Letter number 36 of November 2008
- QUESTIONS & COMMENTS
For some Vernimmen readers, this will be your first financial crisis. It's not the first we’ve seen and it won't be the last. One thing we can be sure of though is that as long as the human species continues to inhabit the planet Earth, we will continue to see the rise of speculative bubbles which will inevitably burst and financial crises will follow, as sure as night follows day.
Human nature being what it is, the human is not a cold, disembodied, perfectly rational being as all of those very useful but highly simplified models would have us believe. Human beings are often prone to sloth, greed and fear, three key elements for creating a fertile environment in which bubbles and crises flourish. Behavioural finance does make it easier to create more realistic models of choices and decisions made by individuals and to predict the occurrence of excessive euphoria or irrational gloom or to explain it after it has occurred (which is always easier!). But behavioural finance is in its infancy and researchers in this field still have a lot of work ahead of them!
The origin of the financial crisis that began in 2007 is a text book case. What we have here are greedy investors seeking increasingly higher returns, who are never satisfied when they have enough and always want more. It’s a pity that there are people are like about, but there you go.
So, banks started granting mortgages to people who had in the past not qualified for a mortgage, convinced that if, in the (likely) event that these borrowers on precarious incomes were unable to meet their mortgage repayments, the properties could be sold and the mortgage paid off, since there was only one way property prices could go and that was up, remember? This created a whole class of subprime borrowers. Along the same lines, LBOs were carried out with debt at increasingly higher multiples of the target’s EBITDA and with capitalised interest, as the financial structuring was so tight that the target was unable to pay its financial expenses. This meant that virtually all of the debt could only be repaid when the company was sold. Subprimes were introduced into high quality bond or money market funds in order to boost their performances without altering the description of the mutual funds. With the official approval of the regulator, bank assets were transferred to special purpose deconsolidated vehicles (“SIVs”) where they could be financed using much more debt than was allowed under the regulations. Banks could thus boost their earnings and returns by using the leverage effect.
In finance, risk and return are two sides of the same coin. Higher returns can only be achieved at the price of higher risk. And if the risks are higher, the likelihood of them materialising is higher too. A fact of life you should never forget or you may live to regret it sorely(1).
But as long as everything is ticking along nicely, risk aversion is low and any analysis done on it becomes a superficial exercise. Nobody batted an eyelid when ABN Amro invented a new financial product in August 2006, the CPDO or Constant Proportion Debt Obligation, rated AAA by rating agencies as a risk-free asset that earned 2% more than Government Bonds. Mid-2008 it was worth between 40% and 70% of its issue price, which means that it clearly wasn’t a risk-free asset. Similarly, when discussing LBO financing on July 10, 2007, the CEO of Citi told reporters that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. Finally, the market risk premium was at its historical low at 2.86% in May 2007.
But the trees don’t reach the sky, and what had to happen, happened. The mechanical increase in the cost of mortgages that was written into contracts through step-up clauses triggered the insolvency of some households, which brought a halt to the rise in property prices in the USA, followed shortly thereafter by a fall in prices. This had a snowball effect and millions of borrowers became insolvent. Their debts were then worth much less than their face value. Because these debts had been introduced, like a virus, into a large number of financial arrangements or portfolios in order to boost their performances, they contaminated their hosts in turn. By end-2008, losses linked to subprimes revealed by banks, credit enhancers, insurance companies, hedge funds and asset managers reached over $ 500 bn.
This was a very sudden and violent wake-up call for investors, reminding them that risk was the other side of the returns coin. So what do they do? They head off in the opposite direction, no longer quite as greedy but petrified out of their wits! Refusing to subscribe or buy products that in themselves were not very complex, opaque or risky, investors have provoked a halt in lending to subprime borrowers, they’ve brought an end to LBOs as there is no financing available and they are responsible for deconsolidated banking vehicles and most securitisation tools being unable to find refinancing. A liquidity crisis, which is a crisis of confidence, has taken hold, ushering in a sharp increase in spreads leading to financing problems for companies, and especially for banks, most of which were saved from imminent bankruptcy by nationalisation (Northern Rock, Royal Bank of Scotland, Fortis, etc) or a fire-sale disposal (Bear Stearns, Merrill Lynch, HBOS, etc), or an explicit government guarantee (all the others!) Only Lehman Brothers was left to go under, and the lack of intervention was seriously regretted later as it dramatically increased the risk of collapse of the whole financial system.
Confronted with this crisis, everybody jumped onto the deleveraging bandwagon, especially banks and hedge funds, by selling off assets which in turn triggered a drop in prices, and by introducing stricter prudential controls for the granting of loans. At the climax of the financial crisis even top quality borrowers were unable to find financing. We were inside a real credit crunch. The cost of credit has shadowed the market mood, going down when the going was good, and going up when the going got tough. In early 2007, AA rated borrowers like WalMart could borrow at 0.35%, higher than the government bond rate. In October 2008, the margin is at least 3.30%. Times are tough for anyone who needs cash. The banks themselves haven't got enough and have had to rely on government and central banks to get some (a major part of Paulson and the other bail out plans).
Today, access to liquidity and financial flexibility are much more important to a company’s financial director than a hypothetical debt-driven reduction in the cost of capital. This hypothesis has, incidentally, been called into question by Almeida and Philippon who provide figures demonstrating that the costs of debt-related bankruptcies more or less correspond to the savings made through the tax deduction of interest. Their results show that the idea that carrying debt to reduce the cost of capital (an idea we've never been too keen on) is in fact something of a fallacy. Has a research cycle initiated in 1958 by Modigliani and Miller come full swing?
The financial crisis is leading to an economic crisis, fostered by the deleveraging going on in the financial world and the sharp falloff of business in the construction and automotive sectors, the impoverishment of households due stock exchange collapses, and the increasing insecurity felt by everybody. As liquidity disappeared, economic activity (consumption and capital expenditure) came to a brutal halt. The record margins registered in 2007 (European listed groups were posting operating margins of 12%) will obviously come down. As most of them are carrying very little debt and given that the largest groups secured financing in 2004/2005 for 5 to 7 years, they have time to reorganise themselves (except probably for some LBOs).
LBO activity, which has practically come to a standstill since the summer of 2007 (due to the lack of debt financing), will be back as LBOs are based on another type of governance that is often better than the corporate governance in place at listed companies and which has demonstrated its efficacy in the past(2). The leverage effect will be lower and we’ll get back to good old fundamentals – financial expenses and a large part of senior debt will be reimbursed using free cash flows. LBO financing is cash-flow-based, not asset-based. This slightly inconvenient truth may have been forgotten but aren’t we lucky that we’re never too old to learn from our past mistakes?
Securitisation transactions, that make it possible to extend the field of possible financing options and provide investors with the level of risk they’re looking for, will be back too. But the days when banks structured operations, dished out stakes in securitisation vehicles to investors, collected a fee but didn't take any of the risk, are well and truly over (the “originate and distribute” model of most US investment banks). Guided by signalling and agency theory (3), investors will only subscribe if they are certain that the banks have done their jobs properly, i.e., if they have analysed and checked the quality of the assets and the cash flows. Investors can only really be sure that this is the case if the banks keep the riskiest tranches in their own portfolios until final repayment. If this basic rule had been complied with, the word subprime would never have appeared on www.vernimmen.com.
In the future, financial history will be written less and less in rich countries and more and more in emerging countries. Funds provided by sovereign wealth funds with their origins in emerging countries, were like manna from heaven to the banks forced to recapitalise following the subprime calamity (UBS, Merrill Lynch, Morgan Stanley, Citi, Barclays, Unicredit, etc.). We doubt that these shareholders are going to remain passive. Why should they when all research into governance has shown that shareholder vigilance (shareholder activism even) is a key factor in the creation of value? Growth in some emerging countries is flattening out or becoming negative. But over the long term, growth will be sustainable and stronger than in the west, boosted by improving standards of living in and the demographics of these countries. The level of risk however, will also be higher.
Like financial crises in the past, the current crisis will come to an end.
At least two salutary lessons will have been learnt (hopefully!):
▪ The extremely high payments made to the managers of corporates, banks and investment funds, without linking them to any risk, was a disastrous mistake. If an investor takes a risk and earns a lot, all well and good, as that’s just one of the basic rules of the game. But for employees to earn tens of millions of euros without having to risk their personal assets is shocking and poses a threat to the social pact;
▪ It is the duty of all investors to analyse the products they are investing in themselves.
And if any of you need a bit of help with that, your Vernimmen is ready and waiting with full explanations!
(1) For more see chapter 21 of the Vernimmen.
(2) For more see chapter 44 of the Vernimmen.
(3) For more on those theories see chapter 32 of the Vernimmen
If you are asking yourselves where the vast liquidity which we enjoyed till recently has gone, the answer is in the above graph. In the US dollars overnight market where the interest rate is as low as 0.4% for a loan to be granted today and repaid tomorrow. And this is a yearly rate, not the rate you get for a day! In other words, if you invest $1,000 overnight, the next day you will be $0.011 richer. There is the price of security.
For more on yield curves see chapter 24 of the Vernimmen
Since the late 1970s, listed US firms have show a tendency to pay smaller dividends and to do so less frequently. It would even appear as if the correlation between profits and dividends, which until then had been very strong, has been in constant decline. D. J. Skinner, a researcher from the University of Chicago, published an article this year (1) showing that many firms have gradually replaced dividend payments with share buybacks.
The article covers listed US firms and analyses their dividend payments over a very long period (from the 1950s to 2000s). The author first shows that dividends policies have become increasingly conservative over the last 50 years. Increases in dividend payments have became less frequent (from 74% in the 1970s to 50% today), and the average amount of these increases has dropped from 11% to less than 7%.
Profits have become more volatile and losses more frequent. Fewer than 10% of firms recorded losses in the 1950s, and over 40% did so in the 1990s, a figure that rose to 50% in the 2000s. Lower dividend payments could simply be a reflection of lower profits. The article shows that in reality, lower dividend payments are mainly the result of a greater propensity on the part of managers to combine dividends and share buybacks, as share buybacks are a better option during periods of profits volatility.
When we look at the sum of payments made (dividends plus buybacks), the link between the amount of the payments and profits is as strong as the link that existed between dividend payments and profits until the 1960s. Today, firms that pay dividends are mainly large, mature corporations that paid dividends in the past. Until 1980, only 3% of firms that paid dividends were making losses, compared with 13% in the 2000s. On the other hand, only 8% of firms that paid dividends and bought back shares recorded losses. According to Skinner, we should look at the sum of dividends and buybacks in order to find a link between profits and cash payouts to shareholders.
Finally, Skinner looks at factors that determine management’s choice of whether to pay dividends or to buy back shares. Firms that carry out share buybacks but don’t pay dividends are mainly in the growth phase, are spending a lot on R&D and are smaller than those that also pay dividends. More and more large firms are also not paying dividends. Skinner provides examples of firms such as Dell, Cisco and Oracle, that on reaching maturity, started to give cash back to shareholders through share buybacks rather than dividend payments.
For more on the choice between dividend payments and share buybacks and restrictions in this area in a European context, see chapter 38 of the Vernimmen.
The article does not explain how firms split the cash returned to shareholders between dividend payments and share buybacks. This important topic will hopefully be the subject of future research.
(1) D.J.Skinner (2008), The Evolving Relation between Earnings, Dividends, and Stock Repurchases, Journal of Financial Economics, n° 87 – 3, pages 582 à 609.
Following the approval of the European crossborder mergers directive in 2005 and its transposition into the laws of UE members which is coming to an end, the main obstacles that used to make them technically difficult to execute have disappeared:
• it is no longer necessary for EU country law relating to merger procedures to be compatible with the law of the other country in question – previously both laws had to be applied simultaneously and they both had to make provision for the possibility of crossborder mergers;
• it is no longer necessary to obtain the unanimous approval of all shareholders when a EU company is taken over by another EU company because the resulting change in nationality of the former.
Of course, there were always ways of getting around these rules, such as the partial contribution of shares or assets to a European company(1).
The law does not cover the whole crossborder procedure and refers a great deal to local law. In practice, when a company is absorbed, local law applies with regard to the consultation and rights of minority shareholders, non-bondholding creditors’ right to raise objections and the rights of bondholders. These rules, that have been harmonised Europe-wide, apply to the crossborder merger procedure itself, which makes provision for the prior confirmation that the merger complies with the regulations by the registrar of the court which has jurisdiction over each company, and confirmation that the merger is legal by a notary or the court registrar.
There is also a labour-related section, a non-negotiable condition for European approval, which states that:
• if one of the companies involved in the merger employs at least 500 people
• if the company that is formed following the merger does not offer the same proportion of staff representatives on the board of directors (or on the supervisory board) that it applies to the companies in question,
then a special negotiating group must be set up to work with the management of the companies in question on determining how employees will be represented and involved in the new company.
(1) For more details see Vernimmen.com Newsletter n°1 December 2004.