The big flaw: auditing in crisis

FT series: with a cabal of auditors dominating the market and chiefs making most of the system of ‘fair value’, what can the industry do to raise standards?

Jonathan Ford and Madison Marriage in London


© Bill Butcher


A decade ago, as the financial crisis gathered momentum, two giants of the US investment landscape, Goldman Sachs and the insurer American International Group, were locked in an arcane but high-stakes accounting dispute.

AIG’s fast-growing, London-based financial products arm had written billions of dollars’ worth of insurance in the form of credit derivatives against a mountain of the investment bank’s packaged-up mortgage loans. As credit conditions deteriorated in late 2007 and these mortgage-related securities started to buckle, the value of this insurance policy became central to the financial health of both businesses.

The bank wanted to recognise the mushrooming gain it was making on its derivative position, based on a probabilistic estimate of the underlying loans defaulting. By its calculation, AIG owed $5.1bn on its outstanding swap positions, a large chunk of that to Goldman Sachs. Unsurprisingly, AIG took a very different view. The insurer estimated its liability was no more than $1.5bn, a sum that helpfully allowed it to continue posting quarterly profits.

Both sides sought the acquiescence of their auditors for these treatments. Coincidentally, in this case that meant the same firm: PricewaterhouseCoopers. And despite the iron logic that one side’s gain in a zero-sum trade should mirror the other’s losses, the same firm allowed these divergent — and mutually beneficial — approaches.

Only months later, with markets still frozen, did PwC toughen its line and force its insurance client to take a substantial writedown. In the event, even this proved wildly insufficient. AIG’s derivative positions ultimately forced it to cough up tens of billions of dollars in 2008 — a sum it could only pay because the US government had by then bailed it out.


AIG was forced to pay out tens of billions of dollars on its derivative positions in 2008 after it had been bailed out by the US government © Bloomberg


The word audit means to survey or check. Ferreting after facts was once the auditors’ main vocation: certifying information to assure investors that a company’s numbers were “true and fair”. But in AIG’s row with Goldman, it is striking how little was verifiable. There were few credible market prices, let alone transactions, to support the key valuations. Speciously precise profits and losses were written, not on the basis of concrete observation, but mathematical calculations derived from computer models.

As to the logic of such contradictory valuations, Warren Buffett’s investment partner Charlie Munger spoke for many when he observed in a 2009 interview that they “violated the most elemental principles of common sense”.

“Accounts have always contained estimates; think of the provisions companies make against foreseeable future losses,” says Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee. “But the un-anchoring of auditing from verifiable fact has become endemic.”

In the UK in the past three decades, standards setters have progressively dismantled the system of historical cost accounting, replacing it with one based on the idea that the primary purpose of accounts is to present information that is “useful to users”. The process allows managers to pull forward anticipated profits and unrealised gains, and write them up as today’s surpluses.

More recently, it is behind a string of accounting scandals involving overstatements of profit, including at the UK supermarket chain Tesco and the software company Quindell. It hangs over the insolvency of the UK outsourcing group Carillion, where sudden contract restatements in 2017 erased the previous six years of dividend-bearing profits. In the US, the conglomerate GE is under investigation over the way it accounts for its contracts.

These events have fuelled concerns about the auditing market, and whether the Big Four accountancy firms— KPMG, Deloitte, EY and PwC — are too big to fail, too profit-driven and excessively compliant to managers’ wishes. Britain has started an investigation into the effectiveness of its auditing regulator, the Financial Reporting Council.

But this may be looking at the symptoms rather than the cause of the problem. That may lie in the accounting standards themselves.



Carillion had only impaired less than 10 per cent of the goodwill on its balance sheet when it collapsed © Bloomberg


Modern auditing in Britain sprang from a great failure: the collapse in 1878 of the City of Glasgow Bank. Stung by the demise of this unlimited liability institution, whose losses hit the city’s middle classes, more banks became limited liability ventures. With that privilege came responsibilities, including the need to conduct independent audits.

Their purpose was to assure investors that companies’ capital was not being abused by over-optimistic or fraudulent managers. “At their heart, audits are about protecting capital, and thereby ensuring responsible stewardship of capital,” says Natasha Landell-Mills, head of stewardship at the asset manager Sarasin & Partners.

Behind this stood a system of accounting that vaunted prudence. The principle that assets were valued at the lower of cost or net realisable value (or the price at which it was thought they could be sold) did not rule out estimates. But they only came into play when values had fallen. It was not possible for managers to conjure up unrealised gains and profits and present these as fact.

The idea that accounts should be primarily “useful” springs from the same source as the so-called efficient markets hypothesis. Indeed, it is an adjunct to that now somewhat discredited theory.

From the 1960s, academics such as William Beaver at Stanford University advanced the notion that for markets to channel capital efficiently to the most productive outlet, accounts needed to give traders of securities a clearer understanding of the current valuation of a company.


Heating up 

$134bn Combined revenues of the ‘Big Four’ auditors. They employ 945,000 people

$2.9tn Total goodwill on balance sheets of S&P 500 companies in 2016, up from $1.8tn in 2007 6

60% Remuneration based on equity for CEOs at S&P 500 groups in 2014, up from 25% in 1992


That meant abandoning inconvenient notions such as prudence and conservatism; instead, accounts had to be “neutral” and use more up-to-date values for balance sheet items.

This was radical. Fair value accounting had been firmly shunned by the US Securities and Exchange Commission for contributing to the losses of the 1929 crash. Yet contemporary events gave the hypothesis respectability. Soaring inflation in the 1970s made historical cost balance sheets seem misleadingly out of whack with property values, leading to asset stripping. America’s savings and loan crisis in the 1980s was partly blamed on these institutions having out-of-date books.

From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.

This was also a time when managers’ pay, especially in the US, was rising through the use of market-linked incentives. Between 1992 and 2014, equity-based pay at S&P 500 firms rose from 25 to 60 per cent of their total remuneration, according to database ExecuComp.

It did not take long for bosses to perceive the pecuniary possibilities of their ability to influence fair values. Between 1995 and 1999, for instance, Enron’s stock underperformed the S&P 500 index. Yet in 2000, when the US energy company’s accounting chicanery started to kick in, its shares wildly outperformed the benchmark. In the 10 months before its collapse, the company paid out $340m to executives.


With accounting chicaery helping its shares wildly outperform the S&P500, Enron paid out $340m to executives in the 10 months before its collapse in October 2001 © Reuters


“The problem with fair value accounting is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth,” says one investor who is on the board of an audit firm.

In theory, fair value should not preclude sound audits. But it does make it harder. The greater latitude given to bonus-hungry management by looser evidential standards increases the pressure on auditors.

There is, however, little evidence of auditors rising to the challenge.Take goodwill, an accounting item that measures the difference between the purchase price paid for an acquisition and the net value of the assets actually acquired.

Until the turn of the century there was a general convention that when one company bought another, goodwill was an effective cost of the transaction that needed to be amortised — or written down annually against group profits. Not to do so, while also counting the additional profits from the purchased assets, was a form of double counting that inflated the benefits of an M&A deal. According to Karthik Ramanna, professor of business and public policy at Oxford university’s Blavatnik School of Government, “it violates the basic premise of traditional accounting”.


A cheque from the City of Glasgow Bank, whose collapse in 1878 prompted tighter accounting requirements © AllyD/Wikicommons


Yet egged on by Wall Street, standards setters softened the rules on goodwill in 2000. This could be recognised in the balance sheet permanently, and only reduced if there was evidence that the discounted future cash flows from the underlying asset had fallen sufficiently to warrant impairment.

Puzzlingly, given the hit and miss nature of most takeovers, this evidence has proved remarkably elusive. Since 2007, the total goodwill on the balance sheets of S&P 500 companies had rocketed from $1.8tn to $2.9tn by 2016, much of it used to collateralise acquisition debt.

When Carillion collapsed in January, the group had only impaired £134m of the £1.5bn of goodwill on its balance sheet, even though at least one large acquisition had negative net assets of nearly £200m and was only solvent because of explicit support from the parent group.

There may be little evidence of auditors getting tougher, but they have reacted in other ways to the challenges posed by fair value accounting: principally huddling together and seeking ways to limit their liability.

From a Big Eight in 1987, the industry consolidated to a Big Five by 1998. With the collapse of Arthur Andersen in 2002, their number shrank to four. These firms entirely dominate the markets for auditing quoted companies in the UK and the US. Many observers accept this lack of choice makes the industry difficult to regulate. “It makes the Big Four too big to fail,” says Guy Jubb, an honorary professor at the University of Edinburgh and a corporate governance expert.

Accounting fines issued


Last year the quartet had combined revenues of about $134bn, employing almost 945,000 people, according to Statista. Scale makes the Big Four much more of a target for shareholder litigation, especially in the US.

To counter this and reduce the scope for actions, auditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of “tick box” rules designed to achieve mechanistic “neutral” outcomes. It is a process, says Prof Ramanna, that is tantamount to a stealthy “socialisation or collectivisation of the risks of audit”.

Into the void have stepped self-interested managers, who acquire ever more influence over the presentation of the numbers. Take the practice of accounting for the zero-interest credit cards that UK banks issue in the hope of making money when the customer comes to the end of the interest-free period and starts paying a high rate.




“Realistic” accounting practices allow companies to recognise revenue up front based on their estimates of the amount of time beyond the expiry of the free period. The more optimistic a manager’s views on customer retention, the higher the asset values. Given the incentives on bosses, it is hardly surprising that the result has been ballooning zero-interest credit card balances, and growing concern at the Bank of England that a bubble may be inflating.

Observers perceive the problem, but worry that the rules now preclude auditorial judgment. “How do you deal with it when you get into a face-off with management and they say, ‘This is how we want to present it and it is all within the rules’? Ultimately, it is very hard to argue against,” says the investor who is also an audit firm non-executive.

There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway. “They have been able to do better with low quality than with high quality work,” says Erik Gordon, a professor at the University of Michigan Ross School of Business. “It is less expensive and clients, who actually are company management, not the shareholders, seem happy with audits that don’t challenge their view of how well they are performing.”

Some at the largest accounting firms do recognise that trust in audit has plummeted. “There are some legitimate reasons for that,” says a senior figure at one of the Big Four firms. “If there was nothing [wrong] we would not be having this debate. It would not be getting so many column inches if, at its core, something wasn’t working.”
 There is ultimately a tension between accounts that are prudent and those that are “useful to users”. Despite the searing experience of 2008, the accounting profession has plumped for the latter. In 2010, in a groundbreaking conceptual paper, both America’s Financial Accounting Standards Board and the International Accounting Standards Board scrapped “reliability” or the need for factual verification in favour of relying on “faithful representation”, which means little more than an educated guess.

“It’s an indication of how standards setters, divorced from public accountability and coddled by corporate special interests, can manufacture their own reality,” says Prof Ramanna.

This has opened a gap between the standards and UK company law, which says the accounts of a company should present a “true and fair” picture of its financial position and earnings.

Critics of fair value worry that standards have diverged too far from this legal requirement. Many of the recent changes have been stealthy, driven by international harmonisation, or a result of the “useful for users” agenda. Ms Landell-Mills worries that investors have not absorbed the consequences for the public interest.

“In the extreme,“ she says, “fair value accounting that treats upward revaluations as legitimate profits, and ignores future foreseeable losses, can facilitate Ponzi schemes where more and more illusory profits permit executives and existing shareholders to extract cash through bonuses and dividends. It won’t be long before you come unstuck.”


Buttonwood

Why the largest group of American corporate bonds is a notch above junk

We’re watching a triple-B movie





BY HIS own account Christopher Hitchens, an author who died in 2011, was a poor student. He left Oxford with a third-class degree. This was not for want of ability. Hitchens would become a prolific essayist and fearsome debater. Rather, it was a choice. His tutors warned him about neglecting his studies. But he preferred to divide his time between his social life, political protests, books (other than the prescribed ones) and lively debates with other thinkers.

As Hitchens’s counterexample demonstrates, it is possible to regret the opportunities missed while striving for top grades. It is a lesson that many of America’s biggest companies have grasped. At one time, the sort of company that could tap the bond market for capital would be given an A-grade as a matter of course. These days the typical corporate-bond issuer has a credit-rating of BBB, only a notch above a junk rating (see chart).

That might seem to imply that business has become less efficient or lucrative. Yet profits have never been higher as a share of GDP. In fact, for much of corporate America a BBB rating is the consequence of a financial strategy. Many established firms have chosen to load up on debt to buy back their own shares in order to boost shareholder returns or, more recently, to pay for mergers.


To understand why, it helps to start with a bit of textbook finance that says share buy-backs are pointless. According to a theory proposed in 1958 by Franco Modigliani and Merton Miller, a firm’s capital structure—its mix of equity and debt finance—has no effect on its value. Debt has first call on profits; shareholders get what is left over. Debt is thus less risky for investors and a cheaper form of finance for companies. The more debt a firm has, the more volatile are its equity returns. Investors dislike volatility. So a firm’s share price should in principle decline as it takes on more debt, leaving its overall financial value (the sum of its debt and equity) unchanged.

Grade deflation

The theory simplifies reality to illustrate a truth—a firm’s worth is ultimately its cashflows. In the real world, there are benefits to using debt. A big one is that interest costs are tax-deductible. This tax shield is in effect a subsidy to debt finance. Debt also has costs. A high interest burden can lead to missed opportunities or a damaging bankruptcy. Each firm has to make a trade-off between the costs and benefits. Capital-goods firms may plump for low debts and a solid credit rating to show they will be around to honour their warranties. Telecom companies, which have more stable earnings, are more likely to gear up.

As the corporate-bond market has expanded, new categories of firms have been able to take advantage of cheap debt finance. The taboo on issuing lower-grade debt became weaker in the 1980s after “corporate raiders” used junk bonds to finance leveraged buy-outs of listed companies. Since the financial crisis corporate-debt issuance has accelerated, says Adam Richmond, an analyst at Morgan Stanley. Low yields on government bonds as a result of quantitative easing have drawn investors into riskier sorts of paper. Companies have seized on this demand as a further subsidy to debt. The number of firms issuing bonds has increased by two-thirds in the past decade, according to PIMCO, a fund manager.

No doubt some firms will discover they have issued too much. It is of some comfort that the ratio of corporate debt to GDP is barely higher than its previous cyclical peaks, in 2000 and 2008. Bond finance has in part displaced bank finance. But if banks are less exposed, investors are more so. For now, strong GDP growth is a balm. A recent report by S&P Global, a credit-rating agency, plays down the risk of a rash of downgrades to junk. Firms might simply choose to buy fewer of their shares back to preserve their BBB rating.

Even so, a recession will come sooner or later. The profits of leveraged firms will be damaged, which will in turn hurt confidence. Downgrades and defaults will follow, as they always do. The process will be more drawn-out than usual if, as seems likely, there proves to be a shortage of buyers for a fresh supply of junk.

For now the market is stable. But corporate credit is an asset class to be wary of in a maturing economic cycle. In good times there seems little prospect that buyers might dry up. But they will. The best time to buy corporate bonds is early in an economic recovery, when downgrades and defaults are still under way. There are likely to be more bargains than usual next time. If companies no longer need to strive for an A-grade, all the more reason for investors to do their homework.


The Never-Ending Summer

Is Germany's Heat Wave a Preview of the Future?

Germany is currently experiencing a state of meteorological emergency. Although many are enjoying the scorching summer, the heat wave has left others with health problems and also led to a drought. Is this a preview of how climate change may soon change our lives? By DER SPIEGEL Staff

Photo Gallery: Germany's Meteorological Emergency

It's early August in Germany, and the country is worried, cantankerous and uncharacteristically sluggish.

The country's recent dramatic heatwave has seen the water authority in Chemnitz impose a ban on pumping water out of ponds or other urban waters, with the Chemnitz River only 25 centimeters deep in some places. Those caught taking water can be slapped with fines of up to 50,000 euros.

In Gotteszell in Bavaria, a regional railway line had to be shut down because the tracks warped in the heat.

And in the city of Bochum, beer brewer Moritz Fiege had to appeal to customers to return their used bottles because he had run out of bottles and crates.

Meanwhile, at the Berlin Zoo, zookeepers are freezing fish, apples and carrots, so they can provide polar bears with chilled food. And in Hamburg, the Hagenbecks Tierpark zoo has installed lawn sprinklers for its alpacas.

Germany in the summer of 2018, feels a bit like a country under a hair dryer. A golden, shimmering summer, as disturbing and strange as it is enjoyable. The sun has been beating down relentlessly and has caused a drought. So, what is this? Is it finally a summer worthy of the name or are we already in the middle of climate change? Is this what the future is going to feel like?

In the city of Kassel, two of the three lanes on the A7 motorway had to be closed because the material began melting in the asphalt joints. In Achim near Bremen, burglars stole ice cream worth 170 euros from a delivery service's freezer. In Hamburg, some indoor swimming pools have been closed so that the staff can be deployed at outdoor swimming pools.

Some are celebrating. The Association of the German Confectionery Industry (BDSI) notes that ice cream sales are up 11 percent over the previous year. As are brewers and operators of solar power plants, which are periodically producing more electricity than 20 nuclear power plants.

Many Questions, But Few Answers

A whole country is decelerating into an almost Mediterranean atmosphere. Much that was important has receded into the background, and people seem mostly interested in weather news, weather tips and weather experts. There are many questions, but surprisingly few answers. The summer is so big and our knowledge about the climate still so limited.

In the meantime, the price of potatoes is climbing on the commodity futures exchange. Temperatures are so hot in the state of Schleswig-Holstein that police are no longer being required to wear their official caps until at least Aug. 10. The drought has meant fewer mosquitoes and fewer weeds because even weeds need water. Electricity is getting more expensive because power plants aren't feeding the warm cooling water into the heated rivers.

All in all, it's unbelievable.

When public broadcaster ARD ran a special on the heat last week, airing just after the usual evening news broadcast, it attracted 4.35 million people. The dry season has turned many of us into victims and all of us into witnesses to history in the making.

Germany this August is a country that is slowing down voluntarily in many places, but also coming to an involuntary halt in others. It's a country that is now finding time for the essentials: Time to enjoy things and time to reflect. But is this unusual summer a foretaste of what lies ahead?

Not entirely surprisingly, the science currently available doesn't offer a clear answer to those questions. The climate is a complex thing -- there's more to it than just weather. The climate is a mixture of politics and science, good intentions and scaremongering. Those looking for them can detect patterns everywhere, where others at most observe circumstantial evidence.

Weather, weather experts say, has much to do with psychology. As with earlier disastrous winters, earlier summers of the century are dramatized, romanticized or simply wiped from our memories. In fact, contrary to the perception of many people, the summer of 2018 hasn't even set a new record for a heat wave. Indeed, it has only been since mid-July that temperatures in large parts of Germany have been above 30 degrees Celsius (86 degrees Fahrenheit).

'Somebody Is Always Complaining'

It is true that the Germans are sweating, but it is also true that there have been times when it was even hotter. During the 2006 World Cup, when the Germans were on a high as hosts of the event, their "summer fairy tale," July was 2 degrees Celsius warmer than it has been this year. And rather than complain about it, people celebrated. Whether temperatures are perceived as invigorating or distressing is highly subjective.


Graphic: Drought months per year


"Somebody is always complaining", says Jörg Kachelmann, Germany's best-known meteorologist. "For some, summer only starts at 35 degrees in the shade, but others consider that to be Saharan heat." In Kachelmann's mind, it's "sheer nonsense." Typically, summers in Germany are known for their capriciousness, and the rollercoaster weather that the tabloids love to report on is perfectly normal.

What makes summer 2018 an exception is the unusually long period of heat. Such a persistent period of fine weather, with lots of sunshine and little rain, occurs on average once every 10 years at most in the country. And given the lack of rain, it's not the heat that's the problem, but the drought -- especially in northern and eastern Germany, where there has been virtually no rainfall in some places since May.

This may be due to climate change, but it may also be unrelated. Germany has also experienced extreme droughts in previous years. In 1992, for example, when wheat withered away in the fields, wells dried up and priests prayed for rain at church services. Or in 1971, when forest fires flared up in many places across the country. Or in 1947, when even drinking water became scarce.

What we do know is this: The reason for this endless summer is a so-called Omega Block. Usually, a strong high-pressure area has already formed by the spring, which is wedged between low pressure areas (the formation gets its name from the fact that it resembles the Greek letter Omega). For months, an omega layer barely moves from the spot. In the manner of a bellows, it temporarily weakens and then quickly rebuilds itself.

This year this stable weather situation arose over Scandinavia. With the sun shining all day long, the dry mainland air has heated up continuously, even in northern Europe. The huge high-pressure cell directs the warm air as far as Germany. On its way south, the warm Scandinavian air hardly barely cools and, as such, forms a heat dome over Germany.

Hotter than Rome

Bernburg in Saxony-Anhalt was the hottest spot in Germany last week. The German Weather Service (DWD) measured 39.5 degrees Celsius on Tuesday: hotter than Rome.

Matthias Hirsekorn is the head of the Ameos Hospital in Bernburg. It provides care for people who are unable to cope with the heat. Senior physician Claudia Schmidt works in the Department of Internal Medicine at the Bernburg facility. She has seen how people have literally been dragging themselves to the emergency room in the last few days. Elderly people who have had too little to drink, young people who thought that even in this heat they could go jogging.

The treatment is almost always the same. Schmidt runs tests in order to check electrolyte levels. If necessary, infusions and drinks are administered and the patient is kept in a reasonably cool room. But even that is getting difficult to find. The emergency rooms and operating rooms are, of course, air-conditioned. But the standard patient rooms aren't. There are roller shutters on the windows. In the internal medicine department, they've also installed fans in the corridors. And at night, the nurses become ventilation managers: All the windows have to be opened and then closed again at sunrise.

Typical patients these days include a cyclist riding along the Saale River with little shade, a man who harvested potatoes in the midday heat or people who've drunk beer in the sun and forgotten their hats. Most are treated as outpatients. And drinks and infusions are often enough to get them back on their feet.

Hospital staff can even order special summer uniforms with thinner fabric. They're also provided with free beverages. Hospital director Hirsekorn personally walked through the departments and delivered ice cream to the staff.

Emergency physicians see heat fatigue on a daily basis in midsummer, as well as sunstroke and potentially lethal heat strokes -- often diagnosed in people who have passed out. If a person loses too much salt through sweating, that can also cause a seizure. Joggers, mountain bikers or Nordic walkers are particularly at risk if they continue exercising even when the asphalt is melting outside.

With these temperatures, most emergency calls are placed from retirement homes. A common problem is that there aren't enough caregivers to ensure that the elderly get as much water as they need. The mineral water provided in old people's homes and social services, is often also low in sodium. Tea, coffee and fruit juices are also of little use unless salt is added by other means.

The consequences can be cardiovascular problems, kidney failure and even cardiac arrest. There's a lower risk for most healthy adults in Europe, but the higher temperatures do present a risk, especially in people with pre-exisiting conditions who are over 70. More than 40,000 people died in Western Europe during the last major heat wave in 2003. In Germany alone, 7,000 people died. The victims were mostly elderly, but the heat also killed poor people, homeless, small children and also a large number of people suffering from chronic illness.

Doctors have an unsentimental technical term for the phenomenon: Temperature-related excess mortality.

People taking medication are also at greater risk. Dehydrating drugs, for example for people with heart problems, can cause patients to get dehydrated more quickly. Anti-convulsants and antidepressants can also affect the heat balance. Antihypertensive drugs for lowering blood pressure can also increase the risk of harmful effects from the heat.

The body has a sophisticated system that can withstand even extreme heat. It emits a lot of heat through evaporation, a process better known to us as sweating. Humans have around 2 million sweat glands and can release more than two liters of sweat per hour through them. The less a person replaces the liquids that have been expelled through sweat, the less sweat that person produces.

Are We Peeking at the Future?

Drought affects well-being, but also changes public space: It transforms the landscape from green to yellow and it also causes people to relax their attire and their behavior. The Roman historian Tacitus, who was very familiar with high temperatures, once wrote of the Germans: "Heat and thirst they cannot in the least endure."

The summer of 2018 provides a hint of what the future might feel like for us Germans, for us Europeans, indeed humanity in general -- on an earth that is one and a half, two or even three degrees warmer than it is today, in which extreme weather conditions are no longer perceived as extreme, but as normal. The heat is also hitting a country that has become sensitive. A country that has suddenly begun worrying about general weather conditions, about the probability of rain and about the medium-term and long-term forecasts. A country that is eagerly awaiting the harvest report for the first time in years because a surprising number of things are dependent on the 2018 harvest: the price of milk and the size of french fries, the quality of wine vintages and the availability of everyday produce: bread and beans, potatoes and peas.

Germans are learning new terms in these weeks: Emergency aid and emergency harvests, "blow-ups" (when the asphalt buckles), apple sunburns and low water situations, the term used by inland waterway operators to describe low water levels that endanger river navigation.

Suddenly, people are showing an interest in niche issues, from barbecue tips and sunblock factor levels to legal questions ("can you lie naked on the balcony?") -- all united in the feeling of experiencing something historic, the beginning of something new, unknown and perhaps even sinister.

In Westerrade, located 25 kilometers northwest of Lübeck, Dietrich Pritschau, 57, stands on his paddock staring at withered sugar beet leaves lying on the ground. For at least six generations, the family has made its living through farming. He runs the business together with his wife Cathrin, his brother Klaus and his son Tyll. "I've never seen anything like this before," says Pritschau. "It all looks so sad the way it is lying there."

Pritschau holds a degree in agricultural engineering. He cultivates more than 1,300 hectares with the help of 14 employees and 2 trainees. He farms 75 hectares near Westerrade, and the rest of his property is located in the eastern state of Mecklenburg-Western Pomerania.

These days, his staff are harvesting the last fields about three weeks earlier than usual. The corn stands in the sun with bright, rolled up leaves, they have the pale color of cacti, not the rich, northern German green. On some fields, Pritschau has already treated the stubble, a kind of weed control with tractor and disc harrow. While working, the tractors drew a cloud of dust behind them.

Pritschau grows nine fruits, five of which he has already harvested. In the barley sector, this year's crop failed by 28 percent compared to the average of the past five years. The figure was 26 percent for rapeseed, 45 percent for rye and 47 percent for wheat.

For him, this dream of a summer has turned into a nightmare. "It's the weakest harvest of my life", says Pritschau, who has been in business for 31 years.

Last year was already a disappointing year for grain farmers in northern Germany. After months of rain, the water in many fields was still so high that many farmers were unable to get their planting done before the frost arrived. But without cold stimulus, winter wheat doesn't bear any fruit. This is why summer wheat -- a variety that yields one-fifth less than its cold-dependent twin -- only got planted in many fields in February.

The German Farmers' Association (DBV) is forecasting harvests of 6 tons per hectare of winter wheat due to the drought, or 20 percent lower than 2017 yields. That's the bad news. The good news for farmers is that prices have also risen 20 percent in the past four weeks alone.

But questions still persist. Is what we are experiencing this summer really evidence of climate change, every sunburn and every hot and sweaty night? Is this summer the final, irrefutable proof that the planet is heating up? 
Relentless Summer



This much is clear: The summer's relentless sunshine matches climate observations of the last 138 years and predictions for upcoming decades with astonishing precision. The planet's average temperature is set to climb by two degrees or more. As a result, there will likely be more droughts, heat waves and heavy rainfall - extreme weather that used to be rare. For the time being, the dry summer of 2003 and the blazing hot summer of 2015 remain unsurpassed in Germany since records began. But if the planet heats up by two degrees, they could become the norm in our latitudes.

Yet it does not mean that all of Germany and indeed the rest of the world will become uniformly hotter and drier. Change will vary from region to region and season to season. Nor does it mean that next summer will necessarily be as hot and dry as this one.

The weather is unpredictable. Sometimes it rains, sometimes it snows. It can be windy. It can be calm. The climate, however, describes the average of these erratic conditions over a long period of time.

In short, this standout summer fits neatly into the 21st century's long-term climate trend. But it is dangerous to read too much into one-off weather occurrences. A single cold, wet summer does not disprove the long-term global warming trend. These exceptions are subsumed into the statistical average.

For this reason, one must be careful not to rush to conclusions and to assume that the current drought is the inevitable consequence of climate change.

'Fewer Extremely Cold Winters'

Nevertheless, the endless summer of 2018 provides a glimpse of what could be in store for the planet, and what life in 50 or 70 years might look like. By 2100, it will perhaps have become perfectly normal. The global temperature will have risen by at least two degrees, and most likely even more.

That, at least, is beyond doubt. Weather records began in Germany in 1881, and already show a rise in average temperature of 1.4 degrees Celsius - not, however, across the entire year but mainly in winter and spring. The temperature exceeds 30 degrees more often and falls below zero less often.

"There will be fewer extremely cold winters in the future,", says Gerhard Lux of the German Meteorological Service (DWD). "But this doesn't mean that winter will be more pleasant. There will be increased rainfall, so less snow and more rain." And that's bad news for winter sports regions, and also for our streets and roads, especially in mountainous areas. Melting permafrost will result in more frequent rockslides.

One positive effect is a reduced likelihood that rivers such as the Rhine will overflow as a result of spring snowmelt. Floods in Cologne, for example, will become less common.

"Spring will arrive earlier than we are used to, as happened this year," explains Lux. "The wine harvest will be earlier and the grape pickers will be wearing t-shirts rather than anoraks."

Lux is concerned less by the heat this summer than the drought, caused by the prolonged high temperatures in Scandinavia. A persistent weather system, such as the one currently keeping temperatures locked above the average, could become more common. It could also have the opposite effect, as evidenced by the heavy rain of summer 2017, which saw sewer systems in northern Germany overflow and cellars flooded.

Persistent weather fronts are made more likely by the fact that it is warming up in the high latitudes more than it is in the lower latitudes. Temperature differences between the Equator and Poland are narrowing. This results in the fast-flowing air currents circulating in the atmosphere, known as jet streams, meandering and causing atmospheric "blocking." In other words, the engine in the atmosphere that ensures constantly changing weather conditions could start to sputter out and slow down.

"When a weather system has become anchored, then there could be rain occurring on one trough axis and persistent drought a thousand kilometers away on the other side," says Lux. "One region will get too much rain and another too little. It's bad news for both."

Lux is aware that many effects of climate change might seem surprising to laypersons. Summers will tend to be hotter but there will also be a slight increase in aggregate rainfall, due to winters becoming damper.

A study conducted by the Climate Service Center Germany in Hamburg suggests that arid summers like the one currently gripping Germany may become more common by the end of the 21st century. The northeast, the southwest, the south of the country and the Alps in particular look set to see dramatically less rain in the summer months.

Germany To Be Spared Worst

Germany, situated relatively far north, will in fact be spared the worst. Mediterranean countries such as Spain are expected to see as much as a three-fold increase in their dry seasons, which would then last for more than five months of the year. Parts of Spain, Italy and Greece would then transform into deserts.

Based as they are on extremely broad-based data, these regional forecasts are not 100 percent reliable. London or Paris, Amsterdam or Aachen? Climate modeling isn't an exact science. Precise coordinates don't tend to be factored in.

Which climate model is the right one? Most scientists use as much forecasting as possible, gradually figuring out the various models' respective strengths and weaknesses. The range of climate predictions is therefore wide, but by no means random. Despite the variety of climate models, there is a consensus -- and the summer of 2018 fits into the picture perfectly.

Germany would in fact be able to cope with an increased frequency of dry periods, although this does not prevent associations, lobbyists and parliamentarians from championing their own causes.

Graphic: Temperature Deviations in July 2018

For example, the aridity has just been quantified. Joachim Rukwied, president of the German Farmers' Association, has asked for 1 billion euros in special aid to compensate for drought damage. It would go to any farms whose harvests are down by at least 30 percent compared to their recent averages, due to the drought and heatwave.

Farmers Struggling

One-billion euros. That's more or less the amount the government has pledged to spend on its emergency program to boost old-age care over the next four years. But then, the farmers' association has always had the ear of the conservative Christian Democrats, the government's senior coalition partner, and specifically that of its parliamentary group.

Volker Kauder, the conservatives' parliamentary group leader, took a clear stance on the issue, proclaiming "we should not be stingy." A was a remarkable response, not least given that Julia Klöckner, a member of the Christian Democrats and agriculture minister, had only just sought to distance herself from the farmer lobby's demands. Before paying out 1 billion euros, she said, it was worth waiting for the ministry's own harvest report, due in late August. It now seems doubtful that she will succeed in fighting her corner even within her own party.

Friedhelm Taube, an agricultural scientist based in Kiel and a member of the Agriculture Ministry's scientific advisory board, is among those who believe the farmers are not yet dealing with an emergency, despite the association's protestations to the contrary. The fruit harvest was disastrous last year, he points out, but by winter, the farmers' complaints had completely subsided. Substantial price hikes had compensated for their modest yields.

From land leasing costs, Taube can tell that value creation has flourished in agriculture in the last decade. They rose by more than 50 percent in some regions, and farmers could still afford them. For Germany as a whole, the added value of farmland based on purchase price development was around 100 billion euros. "Anyone who gets into existential difficulties after one bad year has been inefficient," he says.

Werner Schwarz, president of the farmers' association in the state of Schleswig-Holstein, takes a different view. Sure, dairy farmers have gotten back on their feet in the last 18 months, after a long period of struggle, "but not enough to create reserves." The shortage of animal feed due to parched fields means more and more farmers are having to slaughter their herds. In July, 20 percent more animals were slaughtered than usual.

Lobbyist Schwarz also cautions against a scattergun approach. He himself is a pig farmer, his business is doing fine. But a crop farmer doesn't have a pigsty or an apple orchard to make up for losses. Some of his colleagues are seeing a 70 percent drop in their harvests. Without aid, they could find themselves facing bankruptcy.

But Germany would need the EU to sign off on any aid package. The first condition would be that the emergency was a nationwide one. Drought is rarely a nationwide problem. Even in the exceptionally dry summer of 2003, federal and state governments "only" paid out 72 million euros in aid to farms struggling to survive.

The Green Party, meanwhile, has voiced deep-seated criticism of an aid package. With every instance of drought and flooding, the party sees itself vindicated in its conviction that a climate catastrophe is just around the corner. And party leader Annalena Baerbock doesn't buy Klöckner's reservations. "If she's serious, then she wouldn't be blocking agricultural reform, which is urgently needed, at the European level," she says. The European Commission, she points out, only recently proposed that the criteria for agricultural subsidies should be sustainable farming practices rather than farm size. Baerbock thinks it is regrettable that Klöckner rejects this approach.

Good News for Vintners

Unfortunately, the chorus of complaints has somewhat drowned out the fact that not all farmers have been equally hard hit by the dry weather. Asparagus and strawberry farmers, for example, had a good year. And wine-growers could be looking at record harvests.

The south-facing Knipser Himmelsrech Dirmsteiner Mandelpfad vineyard is ideally located to soak up the sun. Wearing shorts, Stephan Knipser, 42, is standing among rows of vines. Here on the edge of the Rhine Valley he grows cabernet sauvignon, a grape that used to be associated mainly with the Bordeaux region.

But Knipser has even had to shield the cabernet sauvignon against excessive heat. The vintner has thinned out the foliage in the middle and is giving the leaves at the top longer to grow. "The grape canopy gets enough air," says Knipser, "but we let the foliage at the top grow so it provides the grapes with shade." Excessive heat can break down acid in the grape, so the wine ends up less fresh and long-lasting.

And if there is not enough water, the leaves' stomata will close and the grapes would stop growing. This can easily happen with young vines on sandy soil. Old vines have much deeper roots, and are therefore far less likely to dry up in hot weather.

"So far we have been very lucky with the weather," says Stephan Knipser, notwithstanding a hailstorm in spring. "Plentiful sunshine means riper grapes and more sugar and therefore more alcohol."

Thirty years ago, Knipser's father was one of the first to start growing sun-worshiping grapes. He came in for a lot of ridicule at the time. These days, he's seen as something of a visionary. "With climate change, these grape varieties are now flourishing here," he says. Knipser even grows Yellow Orleans, believed to have been the favorite tipple of Charlemagne. It long ago disappeared from German vineyards because it rarely ripened in time. But in recent years grapes are ripening earlier in Germany, which according to Knipser, is indicative of climate change.

Stephan Knipser, for one, is a happy man. But what does the scorching hot summer of 2018 mean for everyone else? What's in store for Germany in the next few weeks?

The heat will start to subside, mainly because the days are getting shorter and the nights longer. So the sun has less time to heat up the atmosphere. According to the European Center for Medium-Range Weather Forecasts, based in Reading, England, the drought could continue, and not just for one or two weeks but for the whole of August and possibly even into September.

'A Quiet Revolution'

Medium-range forecasts are not necessarily completely accurate, of course. How could they be? "It's an experimental product," says meteorologist Kachelmann. "But the best one in the world and very alarming."

So, it will be less hot, but the drought will remain? That's not what farmers, doctors, energy utility providers and fire services want to hear.

But there is a silver lining. Weather and climate research has advanced in leaps and bounds in recent decades. News of extreme heat claiming lives or heavy rainfall causing flooding tends to overshadow the quiet, dogged advances being made in weather modeling, day in, day out, by trial and error. These advances go largely unnoticed. All we ever do is moan whenever a storm strikes an hour later than predicted. Disasters shout, whereas progress whispers.

"We are witnessing a quiet revolution in weather and climate prediction," says Peter Bauer, deputy director of the EZMW's research department. "We've been seeing steady progress for decades. Every 10 years we've been able to add a day to the weather forecast."

These are busy times at the European Center for Medium-Range Weather Forecasts in Reading. Bauer sometimes ties together over 50 variations of a weather model into one. There is a constant stream of new datasets. The efficient linking of forecasts in the southern and northern hemispheres with the help of satellite data that allow for a systematic overview of the entire planet massively boosted accuracy. Weather prediction is now so reliable that it can help the planet adapt to climate change.

Many ways it can adapt are simple and already tried and tested. Protective grids and windows against hailstorms, the greening of rooftops - as recommended by the Federal Environment Agency. Urban planners must find ways of guarding against flooding in the event of heavy rain. White roof surfaces reflect sunlight and deflect heat. Parks provide shade when the sun shines and absorb moisture like a sponge when it rains.

Farmers also need to adjust. Mixed farming is less vulnerable to extreme weather. Genetically modified crops that can withstand hot, dry weather must also become more acceptable to consumers.

For many people, the summer of 2018 will be one to remember. It's been intense -- a pleasure for some, a nightmare for others. But first and foremost, it has been a wake-up call. We need to start preparing ourselves for warmer times to come, and the advantages and disadvantages they will bring.


By Melanie Amann, Annette Bruhns, Anna Clauß, Hauke Goos, Dietmar Hipp, Ann-Katrin Müller, Martin U. Müller, Timofey Neshitov, Christopher Piltz, Hilmar Schmundt, Olaf Stampf and Steffen Winter


Vanguard Warns of Worsening Odds for the Economy and Markets

By Jeff Sommer


CreditMinh Uong/The New York Times


The chances of a recession by the end of 2020 are mounting. And the prospects for the American stock market in the next decade have worsened appreciably.

Those are prognoses, not facts. But they’re not just offhand projections, either. They are the sober assessments of Vanguard, the $5 trillion asset management firm. And they suggest that the current good times may amount to a reprieve: an opportunity to make sure that you are prepared for a storm.

Vanguard, known for its caution, emphasizes that this is a general forecast. “We don’t make any actual predictions about where things are going next month or, in the markets, next year,” Greg Davis, the company’s chief investment officer, told me. “The stock market could rise a lot, short-term. We don’t know.”

The United States economy could well turn in another series of strong quarters, with the annualized growth rate of gross domestic product above 4 percent, and the unemployment rate below it. Those are statistics for the second quarter, and just may be surpassed over the next year.

But in the Vanguard view, the odds have increased sharply that more challenging times are coming. It is likely, Vanguard says, that the long stretches of sizzling stock markets since 2009 — bouts that have made investing a winner’s game for those lucky enough to afford a seat at the table — will become much rarer.

Vanguard tracks data to predict the likelihood of a recession at certain points in the future. In recent years, the company has put the probability of a recession six months out at close to 10 percent. Now, Vanguard says the chances of one by late 2020 are between 30 and 40 percent. That’s Vanguard’s highest-ever estimate for that time frame, Mr. Davis said. (A six-month forecast reported a greater than 40 percent probability before the recession that started in December 2007.)

The recession projection is based largely on interest rate expectations using two criteria, according to Freddy Martino, a Vanguard spokesman. One is what economists refer to as a flattening yield curve, with the Federal Reserve expected to raise shorter-term rates faster than longer-term ones. The other is rising credit risk for below-investment-grade bonds.

If the facts change — with, say, the Federal Reserve delaying anticipated interest-rate hikes in response to a weaker economy — the recession forecast will change, too, Mr. Davis said. To be clear, Vanguard isn’t predicting a recession; it is merely saying that the odds of one have risen.

“You could also say the chance of a recession not occurring by the end of 2020 are 60 to 70 percent,” said Fran Kinniry, a principal in Vanguard’s investment strategy group. “You want to be prepared for a downturn,” he said, without becoming so risk-averse that you fail to benefit if investments rise.

The forecast suggests opportunities, not just problems, Mr. Davis said. The 10-year outlook, for example, includes lower projected annualized returns, but still positive ones, for these two stock categories:

■ United States stocks, an expected 10-year return of 3.9 percent, annualized, down from a projection of an 8 percent annualized return, made in March 2013;

■ Stocks from markets outside the United States, 6.5 percent, annualized, down from 8.7 percent in 2013.

Non-United States stocks are more attractive for equity investors, on a relative basis, than they were five years ago. (That is partly a reflection of the out-performance of domestic stocks, making them far pricier than they were before.) What’s more, Vanguard projects improved 10-year annualized returns for these asset classes:

■ A diversified portfolio of United States bonds, 3.3 percent, annualized, up from 1.7 percent in March 2013;

■ Bonds from outside the United States, 2.9 percent, up from 1.8 percent;

■ Commodities, 5.9 percent, up from 4.2 percent;

■ United States Treasury bonds, 3 percent, up from 1.3 percent;

■ And cash, held in United States money market funds, savings accounts or other instruments, 2.9 percent, up from 1.5 percent. Short-term cash is becoming more attractive — with greater liquidity and, often, lower risk — compared with holding bonds.

Experienced investors who are “sophisticated enough to focus on these numbers and act on them themselves” can benefit by making their own adjustments, Mr. Davis said. Tried-and true investments like balanced funds and target date funds (which become more conservative as a given date nears) can make basic adjustments for you. Advisers can do this as well.

Tweaking investments can make it easier to live with them — and not panic — if markets fall, Mr. Kinniry said. At the moment, though, many Americans appear to be setting themselves up for trouble.

By the start of this year, the stock portion of investment portfolios swelled to 63 percent, the highest level in decades, according to a Vanguard analysis. That reflects the rising value of stocks after one of the greatest bull markets in history.

American portfolios had the same high proportion of stocks in September 2007. People bailed out as the market crashed a decade ago — taking huge losses after prices had already fallen — and reducing the equity proportion of their portfolios to only 38 percent in January 2009.

Yet in March 2009, stocks began rising. It would have been better to have held more stocks in early 2009, and to have reduced them when stock prices were high, as they are now. “You don’t want to panic and sell after the market falls,” Mr. Kinniry said, “but that’s what a lot of people did.”

Dividing a portfolio between stocks and bonds is a personal decision. If you can afford to ride out a major stock market decline, and truly don’t need to touch your money for a decade or two, you might be fine with a broadly diversified portfolio that holds only stocks, Mr. Kinniry said.

After all, he said, it took only 3 years for such a portfolio to recover all of its losses after the roughly 50 percent stock market decline of the last crash. But withstanding losses like those without selling any holdings took extreme fortitude. That’s why it was easier to live with a broadly diversified portfolio, with 50 percent stocks and 50 percent bonds. Such a portfolio recovered all of its losses in just one year, not three, according to data provided by Mr. Kinniry.

Doing a serious gut check and realistically assessing how you will behave if a major downturn occurs can prevent a lot of pain later. “You don’t want to find out that you don’t have enough car insurance or home insurance until after an accident happens,” Mr. Kinniry said. “You’re better off if you do the inventory now.”

And if the markets do turn out to provide lower returns in the next decade than in the last one, it may be possible to compensate by taking measures that you can at least partly control, perhaps by working more, increasing savings or reducing spending.

The odds have worsened. Surely it’s better to be prepared.