:LPE:

The discussion for a while has been whether and how to regulate hedges. I did a paper a while back needs an update on the convergence of types of investors and the implications for regulation (you might think of hedge funds in this way as the opposite of pension funds), and one of the issues I discussed was whether you could regulate these beasts, without stripping them of their competitive advanatge (whether that advantage is legal or not). Sheer numbers of hedges will erode the available alpha for these investors, but regulation, which in financial services typically means more disclosure, would further hinder their efforts.

That doesn’t mean they don’t need regulating, and one of the reasons it gets raised so often is the slippery concept of “systemic risk”, which the central bankers seem to be most attuned to, though it defies precise definition. Here’s what they worry about:

Yes, the first line is assets under management. Those represent, for the most part, the bundles of money rich people have in hedge funds. About 800 billion now, it seems. If they get lost, hmm, we’d need a forensic to see what the damage is, but certainly it would devastate the financial services community. However, there is little chance a government would ever let those assets get dissipated by a market event.

The other line represents how much those assets have borrowed from lenders (and, who are those lenders, I wonder) in order to place bets in the market, and “leverage” a small gain into a large one. So, total capital at risk is something like 2,500 billions, which is what, 2.5 trillion? That represents the size of the bets, but not the actual underlying money involved. You can see what when one hedge fund collapsed, LTCM, the governors of the federal reserve were called in to figure a workout. Since then there have been a couple of flameouts, as they are known, but so far, no threat of a system-wide panic.

Back to systemic risk. Historically, leverage has avereged 200% or so, until somewhere at the end of 2003, when it appears to have grown significantly, to, what, 275%? Not quite 300%. The graph does not make it quite clear.

The bottom line is, hedges appear to have increased their leverage. It would be interesting to know who is doing all that lending, and what rationale there is that greater leverage is a good idea right now.

The NYT had a couple of articles recently on one of the pet issues tracked in this space, the destination of retained earnings. Krugman most recently noted that in the US, the ratio of corporate profits to GDP was still increasing, but the ratio of investment to GDP was still low and slow. The conclusions he and others drew, which have been the speculation for some time here as well, was that (i) there is under-re-investment of retained earnings in this business cycle, and perhaps even two business cycles, amounting to an “era” going back to pre-1990 times, and (ii) these retained earnings are being used for a variety of other projects, including and most notably, M&A financing, share buy-backs and taking companies private; that is, returning investment dollars to shareholders.

That may not sound like a bad thing, and to some it is not, but it has several implications which we might want to think about. One is direct: lack of investment means lack of new jobs, lower productivity per worker, and overall, reduced capacity to increase economic growth. This can be hid for some time during periods of under-use of capacity (during recessions or slow-growth periods) but becomes an issue when production comes closer to capcity. Brad DeLong said, I think, that one of his favourite statistics is capacity utilization.

The other is sopmewhat more theoretical, and closer to my research on the purpose and function of corporate law, and in this case, capital markets. The traditional purpose of a corporation in law is to aggregate disparate savers and provide a relaible investment form. What we see capital markets doing here, though, is exactly the opposite: getting rid of disparate investors and concentrating ownership. This process is in part related to the retained earnings problem, which is arguably the very heart of the market system, or as it used ot be known, capitalism: accumulation of capital over several cycles not leading to systemic redistribution of benefits (through jobs and wages, or some other method), but to a pool of funds for (remaining) owners to re-jig ownership patterns.

It may be different in Canada, I don’t know, but if I had to guess I’d say it was worse. Historically, we have had more concentration in both capital markets and industry as a whole. I’ll have to make some tables when I have time tracking these variables, and see what they suggest.

I missed this one a week or two back. Senator Obama’s bill requiring public companies to allow a non-binding “advisory” shareholder vote on corporate executive compensation plans has passed the House. The bill would require public issuers to allow a non-binding votes on corporate executive compensation plans, and provides similar votes on golden parachutes.

We’ll see, I remember some of the Op-Eds saying capitalism would come to a grinding halt if exec comp were subject to this kind of intrusive shareholder oversight, CFOs would join hedge funds, talent would flee to Europe, and so-on. The old analogy to professional athelets was mentioned again and again, but with less effect: since the NHL owners saw fit to impose a salary cap on players, that dog just won’t hunt.

About 35 years ago Tom Hadden wrote a book about company law - the UK term for corporate law - one of major conclusions of which was that corporate law needed to be divided up into rules for large corporations and rules for small corporations, for several reasons.

The SEC Commissioner Annette Nazareth recently described the Commission’s approach to principles-based securities regulation which she called “prudential regulation”, which in her view should be divded up between rules-based regulation for small issuers, and principles-based for larger issuers. This conclusion is based largely on complexity: the more complex the entity and transactions being monitored, the less effecitve rules-based regulation. She uses “prudential” in a more specific context, though, applying it to funds in particular (e.g., brokers, sellers of funds, practices of funds).

Corporate law has shifted from corporate statutes, which once even regulated some aspects fo securities, to securities law, so that now corporate forms seem almost vestigal, and this is one more example of the migration of the concepts.

This issue came up in the recent reports on US capital markets, as one of the alternatives to securities class actions. The theory is interesting - low-cost alternative proceedings to class proceedings or SEC/OSC actions. Keeping decisions away from courts, which are relatively expensive and unpredictable decision-makers, especially in specialized areas like capital markets (or labour law, etc.) is usually a good thing.

However, there are some some potential limitations in the case of securities litigation, such as: would the private aspect of arbitration meet the goals of securities law, would extensive discovery still work (the stage in which most claims get sorted), would multi-party claims be efficient in this forum (versus a class proceeding). Other details are presumably something that can be worked out, such as rights of appeal and liability of third parties (advisors).

The FP has an article a couple of weeks ago about a group of investors following the “tragic” story of Crystallex, the Canadian mining junior that is perenally at odds with the Venzuelan government. The story is a little boosterish (small smart honest business, evil communist corrupt dictator), and tends to skip over some of the history of the KRY story, including the episode in which KRY claimed to own deposits in Venezuela that it didn’t - or at the very least, that the government at that time stated were *not* owned by KRY, among other irregularities. I don’t know the full story - I’m not sure anyone does - but the FP didn’t get much past the KRY press release in its reporting.

I’ve been working pretty intensely on a new project and so have not been blogging lately. I have saved a number of ideas for posts and will put them up presently.

Here is what the unions and pension funds worry about private equity. Link. It is a step or two away from the asset stripping of the LBO era. the past four years has seen research, primarily academic, that shows that hedges and PE, along with pension funds, have actually acted as long-termers, and made “good” decisions for their investments, but here is a counter-example of the kind the unions worry about.

In related research, the work life program at Harvard has done some research into the change in share prices after changes in liability estimates of pension plans of the sponsor - which *do* appear to correlate, as the story above would suggest. Dump the plan, credit rating goes up, share price goes up, is the thinking. We ought to be somewhat wary of this correlation, though, as many things influence share prices, and credit ratings are subject to real conflicts of interest on the part of the raters.