Happily ever after ...

Bank of Israel governor David Klein spread panic and confusion on the capital and foreign currency markets two months ago, when, after a marathon meeting with the prime minister and minister of finance, he announced a dramatic 2% slash in interest rates, swerving sharply from Bank of Israel's conservative and careful policy of recent recent years.

A few weeks after Klein lowered interest rates, it began to sink in that while he had come up with the goods in a "package deal", the prime minister and finance minister can't or won¿t come up with their part of the bargain ¿ there's a good chance for a much larger than planned budget deficit in 2002.

But not only the cabinet planned a surprise for the governor: the capital and foreign currency markets also cooked up phenomena the likes of which hadn't been seen in years. It became clear that many Israeli investors panicked at the rate cut and subsequent dollar gain, and began feverishly seeking investments with higher yields or "protection" from the dollar.

Banks immediately recognized the public panic and invented new, creative solutions. Within days they launched marketing campaigns for new mutual funds, calling them "dynamic" and "active", pretending to protect the public in an age of low interest rates and a sky-rocketing dollar.

Behind these fancy names, hide fairly run-of-the-mill funds investing in the two simplest instruments, namely dollar and index-linked bonds. The problem was that the huge demand for those bonds led to a sharp rise in price, rendering the investment dubious at best.

After mutual funds raised NIS 10 billion in one month, Klein realized he could be facing a new monster, reminiscent of the stock-based mutual fund monster of '93 or year 2000's technology mutual fund monster. So Klein warned the public two weeks ago.

Pay attention, Klein said, to the huge risk in dollar-linked bond investment. Note that not only can the dollar drop, and not only is the return on redemption on these bonds very low, but you are "fined" with a 35% tax on interest when you invest in these bonds.

In interviews with the press Klein hinted that the banks again exploited the public's panic to make a buck at their customers' expense. They took customers out of shekel deposits and put them in mutual funds, along the way collecting commissions for the mutual fund acquisitions and for managing the mutual funds.

But the really big winners on the panic that led the public to buy into the bluff funds weren't the banks, but the banks' biggest clients ¿ the country's big borrowers. While the mutual funds claim to be active, they are basically passive. The really "active" and "dynamic" players during this period were the big companies and tycoons.

Near the end of 2001, there was a credit crunch in the Israeli economy. The combination of deepening recession and Supervisor of Banks instructions on doubtful debt provisions worried the banks, who started limiting their exposure to big, risky borrowers. The banks began to raise interest rates demanded from large borrowers to improve their margins. And then interest rates came down, accompanied by huge demand for dollar and index-linked bonds ¿ a virtual godsend to the country's big borrowers ¿ opening a rare window of opportunity to raise hundreds of millions of dollars from institutional investors by issuing index-linked bonds.

Here's how it worked: The panicked public deserted shekel deposits, the banks pushed them into "active" mutual funds, which ran to the market to buy index and dollar-linked at sharp price rises. The institutional investors, led by provident funds and insurance companies, sold them the bonds.

After the latter players got rid of large quantities of bonds, they had a lot of free cash to invest in index-linked assets. And along came the big concerns conveniently ready to sell them index, dollar and euro-linked bonds.

While the banks raised their collateral demands from big borrowers over the past half year, the institutional investors loan bond-issuers money with no collateral.

As usual, the person quickest to the draw to exploit the moment was Eliezer Fishman, first with private offerings, but tomorrow with a public offering of Industrial Building bonds for hundreds of millions of shekels. Fishman will use the money to pay off bank loans and free up collateral.

But Fishman isn't alone. All the leveraged players who can get an A or higher rating from Maalot have made or are about to make big bond offerings: Super-Sol, Dankner, Ma'ariv and Ellern.

In a month, or two, or three, the dollar panic will be long forgotten, inflation fears will have calmed, bond prices will go back down, the money will start to dribble out of the "active" mutual funds and interest rates will climb back up. Investors in the "active" and "dynamic" funds will discover that their money was really quite passive ¿ and the big tycoons will again be able to smile at a chapter in stock market history that ended like all the others. Happily ever after ...

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