:LPE:

Barlcays bank has or is about to issue a pile of new equity to shore up its balance sheet after the write-downs. You might also remember that this is the bank that is literally funding Mugabe, making loans to him secured by local real estate. Maybe there will be a couple of write-downs there as well.

From the esotric world of credit market products and indicators, Markit provides some basic charts of the prices of credit default swaps and asset-backed securities, which are sometimes called CDSs (credit default swaps) and CDOs (collateralized debt obligations, a form of “structured product”). The former are essentially derivative contracts, the latter a security whose value is dependent, in some form, by another security, and whose value is “backed” by that asset. The most famous CDOs are of course sub-prime products and in Canada ABCP, which we have heard something about in the past 12 months.

Not long ago Mary Walsh in the NYT did some back-of-the-envelope calculations and found that CDSs and related products in the US have a total notional value of about 45T, an amount freater than the value of US equity markets. The comparison is awkward, because CDOs have notional values whose actual costs (e.g., the amount paid by one counter-party to the other on the basis of some fraction of the notional value) may be far less, and they may be used to hedge, so that the risk or exposure may be much more limited than the notional value suggests. Anyway, right now I’m interested in the trend metrics of these things, because a number of the fixed income wags in the paper trade rabbit on about the spreads in these markets, and I’d like to know more about what they are using as data.

I’m still tinkering with these, but they are a form of insurance against events of default, and so are meant to be a way of double-checking on credit market conditions: they are one proxy for what people expect about corporate bond defaults and defaults on a basket of asset-backed securities.

First, the recent price of corporate credit default swaps for Markit’s basked of issuers (100 major issuers with mixed rated corporate dept):

If I understand these properly, the cost of insuring corporate debt is expressed in basis points (bps, left hand scale), so that, say, 250 bps suggests the cost of swapping the default on (insuring) $1M of debt is $25K. The lower the chance of default, the lower the price charged for a default swap. This index shows some decline in the cost of default insurance over a short 3-month time period, and a slower rise again in the cost of insurance.

Next, the same index with the spread overlaid, which move in tandem with price. I wish I had better historical data on these spreads.

Next, an index of asset-backed issue. This type of chart is different, it is quoting a price for the security itself on the left-hand side, I believe as a percentage of its par or face value (e.g., not a price to get *rid* of the security). This series are composed of indexes of different grades of CDOs depedning upon their rating.

This looks a lot worse than the corporate issue, despite supposedly being “near cash”. A number of these structured products are hard to price — even in a liquid, transparent market, let alone this murky, muddy one.

Finally, a look at a lower-rated group of asset-backed issuers. Same story, worse assets. Of course, we can raise a pile of questions about the actual ratings these get — AAA, -AAA, BBB and so-on, because those same ratings agencies were way, way off. It is still something of a mystery to me how these tranches were developed and obtained their ratings, but I suppose that is the art of these things when sludge goes in and diamonds come out.

Finally, yesterday the SEC announced that it was seeking changes to the way ratings agencies’ ratings will be used — it will no longer require some investors to purchase according to some ratings, or, in other words, they will be free to do their own analysis, and not rely on ratings. The idea, it seems, will be to force buyers to make their own analysis of the security. It isn’t clear to me how they will do so.

More precisely, they said the Board of BCE acted appropriately in entirely ignoring the effect of entering an LBO transaction on the price of bonds they issued notwithstanding prior statements to the contrary. This is entirely in line with broader expectations, a little awkward under the wording of the statute, and impossible to comment in any detail upon until the reasons are released, which could be six months.

It was supposed to be the most important corporate law decision in 20 years: it may be still, but it is pretty much within expectations and doesn’t do much to upset the status quo. The Globe has devoted pages and pages to it, which I have not digested in favour of the Euro Cup matches. It may actually be a bit of a tempest in teapot. We’ll see. It does, however, continue the fiction that shareholders are supreme.

Some consequences: the BCE deal moves on, overpriced as it is, it may still be able to transform itself into a sale to a global telecom player within a few years (IT stocks are up versus the broader indexes); US doctrine is imported into Canada (the so-called Revlon rule which requires that shareholders’ interests trump others in these transactions); those who said Peoples v Wise was an indication of wider judicial attitudes toward stakeholders (and support for stakeholder theory) now have to deal with a case supporting shareholder supremacy, albeit in a different transactional context; bondholders will want to insert stronger language about additional debt or, more likely, ask for a better premium in its absence if issuers want to retain the ability to pile it on. I suppose there is some notional additional cost to issuing debt, but now that the LBO era is firmly behind us, however, it likely won’t have a huge impact on current deals and by the time we get another cheap-debt driven series of buyouts, all will be forgotten (note that the bondholders in this case were from 1997 and 1977, 10 and 30 years out).

More when reasons warrant.

So, the Chancellor of the Exchequer (Minister of Finance), a member of the Labour party, has harangued unions into not asking for wage increases. Link.

He fears there will be a return to 1978, after which Labour was pushed out of government for a decade or so by Lady Thatcher. We no longer need a Lady Thatcher, however, when Labour is willing to do exactly the same job.

We might also note that Minister Darling hasn’t made a squeak about skyrocketing executive compensation, or a housing bubble he oversaw, or providing controls over non-wage domestic price inflation — he isn’t out there telling Shell to charge less for oil or Tescos to charge less for food. In short, he’s quite content to let everyone else make money, just not employees.

Every now and then a government in Alberta, and one in Ontario, awash in cash, decides to give everyone back a few hundred bucks. This, to spend some of the revenues. In the U.S., however, Congress passed a one-time tax amnesty to re-patriate profits from subsidiaries at a 5% tax rate, which would otherwise be taxed at the normal 35% rate. Now that’s a tax break, and a direct sucking sound from treasuries and firm investment budgets. The NYT article found that much of it came from offshore holding companies in low tax jurisdictions, but you can also expect that some of it came from retained earnings in overseas subsidiairies, like, say, Canadian subs oif US oil firms.

Link.

And here is a quick-and-dirty chart of U.S. corporate profits since 1990, with adjustments for inventory and capital cost allowances.

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The Governor of the Bank of Canada recently decided not to lower interest rates to ease the credit crunch because he’s worried that inflation will erode price stability, in the lingo. To wit:

“In the face of the largest commodity price shock in our lifetimes, we cannot be complacent…a relentless focus on inflation clarifies policy decisions, makes communication easier and maximizes the likelihood that expectations will remain firmly anchored.”

Maybe. Maybe tightening monetary policy will cause us all to expect lower price inflation, because it will slow down borrowing, reinvestment, economic growth overall and perhaps speculation.

What is not that clear is the impact of tight Canadian monetary policy on commodity price inflation (oil, maybe food). What we think we know about those commodities is that they are being driven up by events outside Canada, and by definition and practical consequence, outside the power of Mark Carney to address though interest rates at all.

As yourself, why are oil prices high, why are other commodity prices high, and you start to generate a list of things like OPEC, Chinese demand, hedge fund speculators and so-on. Causes are hard to pin down, but they don’t usually include Canadian domestic interest rates. Actually, they do — several central banks are citing lower domestic rates as contributing to “inflationary growth” which, they say, needs to be stopped. The Bank of England recently said employees will have to learn to live with higher inflation without wage increases to cope with it — in other words, not only to take pay cuts, but to pay higher prices to protect corporate profits. Merril Lynch has also weighed in with a study saying there is no connection between speculation in commodity prices and those commodity prices themselves, but a strong correlation to low domestic interest rates. This seems a bit of a stretch - they say “no correlation at all” and offer an alternative explanation that refutes their own argument. Their views represent a significant group of speculators, including hedge and pension funds, and those funds do seek returns better than market in all sorts of places. The last time they were faced with low domestic interest rates, they sought alternative investments in relative safe bond-like instruments known as asset-backed securities, and they have also moved heavily into commodity futures. Sure, the problem is low interest rates: that is why they speculate in commodities.

We might also question the demand hypothesis: did the world suddenly run out of major food commodities in 2007 and early 2008? What wall did it hit? Same with oil — the amount of supply and demand are pretty well known in advance, and supply keeps increasing, but it does not seem to affect prices as liberal economic theory would predict. Where is this sudden demand coming from, this sudden preference to consume these commodities? There is no easy evidence of the demand driven theory in the short term.

But even the Merril Lynch and Bank of England views are a bit weird as policy analysis: if this price inflation is demand-driven and not mere speculation, and the new or additional demand is not domestic in large part, but overseas (China, India), I don’t see how domestic interest rates will adequately address the problem, except to dampen domestic growth.

I am probably missing some non-obvious economics in all this, but if the prescription is entirely unconnected to the symptom, what are the chances of a cure?

Or, if the cause is leveraged speculation in food and oil prices that is somehow within the Canadian jurisdiction, wouldn’t a more precise way to discourage that behaviour be to tax it, rather than risk an economy-wide recession?

It’s buzzing around the digerati circles, the weird resignation letter that Butterfield (Flickr founder) sent to Yang (Yahoo founder). In it, he suggests that he’s a tin worker and he can’t cope with being in the Yahoo congolmerate of everything-but-tin manufacturing, and is leaving to work with tin again. He mentions the good old days back in “‘21″, and so-on. Huh? This from a 20-something with a philosophy degree from Oxbridge and $35M burning a hole in his pocket.

It’s obviously a metaphor for something, but it seems to have most people baffled. Unless, I suppose, he is comparing himself to tin workers in Cornwall in the 1700s, who organized themselves into a sort of proto-open-source community, sharing their technical knowledge and developing new and better production methods. An appropriately obscure metaphor for an overpaid philosopher who tripped over his fortune as much as beat it from zinc and iron.

A new book out by Thaler and Susnstein is getting a bit of attention south of the border. It’s titled Nudge:

It’s main point is that social policy can and should be used to guide people toward optimal choices, for example, in saving for retirement or buying health insurance. They wish to stop short of “paternalism” — having choices made for you — and emphasize a “liberatiran” version of it, which requires individual choice to be made by you, but with approprirate incentives and “choice architectures” (options) in place. A basic example everyone in the pension world is familiar with is the “opt in” versus “opt out” choice for pension plans. Making people “opt out” tends to keep people in plans, because of some sort of decision-making inertia. Keeping people in plans is usually good, it helps force savings for a period in life where active work is less available, although it varies with individual circumstances (very low income people are better advised not to save for retirement at all because public programs claw back private savings).

The authors themselves call these insights “unremarkable”, and indeed they are: they have formed the basis of social policy intervention for some hundred or more years. We have had subsidized education, health care and of course, retirement savings, for a long time. What is perhaps more remarkable is that this is considered a new or radical debate at all…it is as if we forgot that “human fallibility” is an appropriate an entirely legitmiate normative basis for intervention, and have to re-discover the principle throgh behavioural economics, which is the branch of economics that makes fewer stylized assumptions about people’s actual behaviour and finds, voila, that people can make some pretty ’sub-optimal’ decisions from time to time.

If we stretch this little tension a bit too far, we can see that in fact what we have here is the slow re-emergence of difference between ‘judgment’ and ’science’ as bases for regulation. Where once we used lived experience to form judgments about appropriate policy interventions, sometimes in a very pre- or non-scientific manner, we then began to use experimentally-based theroems to root regulatory intervention, the most well-known of those being the “market failure”. Regulatory theory has over the past 10 years or perhaps more re-discovered non-economic and even non-social science rationales for intervention (others being, for example, moral or ethical grounds, or grounds based on other forms of authority, such as religious authority). Prosser has canvassed these, I believe, and Santos has written a chapter or two on the end of the science-and-law paradigm. The same thought appears to be creeping into the Chicago school, where they still call it behavioural economics.

UPDATE: Thomas Wolfe and Andrew Sorkin have weighed in as well: Link.

About a year ago the large private equity players were all prepping to take their shops public, and cash out the owners, a sure sign that the boom was over. One of the big names of the PE crowd was Blackstone, which did some $350B of deals in the US in 2006. Its owners, Peterson and Schwarzman, were the toast of the town, having started their shop with about $500k back in ‘96 or ‘97.

If you got in to the Blackstone IPO last July, you bought in at about $31 a share and within six weeks lost about 20%. Here’s how you did on the year to June 20th, 2008.

As you can see, you lost about half your initial investment, if you stuck with it. That loss more or less tracks the S&P Financials Index right through the year, so we could say in Blackston’e defence, the whole sector took a beating in what we are now calling the credit crisis, because they specialized in the use of credit instruments in their deals, especially LBOs. But it also underlines the timing of the issue — the founders got out at the very top of the market, and let a group of institutional holders in less than 30 days before the whole sector went sour. A socialization of the losses, to be sure.

The NYT recently did some math to put the whole sector in context: US banks (notable exception: Goldman Sachs, who got out of junk debt or bought insurance earlier than others) have written off 50% of the total profits reported 2003-2007, the period of the recent boom in LBOs. Put another way, the causes of the profits of 2003-2007 have proven, overall, to be pretty baseless or at least unsustainable, an old-fashioned bubble. Some banks failed and required federal bailouts, and now we’re starting to see arrests now of some of those pushing bad financial products, although they do not as yet appear to reach too far up into the echelons of financial engineering. However, the sector itself is seeing its worst days since ‘71.

In what will become the cause celebre this year (as indeed it was last), the BCE deal has generated a lovely question for corporate law scholars in Canada: when must a board of a public corporation take into consideration its bondholders? More precisely, when it looks out for its shareholders, does it also need to look out for its other security-holders?

One side — the majority view in Canadian corporate academe — says No, you don’t, because bondholders are protected by the covenants that they negotiate with the issuer. Except, in this case, covenants didn’t do much to protect the bondholders - or arguably, they knew they risked getting screwed by an LBO, notwithstanding management saying bare weeks before the offers came in that it would never do anything to jeopardize bondholder value. Only shareholders, say this side, are protected by the oppression remedy found in Canadian corproate law statutes. Any other finding, they say, would revolutionize/tip upside down/freak out the shareholding classes and VIPs doing all these nifty transactions. Not to mention a series of standard opinion letters drafted by the mandarins of Bay Street. Capitalism would probably end.

The Quebec Court of Appeal, bless their stakeholder-oriented hearts, read the definition of “security” in the CBCA and found that it included holders of corproate debt, viz.:

“security” means a share of any class or series of shares or a debt obligation of a corporation and includes a certificate evidencing such a share or debt obligation…

and that those who may make claims under the oppresion remedy includes holders of “securities”, to wit:

“complainant” means (a) a registered holder or beneficial owner, and a former registered holder or beneficial owner, of a security of a corporation or any of its affiliates…

and after some consideration of precedents coming down on either side and some other aspects of the bond covenants, they decided that a group of the bondholders did indeed have the right to the oppression remedy, and the 1997 bondholders were indeed oppressed, to the tune of 20% of the pre-transaction value of their bonds. The SCC granted leave to appeal on an expedited basis about 30 minutes ago.

The SCC will decide whether a US doctrine has been adopted in Canada - the so-called Palmolive doctrince, in which a similar case was decided in favour of the shareholders, and ushered in the LBO era of the 1980s, which if you remember ended with Michael Milliken, junk bonds, Barbarians at the Gate, a stock market crash and all sorts of other goodies. Not that the USSC was responsible, or any one cause.

The differences (or perhaps, similarities) in this case are that the corporate raider is the Teachers’ Pension Fund, the workout strategy is to sell to an international telecom, and we’ve already had a stock market crisis and a credit market crisis. This would exacerbate both, but also make clear how much of debt-driven deal this was. Ahh, juicy juicy. Next: an examination of the key arguments before the SCC.