer gamers, which fit on the head.

The notion of shoppers wearing brain-scanning hats would be ridiculous if it were not so alarming. Privacy groups are already concerned about the rise of electronic surveillance that records what people do, let alone what they might be thinking. The San Francisco-based Electronic Frontier Foundation is concerned that because RFID tags can be read at a distance by anyone with the necessary equipment they could create “privacy pollution”; being used to discover what is in not only someone’s shopping trolley, but also their cupboards.

To some degree shoppers would have to “buy in” to the process: a bit like having an account with an online retailer which comes with the explicit knowledge that your past purchases and browsing history will be monitored and used to pitch purchase suggestions. And if that makes shopping easier—especially if sweetened with discounts—then consumers might sign up to it. When Dr Sharma asks shoppers what they think about his video-monitoring he says most people do not mind.

But what if psychological selling is done stealthily? That way lies grave perils. It is the anger not of privacy groups that retailers should fear, but of customers at being manipulated from behind the scenes.

There have been backlashes before: “The Hidden Persuaders” by Vance Packard, an American journalist, caused a sensation when it was first published in 1957 by revealing physiological techniques used by advertisers, including subliminal messages. It is what got Dr Spangenberg interested in the subject. He thinks shopping science has limits. “I don’t think you are going to be able to make someone buy a car or a computer that they don’t need,” he says. “But you might persuade them to choose one model instead of another. And importantly, they wouldn’t know it.” But if they did realise psychological methods were being used to influence their choice, “the counteraction can be so huge it can put someone off buying anything at all,” he adds.

Which is probably why at the end of this shopping trip there is not much in the trolley. At least the temptations at the checkout are easy to avoid: a few celebrity magazines and bags of sweets at the eye-level of children. But that will change too.

Barry Salzman, the chief executive of YCD Multimedia in New York, has big plans for the area around a cash till. He is using digital video screens displaying ads that relate to what someone is buying and which can also be linked with facial-recognition software to refine the displays according to the customer’s age or sex. His system is already being used in Aroma Espresso Bars in America to present, say, an advert for a chocolate croissant to someone buying only a cappuccino.

But the checkout in this Sainsbury’s comes to a halt because the teenager at the till is not old enough to sell alcohol and can’t attract the attention of a supervisor for permission to ring up a multi-pack of beer, which is therefore left behind on the counter. The science of shopping is a marvellously sophisticated business; the practice is still a little more primitive.

TECH: Public-Private Cooperation

Apparently Sematech is one of the best known examples of the US government joining forces with private industry to help private US industry regain its competitiveness.

Wikipedia article

Sematech website

In Sematech's case, the effort was geared towards making US semiconductor producers more efficient. Interestingly, the automotive manufacturers are now taking similar steps to convince the US government to enter into a partnership with a consortium of manufacturers to work on battery technology.

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Another interesting example from the NYTimes:

History illustrates how tricky it can be to make public spending work as intended. The many dams Franklin D. Roosevelt’s administration built generated an abundance of electricity, lowering its cost so that families could afford to operate the appliances then becoming available. The construction itself put money into workers’ pockets. But the appliances were too costly for most families during the Depression, and the manufacturers wouldn’t extend credit. For all the money spent by the Roosevelt administration, public investment was failing to jump-start a key private-sector industry.

His administration was inventive, however, and found a way around the problem by subsidizing installment purchases. That was when appliance production finally rose. In time, installment plans evolved into consumer loans and charge cards, and that helped make the American consumer economy the envy of the world.

FINANCE: Level 3 Bonuses...

This is a pretty cool solution to the bonus question for large financial firms:

As Wall Street banks face public outrage over the large bonuses they plan to pay workers this year, Credit Suisse’s investment banking unit told senior bankers on Thursday that they would have to eat their own cooking.

Credit Suisse will pay a portion of bonuses for thousands of its senior investment bankers using shares of troubled assets left over from before the financial crisis.

I'm thinking all firms should do that... (Reference)

FINANCE: Interesting banking information...

Interesting reading: FDIC Examinations Page

Definition of Capital Ratio

Definition of Tier 1 capital

Definition of Capital Requirement

Information on the Gramm-Leach-Bliley Act

Information on Basel II, which was the international standard set up to regulate the capital levels for banks: Basel II

Federal Reserve Board information on calculating capital level post-basel II: The site.

bank of international settlements

Distinction between asset levels: Levels 1 through 3 and mark to model. I think it was SFAS-157 that forced banks to make these distinctions in 2007.

Other interesting sources of general information:

CFO Magazine

RISK net Magazine

FINANCE: The Debt Trap

The credit Trap - A set of NYTimes articles definitely worth reading on what is sure to be the next big ding to the US economy - credit card debt. A good portion of the Tier I assets on the balance sheets of banks like Citi are consumer credit card loans. Its easy to imagine that those assets will prove to be just as unreliable as the MBS CDOs (mortgage backed securities) that they recently wrote down.

I imagine what makes selling credit cards to people already massively in debt so attractive for a bank is that there is a good chance those people will continue running up debt. credit card debt is very attractive to a bank - assuming consumers don't default. Whatever debt consumers run up is booked as an asset on a bank's balance sheet while the bank gets to book income in the form of interchange fees as money is spent and on interest fees and late penalty charges as the de facto consumer loans are serviced. This arrangement works fine for everyone until the consumers can no longer service the loans and are thus forced to default on the debt - at which time the bank's credit card loan assets need to be written down. A state of affairs that must just result in another liquidity crisis as banks end up capital ratios below the acceptable level. But if you're rewarded based upon only a given year's performance, you might just not care...

Another interesting element from an FDIC website page:

These intangible assets are commonly known as purchased credit card relationships (PCCRs). PCCRs represent the right to conduct ongoing credit card business dealings with the cardholders and normally are recorded as assets when a bank purchases existing credit card receivables at a premium and has the right to provide card services to the cardholders whose credit card accounts have been purchased. PCCRs may also be acquired when a bank purchases an entity that owns a credit card portfolio.

And apparently PCCRs are counted as a Tier 1 Capital...

PCCRs are one of only a few intangible assets that are not deducted from Tier 1 capital, subject to certain limitations. A deduction of all or a part of the PCCRs may be required if the carrying amount is excessive in relation to their market value or the level of the bank's capital accounts.

According to this IHT article, citibanks credit card recievables amount to approximately $91 Billion.

ECONOMY: The Effects on Health

Interesting article on the effects that the economic downturn has had on men's confidence and sense of self-worth. To quote:

He came in one day looking subdued and plopped down in the chair. “I’m over the anxiety, but now I feel like a loser.” This from a supremely self-confident guy who was viewed by his colleagues as an unstoppable optimist.

TECH: Net Neutrality Going Out of Style

This is an interesting break down on the history of the issue of net neutrality. I'm including the entire article given that a subscription is required for WSJ articles.

Google Wants Its Own Fast Track on the Web

By VISHESH KUMAR and CHRISTOPHER RHOADS

The celebrated openness of the Internet -- network providers are not supposed to give preferential treatment to any traffic -- is quietly losing powerful defenders.

Google Inc. has approached major cable and phone companies that carry Internet traffic with a proposal to create a fast lane for its own content, according to documents reviewed by The Wall Street Journal. Google has traditionally been one of the loudest advocates of equal network access for all content providers.

At risk is a principle known as network neutrality: Cable and phone companies that operate the data pipelines are supposed to treat all traffic the same -- nobody is supposed to jump the line But phone and cable companies argue that Internet content providers should share in their network costs, particularly with Internet traffic growing by more than 50% annually, according to estimates. Carriers say that to keep up with surging traffic, driven mainly by the proliferation of online video, they need to boost revenue to upgrade their networks. Charging companies for fast lanes is one option.

One major cable operator in talks with Google says it has been reluctant so far to strike a deal because of concern it might violate Federal Communications Commission guidelines on network neutrality.

"If we did this, Washington would be on fire," says one executive at the cable company who is familiar with the talks, referring to the likely reaction of regulators and lawmakers.

Separately, Microsoft Corp. and Yahoo Inc. have withdrawn quietly from a coalition formed two years ago to protect network neutrality. Each company has forged partnerships with the phone and cable companies. In addition, prominent Internet scholars, some of whom have advised President-elect Barack Obama on technology issues, have softened their views on the subject.

The contentious issue has wide ramifications for the Internet as a platform for new businesses. If companies like Google succeed in negotiating preferential treatment, the Internet could become a place where wealthy companies get faster and easier access to the Web than less affluent ones, according to advocates of network neutrality. That could choke off competition, they say.

For computer users, it could mean that Web sites by companies not able to strike fast-lane deals will respond more slowly than those by companies able to pay. In the worst-case scenario, the Internet could become a medium where large companies, such as Comcast Corp. in cable television, would control both distribution and content -- and much of what users can access, according to neutrality advocates.

The developments could test Mr. Obama's professed commitment to network neutrality. "The Internet is perhaps the most open network in history, and we have to keep it that way," he told Google employees a year ago at the company's Mountain View, Calif., campus. "I will take a back seat to no one in my commitment to network neutrality."

Barack Obama

But Lawrence Lessig, an Internet law professor at Stanford University and an influential proponent of network neutrality, recently shifted gears by saying at a conference that content providers should be able to pay for faster service. Mr. Lessig, who has known President-elect Barack Obama since their days teaching law at the University of Chicago, has been mentioned as a candidate to head the Federal Communications Commission, which regulates the telecommunications industry.

The shifting positions concern some purists. "What they're talking about is selling you the right to skip ahead in the line," says Ben Scott, policy director of Free Press, a Washington-based advocacy group. "It would mean the first part of your business plan would be a deal with AT&T to get into their super-tier -- that is anathema to a culture of innovation."

Advocates of network neutrality believe it has helped the Internet drive the technology revolution of the past two decades, creating hundreds of thousands of jobs.

The concept of network neutrality originated with the phone business. The nation's longtime telephone monopoly, nicknamed Ma Bell, and its regional successors were prohibited from giving any public phone call preference in how quickly it was connected. When the Internet first boomed in the 1990s, content largely traveled via telephone line, and the rule survived by default.

'Dumbpipes'

The carriers picked up the unflattering nickname "dumbpipes," underscoring their strict noninterference in the Internet traffic surging over their networks. The name heightened resentment among the carriers toward the soaring wealth of the content providers, such as Amazon.com Inc., that couldn't exist without the networks of the telecom and cable companies.

In August 2005, amid a deregulatory environment, the FCC weakened network neutrality to a set of four "guiding principles." The step had the effect of making the FCC's power to enforce network neutrality subject to interpretation, emboldening those looking for ways around it.

Stirring the waters further, major phone companies including AT&T and Verizon announced they intended to create new fast lanes on the Internet -- and would charge content companies a toll to use it. They claimed Internet companies had been getting a free ride.

That unleashed a firestorm of criticism. A diverse group including Internet companies Google, Microsoft and Amazon joined the likes of the Christian Coalition, the National Rifle Association and the pop singer Moby in what they characterized as a fight to "save the Internet." The coalition claimed such steps could endanger freedom of speech.

Advocates of network neutrality also claimed that dismantling the rule would be the first step toward distributors gaining control over content, since they could dictate traffic according to fees charged to content providers. The fortunes of a certain Web site, in other words, might depend on how much it could pay network providers, rather than on its popularity.

That concern would grow if the carriers themselves offer content, which some have tried, with mixed success. AT&T, the country's largest broadband provider, recently launched its own online video service, called VideoCrawler, to compete with YouTube and others.

"One way AT&T can win that competition is to give their own video service preferential treatment on their network," says Robert Topolski, a networking engineer based in Portland, Ore. An AT&T spokesman says the company has no plans to give VideoCrawler preferential treatment on its network.

Mr. Topolski discovered that Comcast was slowing a video file-sharing service called BitTorrent. That discovery eventually led to sanctions against Comcast by the FCC. Comcast has appealed the decision, arguing the FCC did not have the authority to make such a ruling.

In 2006, Microsoft felt strongly enough about the issue that it wrote Congress to declare that saving network neutrality "could dictate whether the U.S. will continue to lead the world in Internet-related technologies."

The debate eventually reached a stalemate. Legislation to codify network neutrality failed to pass, and carriers backed off their plans for a tiered Internet.

During his presidential campaign, Mr. Obama spoke frequently about the Internet, which was a critical tool in his grass-roots effort to reach new voters, and the importance of network neutrality. "Once providers start to give privilege to some Web sites and applications over others, then the smaller voices get squeezed out," he told Google employees a year ago when he campaigned at the company. "And then we all lose."

Obama Advisers

But some of those who advise the new president on technology have changed their view on network neutrality. Stanford's Mr. Lessig, for one, has softened his opposition to variable service tiers. At a conference, he argued that carriers won't become kingmakers so long as the faster service at a higher price is available to anyone willing to pay it.

"There are good reasons to be able to prioritize traffic," Mr. Lessig said later in an interview. "If everyone had to pay the same rates for postal service, than you wouldn't be able to differentiate between sending a greeting card to your grandma versus sending an overnight letter to your lawyer."

Some telecom experts say that broadband is the most profitable service offered by phone and cable companies, and they are simply trying to offset declining revenue from their traditional phone business.

In the two years since Google, Microsoft, Amazon and other Internet companies lined up in favor of network neutrality, the landscape has changed. The Internet companies have formed partnerships with phone and cable companies, making them more dependent on one another.

Microsoft, which appealed to Congress to save network neutrality just two years ago, has changed its position completely. "Network neutrality is a policy avenue the company is no longer pursuing," Microsoft said in a statement. The Redmond, Wash., software giant now favors legislation to allow network operators to offer different tiers of service to content companies.

Microsoft has a deal to provide software for AT&T's Internet television service. A Microsoft spokesman declined to comment whether this arrangement affected the company's position on network neutrality.

Amazon's popular digital-reading device, called the Kindle, offers a dedicated, faster download service, an arrangement Amazon has with Sprint. That has prompted questions in the blogosphere about whether the service violates network neutrality.

"Amazon continues to support adoption of net neutrality rules to protect the longstanding, fundamental openness of the Internet," Amazon said in a statement. It declined to elaborate on its Kindle arrangement.

Amazon had withdrawn from the coalition of companies supporting net neutrality, but it recently was listed once again on the group's Web site. It declined to comment on whether carriers should be allowed to prioritize traffic.

Yahoo now has a digital subscriber-line partnership with AT&T. Some have speculated that the deal has caused Yahoo to go silent on the network-neutrality issue.

An AT&T spokesman said the company should be able to strike any deal it sees fit with content companies. Yahoo said in a statement that carriers and content companies "should find a consensus on how best to ensure that Americans have access to a world-class Internet."

Google Connections

Google, with its dominant market position and its perceived ties to the Obama team, may hold the most sway. One of President-elect Obama's most visible supporters during the campaign was Eric Schmidt, Google's chief executive officer. Mr. Schmidt remains an adviser during the transition.

Eric Schmidt

Google's proposed arrangement with network providers, internally called OpenEdge, would place Google servers directly within the network of the service providers, according to documents reviewed by the Journal. The setup would accelerate Google's service for users. Google has asked the providers it has approached not to talk about the idea, according to people familiar with the plans.

Asked about OpenEdge, Google said only that other companies such as Yahoo and Microsoft could strike similar deals if they desired. But Google's move, if successful, would give it an advantage available to very few.

The matter could come to a head quickly. In approving AT&T's 2006 acquisition of Bell South, the FCC made AT&T agree to shelve plans for a fast lane for 30 months. That moratorium expires in the middle of next year. A Democratic lawmaker has already promised new network-neutrality legislation early in 2009. And a new chairman of the FCC could take a stricter position on forcing companies to comply with network neutrality.

Richard Whitt, Google's head of public affairs, denies the company's proposal would violate network neutrality. Nevertheless, he says he's unsure how committed President-elect Obama will remain to the principle.

"If you look at his plans," says Mr. Whitt, "they are much less specific than they were before.

AUTO: Kristof on Auto

Op-Ed Columnist

A Finger in the Dike

By NICHOLAS D. KRISTOF

Published: December 13, 2008

For the first time in human history, I agree with Dick Cheney. According to The Los Angeles Times, he warned Republican senators that if they refused to bail out the auto companies, “we will be known as the party of Herbert Hoover forever.” The senators from the Herbert Hoover Party promptly fumbled, but President Bush seems poised to rescue the car companies anyway. Thank heaven!

Look, there are plenty of sound arguments against a bailout. But there’s a practical argument that trumps everything: when conditions are so fragile, we can’t risk a staggering blow to the national economy. When you see a hole in the dike, don’t discuss the virtues of laissez-faire policies — plug it!

There were also sound arguments for not rescuing Lehman Brothers. So the government allowed Lehman to collapse — and almost everybody now recognizes that it was a mistake that cost taxpayers more than a bailout would have.

Lehman Brothers was small potatoes — a tiny French fry — compared with America’s automakers. Lehman Brothers had 25,000 employees worldwide; General Motors alone has 250,000.

The Big Three have almost 400,000 employees worldwide, including about 230,000 in the United States. In addition, several hundred thousand people make car parts for the Big Three, and a half-million more sell or distribute cars from them. All told, considerably more than one million jobs in the United States depend directly on the American automakers, and many more indirectly.

Let’s look at the reasons cited for washing our hands of the auto companies:

A rescue mucks up the dynamic of capitalism; governments shouldn’t spend taxpayer dollars to reward failure. Thomas Murphy, the chairman of General Motors at the time of the 1979 Chrysler bailout, perhaps put it best: a bailout of Chrysler, he said then, would constitute “a basic challenge to the philosophy of America.”

In fact, the Chrysler bailout went ahead and worked pretty well. Jobs were saved, Chrysler retooled and came up with successful cars that included the first minivan, and the Treasury was repaid and made a profit on the bailout.

We’ve already rewarded failure by bailing out the banking sector, because the alternative was worse. If the same is true again, and it’s cheaper to rescue the car companies than clean up the mess afterward, wouldn’t a rescue reflect a pragmatism that is precisely “the philosophy of America”?

The solution isn’t a bailout, it’s bankruptcy. If the car companies enter Chapter 11, they’ll be able to rework burdensome contracts and actually make themselves competitive again. That’s how the airlines recovered, and auto companies shouldn’t be favored.

Bankruptcy would be a gamble because we just don’t know whether cars from bankrupt companies will still sell. I’ll buy a $400 air ticket to fly on a bankrupt airline, because it’ll still be honored in a month’s time, but that doesn’t mean I’ll spend $30,000 on a car from a bankrupt company when I’m counting on its resale value in 10 years’ time.

While bankruptcy would help automakers extricate themselves from onerous contracts, the gap with foreign automakers isn’t as wide as some believe. As my Times colleague David Leonhardt has noted, the reported $73-an-hour wage in Detroit is a fiction. Union workers at the Big Three get about $55 per hour in wages and benefits, compared with $45 per hour for nonunion workers at the American plants of Honda or Toyota. One reason for the gap is that the Detroit labor force is older, and health and other benefits are always more expensive for a 50-year-old worker than for one half that age.

A bailout is hopeless: This is a bridge loan to nowhere.

Yes, the Obama administration will have to come back in January with a full rescue package. The package should focus on saving jobs, not stockholders or bondholders. Shareholders should lose most of their investments, bondholders should get a haircut, managers and board members should be ousted, autoworkers should have their pay and benefits trimmed to market levels, and taxpayers should get an equity stake that they could profit from.

But saving the auto sector isn’t hopeless. Car companies have made progress in recent years, as underscored by the Chevy Volt, a plug-in hybrid that can go 40 miles without using a drop of gas. (The catch is that if gas prices stay as low as they are now, consumers may instead be demanding gas-guzzling S.U.V.’s.)

Think of a bailout as part of the huge planned stimulus package. It’s much cheaper to keep people in their existing jobs than to create new jobs elsewhere.

I lived in Tokyo in the 1990s, as perfectly reasonable arguments for government restraint led to acquiescence in the face of escalating economic disasters. Anyone who lived through Japan’s “lost decade” understands that the risks of inaction are greater than the risks of action.

AUTO: Rick Wagoner

Excellent piece in defense of Rick Wagoner..

Mr Detroit
Dec 11th 2008
From The Economist print edition

The survival of Rick Wagoner of General Motors hangs in the balance, like that of the industry he embodies

IN THE end neither Congress nor the outgoing Bush administration had the stomach to allow two of Detroit’s Big Three carmakers to collapse into bankruptcy before Christmas. But getting the $15 billion-worth of loans which will keep General Motors (GM) and Chrysler going until March—Ford is, for now, carrying on under its own steam—has been a bruising, at times humiliating, experience for the bosses of the beleaguered firms, especially Rick Wagoner, the chairman and chief executive of GM. Not even the most trenchant critic could level much of the blame for Detroit’s deep-seated ills on Chrysler’s Bob Nardelli or Ford’s Alan Mulally, who have less than four years’ experience of the car industry between them. Both were hired to bring fresh eyes and a new approach to dealing with the industry’s woes. By contrast, 55-year-old Mr Wagoner has been at GM all his working life and is the very embodiment of the giant car company’s culture, for both good and ill. As one congressional tormentor after another took aim at the industry for its past mistakes and questioned whether it had done anything to make it worth saving, it was the tall, courtly Mr Wagoner who was squarely in the crosshairs.

On the face of it, it is remarkable that Mr Wagoner is still in his job at all. During his eight-year watch, GM’s share price has fallen from $75.75 to below $3 last month. In the past four years the firm has racked up losses of at least $75 billion. You could say that rather than running a carmaker, Mr Wagoner has been operating a giant value-destruction machine at full tilt. Yet even now, to the incredulity of many observers, he appears to be safe in his job. When Chris Dodd, the chairman of the Senate banking committee, suggested that Mr Wagoner might have to go as a condition of a bail-out, Steve Harris, a GM spokesman, responded that “GM employees, dealers, suppliers and the GM board of directors feel strongly that Rick is the right guy to lead GM through this incredibly difficult and challenging time.” He was telling the truth.

What is the explanation? Partly it is that Mr Wagoner is an intelligent, conspicuously decent man whom people cannot help liking. Partly it is that his knowledge and experience of the industry is unrivalled. Partly it is that all those who still support him signed up to the same strategy and continue to believe that nobody could have done better under the circumstances.

Mr Wagoner started well. As chief financial officer and then chief operating officer in the 1990s he helped turn GM round after three terrible years when losses had topped $30 billion. By 2003, as a result of action taken by Mr Wagoner to cut costs, modernise outdated plants and improve quality, GM’s market share was increasing and it was making profits of $4 billion a year. But the progress proved unsustainable. Each year vast retiree health-care and pension obligations diverted billions of dollars from developing new models, and added $1,400 to the cost of every vehicle coming out of a GM plant compared with rival products built in non-union Asian and European “transplant” factories. Mr Wagoner had to concentrate on generating cash rather than on making great cars. Low-interest finance and lossmaking fleet sales kept production up, and the profits that could be made churning out huge pickup trucks and sport-utility vehicles skewed GM’s model range away from more efficient passenger cars.

In recent weeks Mr Wagoner has been accused of abjectly failing to tackle GM’s problems. But within GM and the car industry generally, there is recognition of what a rotten hand Mr Wagoner had to play, and how close he came to achieving at least some of his goals. The huge losses of recent years have been a reflection of one painful restructuring after another. Since Mr Wagoner took over in 2000, GM has cut its workforce by half to 97,000 and closed 12 factories in America. That was neither easy nor cheap—many jobs have been bought out, and some laid-off workers have been entitled to almost full pay under an agreement with the union negotiated more than 20 years ago.

Expensive though it was, the surgery had begun to work. According to independent surveys, many of GM’s factories have closed the efficiency gap with the likes of Toyota. Under the guiding hand of the flamboyant Bob Lutz, brought in by Mr Wagoner in 2001 to oversee product development, GM is also now making some very good cars, among them the Chevrolet Malibu, the Cadillac CTS and the Buick Enclave. Last month the Opel Insignia was voted European car of the year. And in 2010 GM is due to launch its revolutionary Chevrolet Volt, an electric car with a “range extending” internal-combustion engine that promises to make the Toyota Prius look like yesterday’s technology.

Send for Mr Nasty

A year ago, after a deal was negotiated with the United Auto Workers union to transfer health-care liabilities to a union-run fund and to reduce the pay and benefits of newly hired workers to rates similar to those at the transplants by 2010, Mr Wagoner’s stock was high. There was a real sense of optimism that GM was at last on the home straight to being a viable business. The spike in the oil price and the credit crunch put paid to that, but Mr Wagoner was not alone in failing to see them coming.

Mr Wagoner is far from being the deadbeat portrayed by congressional grandstanders and ignorant commentators. But his courtesy and his aversion to confrontation left his beloved GM more vulnerable to this year’s shocks than it might have been if a more ruthless operator had been in charge. Brought up in the consensual GM way, he recoiled from forcing a showdown with the union, or hacking back the sprawling dealer network, when both were urgently required. It is easy to see why nearly everyone with a connection to GM is hoping that Mr Wagoner will not be forced out or subjected to further indignities by having to report to a federally appointed “car tsar”. But GM is now locked in a struggle for survival that it will not win unless it is led by someone much nastier than Mr Wagoner.

More to come?

Several interesting blog entries on the coming financial problems: one and two.

The Reckoning

Informative NYTimes series on the financial crisis.

New Steel Making Recipes

This is a straight copy from the wall street journal. Its interesting to see that the steel industry is actually somewhat dynamic and interesting...

Steelmakers Develop
New Iron Recipes

By EVAN RAMSTAD
August 29, 2008; Page B1

POHANG, South Korea -- Faced with environmental demands and rising costs, some steel companies are reformulating the centuries-old recipe for making the iron used to fabricate steel.

Companies in Europe, Australia and North America have developed processes that skip a high-polluting step in iron's creation, and they are finding steelmakers in Asia and Africa that are willing to gamble on the innovation. But South Korea's Posco, the world's third-largest steelmaker, has moved even further from the traditional iron-making blast furnace.

Steel is usually made by refining iron in three steps. First, iron ore and coal are heated into materials -- sinter and coke, respectively -- that can bind easily. Then, they're thrown together in a hot furnace where they combine to become pig iron. Finally, the pig iron is melted further and mixed with other materials into a liquid form of steel, which is then cast in forms or rolls.

Reuters/Newscom

Posco's steel plant in Pohang, South Korea, uses a technology called Finex.

Posco, though, has built a furnace that can prepare cheaper types of coal and iron ore to be converted into pig iron without putting them through the highly polluting ovens used in traditional fabrication. It spent more than $2 billion on research to create the process, called Finex, which it co-developed with the predecessor company of Siemens-VAI, now a unit of Siemens AG of Germany.

The Siemens unit previously built the Corex iron-making furnace at plants owned by ArcelorMittal's Saldanha Steel in South Africa, Jindal Vijayanagar Steel Ltd. in India and Baosteel Group Corp. in China. The Corex process eliminated the need for separate coke and sinter processing, and Baosteel, China's largest steelmaker, is now building its second Corex furnace, which is set to start production in 2010.

Posco and Siemens-VAI had planned to build a small demonstration plant using the Corex process, but they decided to take an additional step. While the Corex process can use cheap fine coal, the Finex process uses both fine coal and fine iron ore, making it more cost effective.

Pursuing the new approach was "the second biggest risk Posco has taken," says Posco's president, Chung Joon-yang, adding that the biggest was the decision to start the company in the late 1960s, when South Korea was still an agrarian backwater.

Steelmakers have experimented with new processes at the iron-making stage for years, chiefly tinkering with the ratio of ingredients in hopes of reducing the use of coke. Most alternatives never made it to market because they consumed too much energy. "If you manage to make it without spending much more energy than the usual process, then you win everything," says Jerome Lambert, technology and environmental manager in the Beijing office of the International Iron and Steel Institute.

The iron created in the Finex furnace can be used in any type of steel, including the high-grade kind used in cars, executives say. Posco says it uses the same inspection and quality-control processes for Finex pig iron that it uses at other blast furnaces. In both cases, the iron must have the same composition, and it is evaluated at both the iron-making and steel-making stages.

Posco's Finex plant, which began operating in May 2007, performed below production targets and above energy-consumption projections for months, in part because of mechanical problems. "In the beginning we were trying lots of things," says Lee Chang-hyung, a Posco engineer. "Until September, we couldn't reach our daily [production] target. After that, we got it stabilized."

Posco's plant now produces 1.5 million tons of iron a year, or about 6% of the company's steel-making needs. Its operating cost, which doesn't include fixed expenses, is 90% of the cost at its 10 traditional iron-making furnaces, when measured on a comparable output basis. With plans to expand to India and Vietnam, the company has at least six more furnaces on the drawing boards, and executives say they are likely to use the Finex design for them.

Over the past year, cost pressures have grown for steelmakers as they have been forced to accept huge price increases for coking coal and iron ore.

The gap in per-ton prices between coking coal and the cheaper fine coal used in Posco's new furnace has surged from $15 to $50 this year. Recently, Posco also agreed to pay a key supplier 96% more for lump iron ore, the kind used in traditional blast furnaces. By contrast, the price for the iron ore used in its new furnace has risen only 79% from a lower base.

Posco began working with Siemens-VAI on the Finex concept in 1993. Back then, Posco executives were focusing on the long-term prospect of competition from countries like China, whose economies were rising in South Korea's wake. They realized that the labor and other cost advantages Posco had as it was growing in the 1970s and 1980s wouldn't last.

"We could go two ways. One was to look for totally new businesses. The second one was to go for new technology," Mr. Chung says. "We decided to look at alternative processes."

Even as the economic case for new iron-making techniques is growing, Christian Boehm, a marketing manager at Siemens-VAI, says he is spending more time talking about reduced pollution and other environmental effects with prospective customers.

"Every producer is asked about pollution by the people in their community," he says. "New laws are always coming. China is getting even tougher than Europe on emissions."

Backruptcy and The Big 3

Interesting article contending that the car industry wouldn't benefit from bankruptcy like the airlines.

Madeleine K. Albright, Strategy Consultant

I was reading a WSJ article about Coca Cola's efforts to fully utilize the 2008 Beijing Olympics as a platform to catapult into a dominant position in the Chinese market place - where they had previously been in second place. Coke starting planning their operations as early as 2005, and apparently heavily used strategy consultants to guide themselves through all the ugly periods in Chinese relations between 2005 and now. Which consultancy, you might wonder, would they have used? Mckinsey, BCG, or Bain, perhaps? No - they used Albright Partners the firm eponynmously named firm of former secretary of state Madeleine K. Albright!

Well - I at least though it was strange that Madeleine Albright is now a strategy consultant. But, perhaps it isn't. She is also a principle at Albright Capital Management LLC, an investment advisory firm focused on emerging markets. I gues many politicians have gone far further to exploit their fame once leaving office...

The Rapid Advancement of the Chinese Automative Industry

I just stumbled upon two rather interesting articles on the Chinese automotive industry. The general idea is that Chinese auto-manufacturers won't have that hard of a time advancing to the point where they can compete in developed markets as management, engineering, design, and quality consulting firms from developed markets are helping Chinese manufacturers to advance rapidly.

To boot, Chrysler is helping to create future competition in exchange for better short term cash flows by transferring knowledge and production technology to Chery. Chrysler obtains an immediate source of income via sub-contracting deals with Chery, but Chery intends to enter the same markets as Chrysler several years down the line with their own brand of products.

Both articles are from "Automotive News Europe."

Deals with West boost expertise of Chinese; Maturing automakers will not 'reinvent the wheel' to compete with global giants

BYLINE: Alysha Webb

In July, Chery Automobile said it had agreed to supply small cars to Chrysler for the US, Europe and other export markets.

The deal helps Chrysler because the small, inexpensive car from Chery will fill a large hole in its US lineup. And the deal will help Chery, too.

By working with Chrysler engineers and executives, Chery will improve in areas such as quality control, manufacturing efficiency and supplier relations.

It is no secret that Chery and other Chinese automakers plan to compete in Europe and the US.

What few realize is that Chinese automakers are getting a lot of help from Western companies. European and American auto suppliers - and yes, Western automakers themselves - are providing the expertise and high-quality parts to help Chinese automakers compete overseas.

"The Chinese fundamentally lack products and knowledge, but they need to get into the market very quickly," says Michael Laske, president of AVL China, a division of engine designer AVL List of Austria. AVL designed an engine family for Chery.

Adds Frank Zhao, chief technical officer at another would-be exporter, Zhejiang Geely Holding Group: "A lot of foreign companies think Chinese domestics need to reinvent the wheel. That's not necessary."

Heart of the car

Chinese automakers "realize they can't compete without" the best engine technology, says Laske. AVL's business in China has taken off during the past three years, as more local brands look to export, he says. China now accounts for about 15 percent of AVL's revenue, and ranks third behind Germany and the US.

AVL's global revenue in 2006 was €537 million.

AVL competitor Ricardo also has many Chinese customers, including Shanghai Automotive Industry Corp. and heavy-duty vehicle producers such as FAW Group, says Lee Sykes, executive vice president and head of Ricardo Shanghai.

China accounts for 10 percent of UK-based Ricardo's activity worldwide. Ricardo's revenue for the fiscal year ending June 30 was £171.5 million. "Over the next three years, our plan is to triple our team in China," Sykes says.

Weak on safety

Safety systems are another area in which Chinese companies are weak; regulatory demands in China are less rigorous than in the US and Europe. Chinese automakers are using companies such as Autoliv of Sweden.

Autoliv supplies airbags, seat belts, steering wheels and airbag electronic control units to Chinese automakers.

Business with local automakers such as Brilliance China Automotive Holdings, SAIC and FAW will help push Autoliv's sales growth in China up by more than 50
percent in 2007, says George Chang, president of Autoliv China. Brilliance already has launched in Europe.

"Chinese brands are becoming an important part of Autoliv China's growth," says Chang.

Chinese automakers sometimes buy from a foreign company even when the component is available from a local supplier. Some Chinese automakers even advertise that their cars contain technologies provided by a foreign company.

"International companies ensure our product quality," says Great Wall spokesman Shang Yugui.

Says Vivian Zheng, a senior partner in Shanghai with Roland Berger Strategy Consultants: "The local automakers feel they need to use global service firms to buy some assurance and project credibility to the market."

Teams of Chrysler engineers are at Chery checking out every aspect of the Chinese automaker's operation, says John Felice, Chrysler's vice president for manufacturing technology and global enterprise.

"The engineers on each side need to understand what the customer needs are in the different markets we will sell vehicles in," says Felice.

That knowledge will be helpful when Chery starts to sell its own brand cars in those same markets.

Lan Lan, Luca Ciferri contributed

An article from the same source, but a little later in the year:

Chery: Big ambition or a pipedream?;
Tiny provincial automaker wants to win in Europe, US

BYLINE: Alysha Webb

SECTION: NEWS; Pg. 4

LENGTH: 1243 words

WUHU, China --

This small city in Anhui, one of China's poorest provinces, has little English-language education. So the families of many Western-trained Chinese engineers live in Shanghai, five hours away by train.

Nightlife in Wuhu amounts to karaoke at one of the town's two major hotels. Taxis and trucks share the road with bicycles and an occasional horse-drawn cart loaded with produce from the countryside.

Yet Wuhu, population 750,000, aims to be the car-export capital of China.

Chery Automobile Co., only 8 years old, is talking with major European distributors about selling its cars in Europe.

Chery has hired Italian design houses Bertone and Pininfarina to style models for export. Austria's AVL List and the UK's Ricardo will design engines that can meet European and US emissions standards.

The ambitious automaker also has signed a deal with American entrepreneur Malcolm Bricklin to ship cars built in China to US dealerships starting in January 2007. It plans to start selling cars in Europe in the same year.

Ludicrous, you say? A tiny provincial automaker wants to conquer Europe and the US?

Yes, it's a long shot. But a three-day visit here last month revealed much happening beneath the surface. Little-known Chery has a chance to realize its dreams, even though some of its engineers privately wonder whether it can meet its extreme deadlines to start sales in the West.

Here's why Chery could make it:

* Western-trained engineers are migrating to Wuhu, driven by a patriotic mission to build the Chinese auto industry.

* Highly competent suppliers from Europe and the US are quickly building or designing for Chery what it can't build itself: top-quality assembly lines, low-pollution engines and many other essentials.

* The central government in Beijing is supporting the company with bank loans and export credits.

While Chery has many strengths, pulling off the ambitious plan depends on strengthening its weakest link - mid-level management and workers at Chery and its suppliers.

They must banish ingrained bad habits left over from decades of a planned economy that emphasized high volume instead of high quality. If the first models fail to meet Western consumers' expectations, it could set Chery's export plans back by years.

"We still have a big challenge," said a Chery manager who has a decade of experience working in the US.

History of problems

Chery has a short history of turning out cars. Founded in 1997 by the local government, Chery's early models were problem-plagued, said a manager at a local interior trim supplier.

"They just wanted to start making cars. They weren't too concerned with quality," he said.

The cars couldn't be sold nationwide because the central government wouldn't grant Chery a license. A Wuhu government order to make Chery the city's official supplier of taxis saved the company from bankruptcy.

In 2001, Shanghai Automotive Industry Corp., partner of both General Motors and Volkswagen, became a part owner of Chery. This allowed Chery to piggyback on Shanghai Automotive's license to sell cars nationally. That breathed life into the small local automaker, said a trim supplier manager.

"Around 2002, Chery started to believe it could succeed as a bigger company," he said. "They started to buy better equipment and develop their own engines."

Last year, Chery sold only 86,567 cars, nearly all in China.

The company founded an r&d institute in 2003 that boasts 800 engineers. It has developed three- and four-cylinder engines on its own.

Intellectual property questions nonetheless dog Chery. GM charges that the QQ small car, Chery's best-selling model, is a copy of its Chevrolet Spark, also built in China. The case is pending.

Chery's strengths

A trio of Chery engineers with doctorates from US universities and more than 30 years of cumulative experience in the US auto industry are cautious about meeting Bricklin's 2007 deadline.

"We will play it by ear," said one engineer over coffee in a Wuhu hotel.

Chinese engineers returning from Europe and the US are one of Chery's strengths. About two dozen work at the company, and more are coming.

Chery started advertising for them in 2003 in the newsletter of the Association of North American Chinese Engineers. Nobody took the ad seriously at that time, said one of the returnees. Now they do.

Industry people who have met Chery President Yin Tongyao and Chery's other top managers have been impressed.

"Management overall is quite professional," said Paul Gao, a principal with McKinsey & Associates in Shanghai. "They have a strong can-do mentality."

Yin turned down repeated requests for an interview.

"The level of intent is absolutely clear," said an executive at one of the European engine design firms hired by the automaker. "Chery has its sights set on export."

Money flows to Wuhu

Money isn't a problem. The company is owned by the local government and favored by the national government. In March, Chery received an export credit of 5 billion yuan (€469 million) for overseas expansion from China's Export and Import Bank. The company also received a €225 million loan for r&d from the China Development Bank.

Many world-class partsmakers are supplying parts to Chery. Tower Automotive, Siemens VDO Auto-motive and TRW Automotive, among others, have plants in Wuhu. Delphi also is a Chery supplier.

Chery has purchased state-of-the-art production equipment for cars and engines, visitors say.

"The assembly line is brand new," said a Western supplier executive who has visited the plant.

"Manufacturing experts who have seen the plant say Chery must have spent $1 billion [about €774 million] on it."

The engine plant uses equipment from Heller Machine Tools of Germany among others.

Chery suppliers also use imported equipment. A manager at a local engine parts maker proudly showed off his Fata Group machine tooling equipment from Italy. Other machinery was imported from Switzerland, he said. The company also supplies Cummins Inc. in the US.

"I'm pretty optimistic about Chery's future in terms of exports," the engine parts manager said.

But his optimism faded as he examined the fit and finish on his new Chery Son of the East sedan.

"Look at this ugly welding," he said, pointing to a rough spot on the inside of the rear trunk.

At the top of the trunk door, the wiring leading to the light is exposed. "This looks really sloppy," he said.

Attention to those kinds of details - which can make the difference between success or failure in more mature markets - is where Chery slips up, said the engine parts manager, who worked in Europe for more than a decade.

He attributes the problem to the mentality left over from the days when lifetime employment was guaranteed and quality was not a concern. Workers still think that as long as something works, little things don't matter.

"It's not easy to change the thinking," he said. "Just meeting customers' needs is not enough. Chery has to surpass their expectations."

Another general manager, whose company supplies seats to Chery, figures that 80 percent of Chery's suppliers can meet international standards.

For the other 20 percent, Chery has hired Western professionals such as the US-based Harbour Consulting to raise their quality, he said.

"One of our important missions is to develop our [Chinese] suppliers," said one engineer.

For example, many critical powertrain components still are imported from Europe, he said.

Chery needs to be able to buy the same quality parts in China to meet its low-price goals.

Pharma: Cancer drugs (Avastin)

Somewhat interesting NYTimes piece on the Avastin, a relatively new drug for treating cancer that was developed Genentech. The most interesting elements are:

Medicare requires that the doctor or hospital buying Avastin be paid an amount equal to Genentech’s average selling price plus a markup of 5 to 6 percent. Of that amount, Medicare pays 80 percent and the patient pays 20 percent. Doctors and hospitals typically do not make much money on Avastin for Medicare patients, and can even lose money if they buy the drug at a price that is higher than average. But patients can end up paying thousands of dollars a month. Some have supplemental insurance to take care of it; others do not.

But private insurers sometimes pay several times as much as Medicare pays for Avastin. Doctors and hospitals have at times charged as much as $35,000 a month for the drug, said Dr. Peter Dumich, who reviews claims for cancer patients for AWAC, a company that helps employers contain health care costs. The insurers have little choice, Dr. Dumich says, when their contracts say they must pay a portion, like 80 percent of the charge, whatever the charge actually is. “Providers have them over a barrel,” he said.

And, like Medicare, private insurers may in turn require patients to pay a percentage of what can be hefty bills.

Whats interesting here is that the drug is actually purchased by the hospital or the doctor and significantly marked up (assuming medicare isn't paying). This is hugely different than out-of-hospital drugs where the patient is merely given a prescription that he fulfills on his own.

One would think that the way that in-care drugs are sold creates a rather large and nasty Agency problem. The doctor/hospital recommends the drug knowing full well that a patient is highly unlikely to not take the drug, while at the same time the doctor/hospital stands to make a large profit off of the transaction. Its a very similar problem as to what occurs with over-recommended medical tests - but one would think it hurts patients far more since they're often forced to foot upwards of 20% of the Avastin bill. And Avastin's bill is incredibly high...

I imagine Avastin has to be administered in a hospital since its taken intravenously

Mining - A Return to Veritical Integration

The industrial metal industry is composed of two primary commodity groups - steel and aluminum. Historically, both industries used to be vertically integrated as they would both engage in everything from mining to distribution. Aluminum is still highly integrated, but steel companies sold off their mining and distribution resources in the distant past to reduce their operating leverage. Apparently though, the rise of iron ore and coal prices is leading many steel manufacturers to reverse integrate into mining...

World's Steelmakers Go Prospecting

Industry Plows Profits Into Buying Coal, Ore Mines To Reduce Vulnerability to Rising Commodity Prices

By ROBERT GUY MATTHEWS
June 20, 2008; Page B1

Soaring raw-materials costs are forcing the world's steelmakers to shift strategy. Now, rather than seeking merger partners in their own industry in hopes of gaining market clout, they are trying to protect their access to iron ore and coal by investing in mines.

Steelmakers often owned their own mines in the industry's early days because few other companies had the capital needed to operate them. But in today's climate their goal is to lessen their dependence on big mining companies, whose steep price increases are squeezing steel-making profits. The steel industry's race for minerals, however, pits it directly against those mining giants, who are equally eager to snap up any coal or iron-ore deposits that go on the block.

ArcelorMittal

An open-pit ArcelorMittal iron-ore mine in Canada

A consortium made up of Chinese steelmakers and China's sovereign wealth fund is entering the initial round of bidding for a stake in the iron-ore unit of Brazil's Companhia Siderurgica Nacional SA, people familiar with the situation said Thursday. The group's interest, though preliminary, shows the importance China places on securing supplies of ore and other natural resources amid the current commodities boom.

ArcelorMittal, the world's largest steelmaker, having recently purchased a series of iron-ore mines in Africa, Canada and Russia and coal mines in Kazakhstan, India and South America, now touts itself as the "world's fastest-growing mining group." Last month, it spent $631 million to buy a 14.9% stake in Australia's Macarthur Coal Ltd., the world's largest producer of pulverized coal, a type of coking coal used in steel making, thwarting Swiss miner Xstrata PLC's plans to take over Macarthur.

"Ensuring a reliable source of raw-material supply is more important than ever," Lakshmi Mittal, chief executive of ArcelorMittal, said in an interview. The steelmaker, whose mines supply about 46% of its raw-materials needs, has set aside $5 billion to buy enough of them to provide 70% of its needs by 2012.

Since 2003, the steel industry has been swept up in a wave of consolidation, with steelmakers bulking up to feed the developing world's growing demand for bridges, buildings, power plants and other infrastructure projects. Among other deals, Arcelor SA of Luxembourg merged with Mittal Steel Co. of India and another Indian company, Tata Steel Ltd., merged with Britain's Corus Group. But, now, that wave is decelerating.

Instead, steelmakers are plowing their profits into reducing their vulnerability to spikes in raw-materials prices. In the past year, coal prices have more than doubled, while iron-ore prices have risen about 70%.

"The structure of the steel industry is changing," says Peter Fish, chairman of MEPS International Ltd., a London-based steel research and consulting firm. "It used to be that raw materials accounted for 15% of selling prices. They now account for about 50% of selling prices."

Some analysts say steelmakers are buying at the top of the commodity cycle and overpaying as a result. But with both mining companies and steelmakers vying for the same limited assets, many steelmakers feel they have no choice. Moreover, they say greater self-sufficiency will pay off in the long run.

While China is a huge consumer of steel, it is largely bereft of quality iron-ore deposits, which is why several Chinese steelmakers are moving to secure their own supplies.

CSN, one of Brazil's leading producers of both steel and iron ore, has invited bids for all or part of Nacional Minerios SA, or Namisa, its unlisted iron-ore unit. Major Chinese producers including Baosteel Group Co., Shougang Group and Shagang Group, as well as China Investment Corp., a $200 billion investment pool run by the Chinese government, are interested in the unit, one person familiar with the matter said. But the final composition of the consortium isn't finalized yet, this person said.

CSN has hired Goldman Sachs Group Inc. as its financial adviser for the sale

Last Friday, Sinosteel Corp., a state-owned Chinese steelmaker said it boosted its stake in Australian iron-ore group Midwest Corp. slightly to nearly 44%, further boosting its efforts to take over Midwest.

Other, smaller Chinese steelmakers are also trying to line up more iron ore. Tonghua Steel, the largest steelmaker in northeast China's Jilin province, plans to buy or invest in eight mines near its mills. Company officials say Tonghua can supply only about 20% to 30% of its own iron-ore needs and has to turn to mining companies for the balance. The company hopes to increase its self-sufficiency in ore to more than 50% by the end of 2010. Taiyuan Iron & Steel, a carbon- and stainless-steel producer based in northern China's Shanxi province has said it plans to raise its self-sufficiency to 80% from 50%.

As Chinese steelmakers go on the prowl for resources, Marius Kloppers, chief executive of Australia-based mining giant BHP Billiton Ltd., one of the world's biggest iron-ore producers, said he wouldn't be surprised by a Chinese buy-up of his company's shares.

The race for raw materials is also heating up in other parts of the world. Brazilian steelmaker Usinas Siderurgicas de Minas Gerais SA, or Usiminas, said it will spend $750 million to invest in more mines over the next five years to nearly quintuple its iron-ore production to 29 million metric tons a year. Usiminas already has spent $1 billion this year to buy miner J. Mendes and its subsidiaries. In India, Steel Authority of India Ltd. and Tata Steel signed a deal earlier this year to form a joint-venture coal-mining company.

Write to Robert Guy Matthews at robertguy.matthews@wsj.com¹