Weekly Geopolitical Report

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1 January 19, 2010 Reflections on Terrorism On December 25 th, Umar Farouk Abdulmutallab attempted to detonate an improvised explosive device (IED) on a Northwest Airlines flight. The flight, which originated in Amsterdam, was near its destination, Detroit, when the device was detonated. While the IED failed to explode, it was a reminder that the U.S. remains under the threat of Islamic terrorism. In this report, we will discuss the attack, comparing it to similar ones, and why it is impossible to prevent all attacks with certainty. As always, we will conclude with potential market ramifications. The Attempted Attack Mr. Abdulmutallab s failed attack has been fairly well publicized. The device contained about three ounces of pentaerythritol tetranitrate (PETN) in a plastic or latex sheath. The device was then was sewn into Abdulmutallab s underwear. He also carried a syringe with a liquid glycol. Near Detroit, he injected the glycol into the sheath containing the PETN. Fortunately, the device didn t explode but instead ignited. The ensuing fire alerted the crew and passengers that something was amiss. They subdued the badly burned Abdulmutallab and held him until security personnel arrested him after the aircraft landed. The immediate reaction from policymakers was to focus on the intelligence failures that didn t prevent the attack. Mr. Abdulmutallab was in possession of a multientry visa. He was a student that had studied in the U.K. Apparently he came into the company of members of Al Qaeda in the Arabian Peninsula (AQAP). His father fearing that Umar had become radicalized, expressed his concerns to U.S. embassy officials in Abuja, Nigeria. His name and passport number was sent to Washington and he was also placed on the Visa Viper system which tracks visas and terror suspects. He was also entered into the Terrorist Identities Datamart Environment. However, he was not placed on any no-fly lists. CIA agents who were briefed by Umar s father passed responsibility on to the State Department. These officials decided not to take further action. Obviously, in hindsight, this was a mistake. The use of an underwear bomb may have been tried before. On August 28, 2009, Abdullah Hassan Taleh al-asiri, a Saudi citizen and senior leader of AQAP, offered to turn himself in to Saudi authorities, renounce al Qaeda and participate in an amnesty program. Al-Asiri was on the Saudis most wanted list and so his decision to turn himself in was considered to be a major blow against AQAP. Major jihadists that decide to change their allegiances often surrender directly to Prince Mohammed bin Nayef, the Saudi Deputy Interior Minister, who is in charge of the kingdom s counterterrorism efforts. However, instead of surrendering, al-asiri tried to kill the prince via a suicide bombing. Al-Asiri entered a small room to speak with Prince Nayef; upon entering, he detonated an IED. The bomb instantly killed al-asiri 1

2 but was not powerful enough to severely hurt the prince. Since the bomber was effectively blown apart, it was impossible to determine what sort of IED he was carrying. However, it was clear it wasn t a bomb vest, which would have caused more damage, as shown by the recent suicide attack against the CIA in Afghanistan. Instead, the IED used by al-asiri was not detected; assuming he was given at least a cursory search, we believe the IED was either very small or hidden in an area on his person unlikely to be searched. After this attack, since there was no remnant of the bomb, there was speculation the IED was carried in a body cavity. But, in the aftermath of the Abdulmutallab event, it is now believe al- Asiri probably used an underwear IED. Throughout its history, Al Qaeda has tested various tactics to see if they work. A single event is known as a proof of concept attack. The first known one was Ramzi Yousef s bombing of Philippine Airlines flight 434 in Yousef built an IED in a doll; he carried a separate detonator and timing device from a modified digital watch. He was able to smuggle the parts onto the aircraft, assembled them in flight, and stuffed the doll in an under seat life preserver. Yousef exited the aircraft at an intermediate stop; the bomb exploded in flight, killing one man and injuring 10 others. The blast did damage the aircraft, but the 747 fuselage remained intact and the plane landed safely. The lesson learned from this proof of concept attack was that the IED wasn t powerful enough. Later, in an attempt to increase the explosive power of the IED, Yousef was brewing tricetone triperoxide (TAPT) in a Philippines apartment. TAPT has been called the mother of Satan because of its instability. The concoction caught fire, forcing Yousef to flee. He left his laptop behind; authorities found the plans for Operation Bojnka on the hard drive, an al Qaeda plot to simultaneously destroy 12 aircraft in route from Asia to the U.S. Al Qaeda returned to this theme with Richard Reid s shoe bomb attempt in 2001 and with the British terrorists liquids attempt in Both of these plots failed; the first due to the ineptitude of Reid and the second because the group was penetrated by MI-5, the U.K. domestic intelligence organization. But, clearly, al Qaeda is attracted to aircraft bombing; it makes for good headlines and forces Western governments to take expensive and unpopular steps to prevent future attacks. The Myth of Prevention After the 9/11 attacks, the U.S. has grappled with the best response to terrorism against airplanes. Thus far, the actions taken have been reactive rather than proactive. After the 9/11 attacks, security was tightened virtually all sharp objects became impossible to take on airplanes. Security checkpoints became repositories of fingernail files and small scissors. In addition, cockpit doors were hardened and the airport security workers were nationalized, becoming the Transportation Safety Administration (TSA). Richard Reid s attempt to detonate shoe bombs led to security procedures requiring travelers to remove their shoes for scanning. The 2006 liquids plot, where terrorists 2

3 attempted to put bomb-making component liquids into various bottles, led to restrictions on carrying liquids through security checkpoints. Currently, bottles containing liquids must be small and must be examined separately from other luggage. It is unclear exactly how the TSA will change procedures in light of the underwear bomber. At this point, it appears that sophisticated full body scanning devices are a potential solution. Of course, there is a tension between how intrusive security measures can be. The Israeli state airline El Al subjects every passenger to body searches, full hand examination of all luggage and a tight passenger screening protocol that often prevents Muslims from flying on the airline. El Al s methods have been successful in preventing terrorist attacks and hijackings. However, such methods are probably not appropriate for the U.S. Israel is a small country and the airline industry isn t critical to their transportation sector. In addition, Israelis are generally amenable to these intrusive measures because they live under the shadow of persistent terrorist attacks. At President Obama s press conference, where he discussed the government s response to this latest event, he indicated that he didn t want to turn the U.S. into a garrison state. In other words, he doesn t want to make security procedures so intrusive that they impinge on citizens lives. Unfortunately, at the same time, the U.S. government continues to give the impression that, with adequate intelligence coordination and new technology, Americans can be kept safe. Sadly, this assertion is probably wrong. Al Qaeda has shown that it will consistently try to attack airliners, probing for weaknesses. At some point, it is logical that one of these terrorists will evade detection and successfully attack an aircraft. Essentially, this issue is closely connected to how the U.S. approaches the counterterrorism problem. After 9/11, the Bush administration had to decide how it would conduct the conflict against Al Qaeda. In general, the U.S. could defend the shores or drain the swamp. The former required dramatically increasing U.S. internal security while the second meant attacking terrorist havens in failed states. The primary thrust was to drain the swamp. The U.S. attacked Afghanistan, overthrowing the Taliban-controlled government and sending the leadership of al Qaeda into hiding. Somewhat more convoluted reasoning led to the war in Iraq. Since these incursions, the U.S. hasn t suffered a major terrorist attack. However, both wars have been very costly and have stretched military resources considerably. This isn t to say that there were no efforts to defend the shores. The Bush administration did establish the Department of Homeland Security; however, it was really nothing more than the combination of existing bureaucracies. In addition, the administration created a Directorate of National Intelligence, which was given the task of coordinating intelligence streams from 17 other intelligence agencies in the U.S. However, there was great care taken to 3

4 avoid the creation of a domestic intelligence agency along the lines of the British MI-5. Essentially, both the Bush and Obama administrations want to conduct the war against al Qaeda by projecting power outward rather than by dramatically enhancing domestic security. The general feeling is that Americans won t tolerate intrusive government interference in their lives. In effect, the U.S., unlike the Israelis, hasn t suffered from terrorist acts to the degree where Americans are willing to sacrifice freedoms. The risk of this policy is that policymakers tend to create the image that the U.S. can be safe by attacking terrorists on their own turf and by good intelligence. When President Obama criticized the intelligence agencies for not connecting the dots and allowing Umar Farouk Abdulmutallab to board a plane, he gave the impression that such connects were easy. In reality, the U.S. receives a constant stream of threats; correctly identifying which ones are real is very difficult and, even with best efforts, there is always the risk that a terrorist will board an aircraft. This problem is magnified by the multiplicity of intelligence agencies which increases the odds that key information will fall through the cracks due to inevitable interagency conflicts. Think of it this way if the U.S. wanted better coordination between intelligence agencies, it would make sense to combine all 17 into a single agency. However, such an intelligence behemoth runs the risk of becoming a state within a state much like the KGB dominated Soviet society. The U.S. has tended to prefer a disjointed intelligence apparatus to protect society from abuses of civil liberties by the intelligence services. In effect, the U.S. trades efficiency for civil liberties. As long as we make this trade, the odds of being attacked are higher than they otherwise would be. So far, this has been perceived as an acceptable risk. But, if an attack is ever successful, this may change. Ramifications The failed terrorist strike has had little effect on the financial markets. If an attack is successful, the typical reaction, assuming it isn t catastrophic, is a hard but short-lived selloff in equities and an equally short-term rally in Treasuries. For investors, the pullback is usually a buying opportunity. The greater worry is if an attack spurs a move to defend the shores. Such a policy change may bring a much different economic and regulatory environment. We don t expect this to happen but it is a risk that could come if a terrorist attack is successful. Bill O Grady January 19, 2010 This report was prepared by Bill O Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. 4

5 Confluence Investment Management LLC Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri. The firm provides professional portfolio management and advisory services to institutional and individual clients. Confluence s investment philosophy is based upon independent, fundamental research that integrates the firm s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication. 5