:LPE:

I think it was Frank Partnoy who described the process best, if not first, somewhere in Infectious Greed, his subject being credit derivatives and the shift of risky lending to staid, long-term investors. The subprime meltdown is another classic example. Last week AIG announced a writedown of some measure related to its banking division, and there will surely be more. It won’t just be banks and insurers on the hook for these bad loans, though, through the magic of “structured products”, in this case, mortgage-backed securities and other collateralized debt obligations, the same basic tool that offloaded other forms of lending risk or deal-related risks from the investment banks Partnoy was talking about. Central bankers truly concerned with systemic risk are hopefully taking a gander at this market.

One quick summary of the sub-prime issue is here: Link, which takes a dim view of the rating agenices (also a point made by Partnoy, and subject of recent work by him) and their conflicts in providing investment-grade ratings on what are effectively risky or even junk securities, permitting their purchase by those who ought not to hold them (read: sleepy, mid-western mid-sized pension and insurance funds and their investment managers). It’s a good place to lay some of the blame, because rating agenices hold themselves out as, well, good raters of risks. But they are more, they are effectively gatekeepers for anyone who is not working in an investment bank with a massive research budget and a doctorate in the mathematics of options modelling. Of course, other folks were involved, beginning with those peddling no-interest no-money down mortgages in the first place, on the highly speculative basis that real estate prices would continue to rise an ahistorical rates.

The bottom line: expect to see the sub-prime loan losses reverberate through some of these investors’ balance sheets before its all over. The damage is far more limited in Canada, where the sub-prime market was much smaller than than in the US (more cautious lenders?).

Biovail and its acerbic leader Mr Melnyk have graduated to the next level with the SEC, whose investigation covers some accounting snafus between 2002 and 2004, I believe. One of them was the truck that disappeared or blew up in a fire or some such accident, and lead to a drastic re-statement of earnings on autumn. Who knew trucks were such a risk-factor: but note for the next prospectus. It appears the SEC has decided to take their investigation further based on their preliminary review of the evidence.

Just for context, this is the same Biovail short sellers targetted in the late 1990s and early 2000s on the basis of their (allegedly) sketchy patent claims and pipeline. I didn’t follow closely enough to see if those allegations were true or just went away with settlement. I’m also not sure, but I believe one of the allegations was that the “R&D” costs were in effect a marketing program in which there was some kind of discount on the prescription of the drug made its way to the prescriber, as a method of field testing the stuff. Could all be hokey, but its not an unknown method to get the drug to the user and make the accounting look pretty, as well as justify a statutory monopoly.

The same Mr Melnyk took an aggresive approach to the shorts a year or two ago by naming them in a lawsuit as costing his company money, or at least, market capitalization. Now, it appears, the SEC needs to look closer. The plaintiff side suits won’t be far behind.

Interesting tidbit: the AFL-CIO has asked the SEC to investigate the Blackstone IPO, on the theory that it is using a structure designed to avoid the application of the Investment Company Act (US). Neat theory and no-doubt this is a happy by-product of the chosen entity for the IPO, which if I remember correctly is to raise 40$ bn. Not small change.

This seems like a shot over the bow of private equity, and at an interesting time. Record deals last year, including taking many companies private, and the pace has increased this year. There is growing anxiety on the part of labour about who these new owners are and what their motivations (and workout plans) will be. One of the most interesting aspects is, yes, exactly *who* the new owners are: they appear to be a mix of large wealthy individuals, investment banks, hedge funds and pension funds, the lines between which are all becoming increasingly blurred. There is also a tension working its way out here, between the inherent lack of disclosure necessary to the operation of these funds and their deals, and the increased anxiety for more disclosure about them. It’s going to be a central tension for a while, or until a Harveyite forms of crisis happens upon us.

Regulators seems to be very timid to look more closely at these beasts and these deals - except where some “national security” interests get put at play - which makes it all the more interesting that a union coalition has to make the request to think a little harder about who is buying what, and where the accountability lies.

The many-headed beast of private equity has managed to buy Chrysler at a $20 bn discount on the last sale price (to Daimler Benz). So many issues here, but a couple to note:

+ I’d bet a good chunk of the placements in the private equity funds are pension funds themselves, will this have an effect on decision-making by the three-headed dog?

+ Pension liabilities may stay, they’re relatively more protected than other post-employment benefits, a.k.a. OPEBs. This is where the cuts are expected to begin. Note the difference in Canada and the US: here, health care is at least partly state-funded. There, it ain’t for a goodly portion of the population, and the implications of reductions of OPEBs could be more severe.

+ What does Cerebus know about making cars Daimler doesn’t? Is this going to be an asset strip or palliative care? What is Cerebus’ workout plan?

+ Compare the experience to the current debate in the UK, and to some extent Germany, about private equity, where the TUC is far more aggresively anti-PE. A couple of weeks ago Macquarie bought Michelin UK, and within 60 hours dumped its pension plan. Boots’ famous pension plan is holding out ofr a 1$bn influx from its new owners, KKR, who are offering $50M. The question is a test: are these guys going to be “good owners”, or are we just waiting to see who is first off the mark in an total restructuring and workout, and then see the flood of them?

+ Hollowing out…

Maggs Wente noticed it yesterday, and it seemed to pique her just a bit. Link. I wrote about it here, oh, three or four months ago: Link. It’s been happening in earnest since 1985 and studied seriously since 1998, and as Maggs points out, it is a perennial concern for Canadian plutocrats: selling the businessess to foreigners. The Europeans are getting concerned and blocking mergers, Congress has been blocking sales of US energy assets to China (national security trumps free trade when you’re selling, but not when you’re buying), all of which has been blogged about here since ‘05. The wonk magazines are now writing about the threat of a new nationalism. Now, D’Allessandro has mused (far too late) about protecting Canadian resource sector from being bought out, because, he correctly points out, once sold and pulled out of the ground, we can never get it back again. What if we needed it? Yes, he’s come around to viewing the place like Maude Barlow, finally, and Maude is not getting any credit.

A couple of quick points from which to view the emerging discussion.

+ we are going to see a schism within business communities open up, between the True Believers in free trade, globalization &etc., and the Strategic Intervenors, like Mr. D’Allessandro, who see the perils involved in true belief. This will also pit the internationalists versus the protectionists.

+ one of the battles will be over free trade theory versus practice. What people like Barlow have been saying honestly and correctly for decades, the theory is rarely if ever implemented, and the practice has a pattern of favouring certain (sometimes in non-economic decision-making) constituencies. This analysis was around in 1984, and in 1974, and if we are honest and thorough, 1874 as well. The new Canada and the rapidly emerging US both understood very well that free trade with Britain at the time was a boondoggle.

+ another battle will be over the term globalization - perhaps it could be referred to as a “third phase” of the current era of globalization, the first being its creation, the second the counter-analysis that emerged following Seattle. Now, however, we will have elites in Northern countries re-examining the economic tenets of globalization, seeking to modify them.

One amusing local globalism is Mr. D’Allessandro, whose businessess (financial services) never were that exposed to foreign competition, and certainly not foreign purchase: they are protected by legislation. However, this was the same D’Allessandro who fought tirelessly for the FTA and NAFTA. Competition was good for those in goods sectors, for example, because it tended to drive down wages.

It’s not news, although there does not seem to be much second level analysis of it: Canadian capital markets are far more expensive than anyone else’s. Link. Indeed, the most expensive.

Why, you might ask, and it would be a very good question. The Canadian financial markets are very protected and the domain of a few very large players. Prices are barely, or not regulated, and so there is really no reason why a large bank or a mutual fund needs to offer you lower prices. You dump your RRSP donation into the account each year (month/week), and they don’t have to do much else.

I’ll do a bit of research and provide a description or justification for these fees, but the study speaks for itself: most expensive place to buy mutual funds in the civilized world. Now, if we could only get them to study bank fees…

It should surprise no-one who reads, but Stats Can data has confirmed that the gap between the richest and poorest has grown. Here’s the Globe’s report. Link. The bottom line: since 1996, the richest quintile has seen a 24% increase in their incomes, much more than others.

Then in paragraph 4, Ms. Tavia Grant states “At the same time though, the rich are paying a greater share of federal taxes. The wealthiest fifth of families and individuals collectively paid almost 60 per cent of all personal income taxes that year — up from 50 per cent in 1980″.

See the trick? First of all, the proportion of taxes paid by the top quintile is compared to 1980 — 15 years before the *start* of the Stats Can study, 1996. So, we’re comparing one number across 10 years (25% increase in income), and another number across 26 years (10% more of the total income tax revenue). Ummm, no. They’re not comparable. It’s such a bad comparison it is not even wrong.

Second, if the rich receive a higher proportion of income, you’d *expect* to see them paying more in taxes under a progressive system. The real story (especially if we compare to 1980) is that they aren’t paying *more* in taxes, given the massive rise in their incomes. If, for example, they got 25% increase in income, but are only paying 10% more in income taxes, then the story is the difference between those numbers.

Finally, an incredibly important qualification to this statistic is that while poor people (or the bottom four quintiles) accrue the vast majority of their wealth by employment income, the top quintile (but more accurately, the top decile and top percentage point itself) accrue their income in a myriad of ways that may escape the income survey, such as capital gains on portfolios, and so-on. So, in fact, these statistics likely under-state the amount by which the accumulation of wealth of the top quintile has outpaced the wealth accumulation of the rest of Canada.

notices the same thing…link.

Yes, they’re worried about hedge funds and systemic risk.