Primary capital market corporate governance in the US needs tweaking?

The Dealbook reports a potential primary market corporate governance loophole in the United States. In a recent piece, Deal Professor Steven Davidoff flags off concerns to this effect pointing to the "locked-in" staggered board provision (that may only be repealed with a 80% vote-- a very high threshold to beat) in the constitutional documents of LinkedIn as exhibit A that go with dual class shares as part of its capital structure. This is because proxy advisory services like the ISS dont rate companies' corporate governance at the IPO stage, and because subscribers to the IPO subscribe only to flip their shares at the listing and could not care enough to monitor it's corporate governance.

It could be argued though, that the corporate governance risk that these issuers present is likely already priced into the cost of capital for them and that LinkedIn stock was bid for at the IPO at a slight discount to its fair value to account for this latent risk. This is likely an empirical question and we may receive some guidance from comparing the costs of capital for issuers like LinkedIn having "anti-corporate governance" clauses in their charter documents, with peer group companies not having such clauses to see if the investors apply any "corporate governance discount". If they do, then the risk is priced in and the regulators need not care. If the difference is negligible though, we may have to think of appropriate policy responses.

RCB v. DC--- Or a Story of another triumph for the unsung

What a game we had last night! One of the greatest sights in any sport, is a come from behind win for an underdog. And thats what DC's win showed us last night.

And who got them there? Not Gibbs or Sharma or Gilchrist and Symonds in substantial measure, it was the unsung, Suman. In many ways, this past week's results are showing how, for all the Pollards and Kohlis, small town guys are the ones that are winning matches. We saw Naman Oza do that for the Royals consistently and with a Bond-like understatedness, we saw the minnow Dinda castling Warner (another of those (over?) hyped possessions and now we have Suman joining the party.

These unexpected results have thrown the third ed. wide open-- Rajasthan Royals' run in particular brought back memories of Senegal's giant-killing Football team. Remember Pape Diouf or Henri Kamara!

I am rooting for these underdogs as the IPL moves in its final leg. Lets hope the media gets a lesson from their triumph. And we learn to celebrate sport for what it teaches us---- Underdog is just a word.

Interesting Reads

I have been following the blogosphere with great enthusiasm lately-- posting comments etcetera, and I must recommend two of those--- truthonthemarket and the conglomerate

And while @ the Glom, as the Conglomerate is affectionately known as, do read Christine Hurt. She is amazing. And so are Josh Wright and Thom Lambert at truthonthemarket.

Of LLM Markets, Tragedy of the Commons and Elinor Ostrom

Phew! The silly season of LLM admissions is behind me now, (where I gave generally a good account of myself, offers from Chicago, Columbia, and wait list at Stanford law being the highlight of this campaign. Was not offered @ Yale. Surprising results from Cambridge, Mass. though :)!) (Guess you guys know who the offerees this year from Government Law College are). No Comments.

Anyway, now that the season has ended, I want to blog about Elinor Ostrom and the tragedy of the Commons and the solutions that she proposed for the same.

Elinor who? Yeah, you could be forgiven for this question. After Elinor won the Nobel memorial prize in Economics in 2009 for her work on the global commons, mainstream Economists, that usually throng the lobbies of such universities as Harvard, Chicago, Berkeley asked the same question. So, that question is not unusual for law students to ask. Answer: Elinor Ostrom is a political scientist from Indiana University, Bloomington and sth of a pioneer in solving the tragedy of the commons.

Tragedy of the Commons? Gareth Hardin writing in 1966(?) spoke about the problems faced in conserving common pool resources. He wrote that common pool resources are likely to suffer from sth like the race to the bottom where every individual consumer will have the incentive to exploit the resource to the hilt (whereas collectively they all stood to benefit from conserving the same). This race to the bottom, Hardin prophesied, will destroy the common pool resource and that he termed as "tragedy of the commons".

Free market proponents argued that the tragedy of the commons could be averted by creating private property rights in the resource so that persons have appropriate incentives to conserve the resource (and so that the Coase theorem may operate to "push " the resource to the person that valued it the most). Others termed it a patent case where Government ought to step in to nationalize the resource and conserve the same (This is because there are no private incentives to conserve the resource as the costs of conservation are concentrated on the one party and the benefits that derive from the conservation are diffuse; the so called public goods problem in Economics and a classic case of government intervention).

For decades, private property and government intervention were supposed to be the only solutions to the tragedy of the commons. Elinor however had a different perspective to offer. She believed in the market hierarchy but not to the extent that Chicago did and being a political scientist she was aware of the public choice and political economy literature (indeed, she served as the Chair of the Public Choice Society for a while) to believe that government intervention could be a solution to the tragedy.

Using tools including qualitative empirics and game theory, Elinor proved that locally created governance solutions could solve the collective action problems that lead to the tragedy of the commons. Her solution is basically a model of how public goods could be provided privately and it tends towards a "non-government" model of managing the commons. "Polycentric Governance" as her team termed it. View her Nobel lecture here.

More Interesting Read

Barack Obama on the The Financial Crisis Responsibility Fee "to be imposed on major financial firms till the American tax payer is fully compensated" of the $117 billion bailout cost.

Read on!

Interesting Reads

Nobel Laureate Paul Krugman on "Bubbles And The Banks" In The New York Times. Krugman says its high time reform takes on financial industry's compensation practices. Elsewhere, Thomas Friedman wonders if going short on China really makes sense in Whether China Is The Next Enron?.

Why the Class Action Remedy Proposed In the New Companies' bill Will Fail

The "Economic times" recently published a debate on the efficacy of the class action remedy proposed by the new Companies' Bill on January 6, 2010. (Found Here and Here).

In a nutshell, the pro/con seems to be,

1.) Yes; Class actions may be useful but possibilities of the misuse of the device ought to be foreclosed. Class Action remedies ought to be coupled with statutory prescriptions that limit speculative litigation.

2). The counterview, posited by the President of a regional investor association seems to be that class action is a remedy whose time has come and "defaulting promoters" ought to be held accountable.

Seems to be me that debaters missed a vital dimension; the incentive structure in the legal services market.

If one factors in this dimension, the class action remedy will most likely be under-utilized, and therefore fail, in most respects.

Here is a capsule low-down:

The Class action remedy is one of the latest transplants that India has borrowed from Anglo-Saxon corporate law and more particularly, the US. But while engaging in this eclecticism, precious little thought has gone into the peculiar institutional design that makes the class action remedy favourable in the US market.

The reason why class actions were successful in the US (in fact so, successful, that speculative litigation abounded, prompting the House to enact the PSLRA, 1995, to regulate causes of action and standi) was the incentive structure of the legal services market. In the US, unlike India, as most of us might be well aware, the incentive structure is characterized by contingency fees.

In their design, contingency fee arrangements replicate the risk-sharing model where the attorney of the plaintiffs takes an "equity interest" in the "litigation venture". Consequently, while the lawyer stands to reap windfall gains should the class action succeed, the returns may be substantially lesser if the action fails.

These rules of the game in the legal services reduce transaction costs, agency risk and result in a robust market for class actions; With her incentives aligned to those of the class acting plaintiffs, the lawyer is much more pro-active in faster "turn around" times.

Contrast this market design, with the "lodestar rule" prevalent in India that de-links the attorney's incentives from the outcome of the litigation to its process--the hours that she dedicates for the client/appearance that she makes for the clients in courtrooms. To make matters worse, institutional rules of the game forbid "opt-out" of this inefficient rule by foreclosing contingency fees as an option.

With the lode-star rule in place, I doubt that aggrieved investors will have appropriate motivations to pursue class action remedy. Admittedly, the class action device reduces the cost of litigation for the plaintiffs. However, the disincentives created by the lode-star rule will make it highly unlikely that the law firm that they engage, will advise them correctly as to which actions to pursue to trial and which actions to settle. And if so, they will prolong most actions that they should have settled earlier, adding to the cost of litigation. Class actions in securities fraud cases are likely to be complex (causation is notoriously difficult to prove, unless the rules of evidence are changed to reverse the burden of proof) and this information asymmetry between the principal(plaintiff investors) and the agent (attorney) coupled with the perverse incentive structure make this scenario much more likely.

Another Case Of Regulatory OverReach under the Take Over Code?

In a recent adjudicating order, Adjudicating Order No.VSS/AO-27-2009, that may be viewed here, SEBI found that the Directors of a "Non Promoter Controlled Company", Matra Realty Limited were obligated to disclose their share holdings pursuant to the Disclosure law in the Take over Code. The SEBI found that the Directors were "persons having control over the company" within the meaning of relevant regulations [6(3) & 8(2)] and therefore were required to disclose their share holding to the company. It seems to me that this is yet another case of regulatory overreach. Conceding that the relevant provisions of the take over code distinguish between promoters and persons having control over the Company; the expression, "persons having control over the company" cannot in the context of the take over Code disclosures mean Directors of the Company. Let us therefore analyse this latest juridical wisdom that comes from the regulator.

The adjudicating officer found that the expression "control" is defined inclusively in the Take over Code. Regulation 2(1)(c) defines Control as:

“control” shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.

Thus Control includes the right to a) appoint majority of directors b) (the right to) control the management or policy decisions. Further such right(s) are exercisable bby a person acting individually or in concert. And lastly, such right(s) of Control as above stated were tracable to (should emanate from) such sources as their share holding, management rights, share holders Agreements, voting agreements or analogues thereof. Again here, the sources of the right to exercise control are inclusive.

The adjudicating officer found that the above definition meant:

"any person who controls the management of a company either individually or collectively with other persons or controls or influences the policy decisions, by virtue of his position can be said to be in ‘control’ over the affairs of the company... a Director is one of the controller of companies affairs. The Board Of Directors is the brain of the Company. When the Board functions, the Company is said to function. Thus the functioning of the Company is totally controlled by the Board..."

Further, having analysed the share holding pattern, he finds that the Directors and PACs were the largest share holders in the Corporation as they held 13.75% together with their PACs as of 2004.

"In view of the foregoing", he finds that the Directors are "in control" of the Corporation and having not disclosed, finds them not compliant with the law.

Thus the analysis seems to rest on two main premises: Firstly, the Directors had control over the Company by virtue of their position. Secondly, they were the single largest share holders of the Company, taken together with their PACs.

If this is the case, the analysis is faulty;

even conceding that the definition of control is inclusive and that the sources from which Control rights emerge is (also) inclusive, the analogues are to be considered ejusdem generis to the more particular words used in the definition. The sources of Control rights that the definition speaks of are :

a) share holding b) share holding agreements 3) voting agreements 4) management rights. So, the analogues, applying ejusdem generis, should only include Control rights that are "contractual" in orgin.

Directors of a Company, in contrast, receive their power/right to manage the corporation from the Companies Act. The Companies Act mandates that there should be a Board Of Director and articulates the powers of the Board (See for e.g. Section 291/292 of the Companies Act that speak of "Powers of the Board"). Their source of "Controlling power" (or Controlling Rights, leaving aside the jurisprudential difference between "Power" and "Right"), is the Statute and therefore those rights have a "in rem" origin rather than "in personam" origin that Contractual rights have. Consequently , the Control that they exercise over the Corporation pursuant to the powers under the Companies Act cannot be read in the understanding of control that we have under the Take Over Code. ( because the illustrative sources of Control rights in the Take Over code are only Contractual in origin).

Finally, the reliance of the adjudicating officer on the share holding of the Directors and the PACs taken together being the largest was incorrect.

It is clear that the powers that the Board exercised over the Company were traced to or emanated from their position/status as Directors ofthe Company. The source of the power to control the management or policy decisions emanated from their position as Directors. The source of that power/right was NOT their share holding. So,it need not have figured in the analysis at all. (indeed if the control rights emanated by virtue of them being the largest share holders, Control as understood in the take over Code is triggered. See, the definition of "Control" above. But the Right/Power of taking Management decisions emanates from the Statute as we saw earlier).

A case of regulatory overreach (again)?

Satyam Pricing Relaxation- Does SEBI Have Ex ante Competence "To Consider"?

News Paper reports suggest that the securities regulator is "considering" a proposal to link the open offer price of Satyam Computer Services, to the average price of the stock in a shorter and more recent period. This is apparently been done because potential "white knights" who "d want to acquire Satyam, under the extant take over regulations, face the prospect of coughing up Rs. 270 per share; this is as required by the formula prescribed under regulation 20 that prescribes higher of the average price of the stock for 26 weeks or two weeks.
Basically therefore, The price of Rs.270 is causing a "chilling effect" on potential white knights and so the regulator is contemplating this "regulatory discount"...

There are many issues that arise from this chain of events; But implicit and the more important of these is that of regulatory competence to allow such waivers from the provisions of Chapter III of the Take over Code. SEBI seems to have assumed that such a power is existent ; but thats not entirely clear.

The scheme of the Take over Code is clearly indicative of the fact that Regulation 3 of the same is complete code so far as exemptions go. Now, within the scheme of Regulation 3, we have a residual clause 3(1)(f) that reads as under :

"Other cases as may be exempted from the applicability of Chapter III by the Board under Regulation 4"

Regulation 4 then provides that

"The Board shall for the purposes of this regulation constitute a panel of majority of Independent persons from....."

The later sub clauses of Regulation 4 then carve out the procedure to seek an exemption under the above referred sub clause. The scheme of this procedure is such that the Board is merely a "Conduit" to allow passage of the application from the acquirer to the Panel and it is the Take Over Panel ( Not the SEBI Board) that has the first power to "Recommend" whether the exemption ought to be given or not. It is only after the Panel has communicated its views to the Board, the Board shall..... after considering all the relevant facts including the recommendations, if any, pass a reasoned order on the appplication.

It seems therefore that the powers of the Regulator to "Consider" the exemption are triggered at a stage after and not before the recommendations from the take Over panel are received.

Before the Take Over panel is seised, Its role is merely that of a "conduit" to relay the application from the acquirer.

Also, even this power to decide on the exmption is exercisable by the regulator, only in the specific context of an application from the acquirer. At the present instant, No acquirer has made a formal application for exemption. It seems from the reports that the regulator is contemplating the two week average as a floor price that potential acquirers will have to improve upon. Clearly then, it does seem that the nature of the exemption contemplated by the regulator is blanket in character..

One might rightfully then question the regulator's own "Corporate governance and compliance" when it engages in this exercise of exempting potential white knights from the rigour of the law....?

Et Tu SEBI?

The Vexed Issue Of Independent Directors-II- The Solutions

[continued...]

I think one of the policy alternatives that the State ought to consider is by way of tightening the ex post law activation and enforcement.

Say have a law to provide Class action litigations.

Once the Directors know that there are expedited judicial processes to aid the share holders which disperse litigation costs and risks, ex ante, there will be considerable incentives to act in a manner befitting their fiduciary status. The Independent Directors also will be more agile in monitoring the executive component of the Board.

The problem with placing too much reliance on Institutional Share holders to do the monitoring and to let retail share holders to piggy back is that with portfolio holdings, Institutional share holders hardly have any inclination to monitor their agents. (Although there are instances recently where activist hedge funds did a very good job of monitoring. (Sterlite's failed restructuring).

But its not going to be easy to bring a Class action law on the statute books. For one, its going to add to the cost for Corporates. I see an immediate uopward revision in the D& O liability Insurance premium for example. Also, the possibilty of being found party to a law suit at a later date will act as an ex ante disincentive for the Independent Director to accept the post. ( we have a very recent example of Nimesh Kampani in Nagarjuna Finance)

Also, easier access to remedy ex post might lead to ex ante laxity in monitoring the Boards among the share holders. Clearly, the field is ripe for research!

Should the SRO have a say in appointment of Independent Directors, that might be quasi nationalisation ; management rights to an enterprise are after all a form of property.

May be a peer review mechanism that uses reputation costs as a tool for deterrence can be used in appointment of Independent Directors. That will augment the formal deterrence mechanisms that the legal system provides. This is especially because, Satyam showed that investors factor in corporate governanxce standards in the secondary market. We saw the sensex reacting negatively and FIIs pulled ouit their money. The peer review mechanism will act as an ex ante hedge against the Company appointing Independent Directors with suspect affliation.

The Vexed Issue Of Independent Directors

The recent Corporate Governance fiasco at Satyam raises some interesting issues about the Economics behind the law and policy of corporate governance in India. It shows how these issues from behavoural economics remain unaddressed or imcompletely unaddressed under the compliance driven mandate of clause49.

In this piece I argue that the rule based nature of clause 49 makes the framework underinclusive to address the issues similar to those that arose in Satyam.

An analysis of the underlying theme of clause 49 makes it clear that the term "Independent Director" is defined in the context of her proximity to the promoter/promoter group/BOD. That proximity is seen in two contexts: a) familial association b)Association arising from sustained and repetitive interaction.

This theme is a hedge against moral hazard issues. So far so good. The problem however is that, clause 49 does not address the issue of moral hazard entirely.

It fails to address the issue of moral hazard that arises from being repeat players in the same business segment. Let me try and explain this argument:

If an Independent Director has to be professionally competent (and reason demands that he ought to be competent in the vertical that the firm operates in), then the market for Indepedent Directors includes professionals, and academics well known in that vertical. Now, entrepreneurs, precisely because of their lengthy association with the particular business vertical are more than likely to know these actors. Now the extent of affiliation would differ; in some cases, the affliation will not be more than casual; in others, It could go deeper ( For example, It is likely that the academic was earlier a Ph.D. guide of the entrpreneur or a college senior perhaps). Without going in to the specifics then, it is fairly reasonable to imagine that fact matrices may exist where individuals otherwise qualified within the meaning of clause 49 are "Non Independent" by virtue of moral hazard that arises from being repeat players inthe same business segment and also the sorts that arises from associations that are not familial or professional and yet have decided trappings of affinity.

The other side to this argument is that outside of Directors related to the promoter/promoter group, this is the only set of people that have the skill sets to become directors on the Board of companies operative on that vertical. (Say, for example, Vinod Dham on Satyam).

So, if clause 49 were to include this residuary class as well, acute demand supply mis matches msy arise in the market for independent directors. This again may have its own set of problems; It is reasonable to imagine for example that sitting fees might see an upward revision across the spectrum bringing with it assorted problems of agency costs and issues in Directorial remuneration.

Clearly, the quest to have an optimum SOX in India is far from over!

I Got There First!

Thenewgegrotius on October 13, 2008 had advocated that the ECB Norms be eased; well, the revised and liberalised ECB policy is out and there is secular raising of the "All in cost" ceiling. For borrowing from 3-5 years, the raise is by 100 Bps; For the mezzanine slab that is from 5-7, the raise is 150 Bps and the longer maturity slab too has been upped by 50 Bps to 500 Bps.
Now you know why it should help to read me more often. Cheers!

The Curious Case Of "Going Forward"

You hear this phrase when you tune in to CNBC often, Dont you? "Going Forward Mr..... Where Do you see the Market Bottoming Out?" Or may be, "Going Forward, we see a lot of opportunities in ........ space";
My guesstimate is that "Going Forward" and "Upfront" could be the most used terms daily in the Business Circles. So, this post musing about these peculiarly "Finglish" term... " Going Forward"

Let me like put up a list at why " Going Forward" could be so frequently used one.

(you sure know that there is no lack of these "Heuristics" for a finance guy. Take your pick from " Corporate action", "Deal" etc etc.)

1. Think "Going Forward" gives the person a sense of security amidst volatility; When you are uncertain about the time, When the interviewer asks you to take a directional call and you have no clue, you invariably say, "Going Forward...." So, in Structured finance parlance, its like "hedging" yourself against uncertainty ( Much like you buying Options, a volatility product)!

2. It has a lot of strategic sense; generally, you will find this term in MDA section; where the management is tryin to comply and yet not comply :) ( you know, that can be done, So, this is not an Epigram)! So, you want to fool your owners and yet not be held laible in Derivative suit litigations, you use "Going Forward".

3. It is suitably democratic! in the sense that, even if you are a journalist who has little or no exposure to finance earlier but still want to sound as one of the gang, you blurt, "Going Forward. to my mind......." basically, going forward ensures that you have safe haven to park your ignorance in and yet sound meaningful as a prophet.

Gtg Now guys! Bye 4 now... BTW, Going forward, it does look like a lotta posts are coming your way from thenewagegrotius....

By The Way....

Dani Rodrik makes this interesting point in his October 12 post and places the cause of recent Credit squeeze at the doors of the United States treasury not bailing out Lehman Brothers Holdings. Rodrik contends that the treasury should have bailed out Lehman as immediately after that decision Short term paper spreads rose beyond reason and credit markets seized up. Rodrik cautions there is another "Perfect Storm" coming our way. the whole piece can be read here.
http://rodrik.typepad.com

ECB Norms Should Be Eased

hmmm.. thenewgrotius believes another 50 basis point rate cut is in order so far as the CRR is concerned...Anywayz, given that we are still on course for a 7% growth this fiscal, and given that there are little concerns for the real sector as such, think its high time that the RBI and the Finmin take tweaking the ECB " All in cost" seriously. At present, the " All in cost" ceilings are pegged at too low a level to make the ECB window meaningful for Corporates;
The ECB all in cost for a borrowing with a Average maturity of 3-5 years is pegged at 200 basis points above the six month LIBOR. And the same for the Average maturity bracket of 5 year onwards is pegged at 350 basis points above the Six month LIBOR. As we know the ECB end-use includes acquisitions overseas. With recession looming in US, Inorganic growth options have opened up for EM Corporates. But Given the global liquidity crunch, Borrowings have become dearer with the result that it is difficult to peg the "All in Cost" (which besides the Coupon payable, includes all that is foreign exchange expenditure including fees to keep the Credit lines open and other fees payable in foreign exchange).
What that means is opportunities of inorganic growth westwards are denied in times when valuations are dirt cheap! It is time to increase the "All in cost" to make it in sync with the global realities and facilitate domestic expansion and overseas acquisitions...

In The Mean While....

A full 100 basis point cut! Surely if this does not expand demand, nothing will! Anyway, For all those who have exposure to ICICI stock, my commiserations! But am told the stock has not seen bottom yet. Must say the RBI measure of cutting CRR might shore it up; For now, Chanda Kochhar's assurance yesterday seems to be of no avail.

Should The RBI Cut Rates?

The TOI today carries an interesting poll question; Should India follow the US and the EU and cut rates. I am not too sure the ayes and the nays generated from such polls carry any weight, but the question is nonetheless thought provoking. Should we follow suit? Here are a few reasons why we should NOT FOLLOW SUIT;
1. For starters, the real sector in India is not facing recessionary expectations as the real sector in the US is; the US is hardly keeping up to its 2 % GDP growth whereas we are relatively beter off even with the revised conservative estimates of say around 7%. Rate cuts make sense in a recessionary universe to try and up the growth; Our real sector (with the exception of Realty, where prices were due for correction anyway) are doing well.
2. We should be vary of inflationary pressures; yes, even with crude showing a downward bias in recent times, we are not out of the inflationary rut. Inflation demands monetary tightening to the extent possible , because injecting liquidity in the market means more money chases limited supply of goods, we are better off without the rate cut for now. the CRR cut of 50 basis points ( that will be effective from the week starting October 11th), is good for now. Indirectly, it creates liquidity and therefore incentives demand and that has positive implications for growth. Think this should be enough for now.
3. We should be conservative so far as financials are concerned for now; rate cuts might make the Share holders of the ( battered) Banking Cos. happy and a HDFC or an ICICI scrip may look up, but that might lull the banks in to lending aggressively ( in order to cover up the earlier losses), that way the Economy risks accumalation of bad debts in the longer run. We are nowhere nearer to having a good bankruptcy law in plac; So it is better to play safe than sorry.
4. The Fed Res policy of cutting rates has more to do with bridging the trust deficit that has manifested in recent times than with sound fundamentals; the catch is, if they dont do anything about the meltdown, Bernanke would be "Nero who fiddled while Rome burned"; So, they should be seen to do something to shore up growth. On the other hand, the Fed Res has only limited space in manipulating this policy tool ( the threat of Inflation rules out cuts in the 0- sub zero range). Its more to invoke a " At least they tried" response from the tax payer, who is ultimately goin to bear the burden. We are better off without following this inarticulated measure; (the truth is, the Fed Res should sit back and let the loss lie where it should. The FDIC and not the Fed Res should be more of a player these days in the US).
Let us see what the new Governor does; He is not seen to be as conservative as Mr. Reddy was; Am punting on a status quo though
Ciao for now!

The Sub Prime Primer

http://www.scribd.com/doc/2190705/CDO-Powerpoint-SubPrime-Primer
Visit the link aforementioned. Its an amazingly lucid take on the Sub Prime saga.

OF CDS & CDO

Hmmm... Its been a long long time since I posted the last one; which was around the time Bear Stearns had fallen; Now Wall Street has seen another biggie fall and Another taken over yet another nationalised. Reason enough for the newagegrotius to wake from his Slumber. The newagegrotius sadly notes the end of an era at Wall Street and let us hope some sanity is restored in this new ( hopefully more regulated! ) era.

As Always then the Big Bear Buffet has the last laugh. In his letter to the shareholders of Berkshire Hathaway, he had labelled financial Derivatives "Weapons Of Mass Destruction" and how true his words were! I am sure a lot of you might want to decode the info on CLOs and CDOs and CDS. But random Googling will only lead you to jargon and more jargon; Thenewagegrotius believes in Democratizing the World Of Structured Finance and so this attempt to explain the logic behind the jargon that CLO, CDO, CDS has become in plain English!
Let us take the simplest first:
CDS aka Credit Default Swap:-
This is innovation on the Standard Securitisation Structure with one diffrence in that the reference asset is not transferred from the books of the originator and the risk of the asset defaulting is transferred merely; the buyer of Protection pays a premium to the seller of the protection. ( A bit like Insurance, this solution is, with one major diffrence that is the buyer need not have any " insurable interest"in reference asset he is buying). The "Insurance" is brought on a notional principal and the premium is paid thereon. On Default ( the trigger event could be liquidation, reorganisation bankruptcy of the reference asset ( in plain English, the Borrower Co.). , the buyer sells the reference asset to the seller of Protection or the seller pays the loss to the buyer.
These Swaps are a good portfolio diversification device and also a way to work around regulatory capital requirements. This may be illustrated as follows:
Say Financial Institution has heavy exposure to Steel and wants to increase its exposure to another space, say retail loans ; it simply sells protection to the FI active in the retail loan Space and itself buys protection on its Steel heavy Portfolio. It transfers its risk on the Steel space and hence does not have to make provisioning for that space; Since it is selling protection on the retail loan space, its like synthetically creating exposure in the retail loan segment. Thus it has now to provide for the loan default on the retail loan segment. In effect therefore, the portfolio is no longer comprising merely of Steel Sector, it is inclusive of retail Space as well. Thus the FI has achieved portfolio diversification without actually lending to the retail Space. Also note that since the loans in the Steel sector are already provided for, ( the risk of default is transferred to the seller ofProtection), the provisioning for the same need not be done. this frees regulatory capital and allows the FI to create more assets. This is the way a vanilla CDS functions. more exotic versions exist; but this is the most used Credit Derivative.
CDO aka Collateralised Debt Obligations:-
A CDO issues securities to the investors and itself invests in a portfolio of assets. This portfolio is called the reference portfolio and may comprise of basket of reference assets like Loans, bonds; ( if the underlying is loan, it is termed "CLO");Sometimes the reference asset may be a CDS ( what this means is that the CDO will sell protection to the buyer for a receivable ; as we saw earlier this is the " Premium"). The receivables on the portfolio are used to redeem its own Securities and to pay coupon on them. So, a CDO is not unlike a bank that lends long , borrows Short and pockets the coupon Difference.
Generally, the Manager of CDO will slice the securities in different classes ( called " tranching"); Senior, First Class, Second Class and the last equity layer. the higher layer security holders are protected and get a correspondingly lower coupon and the later tranche holders carry a proportionately higher coupon to compensate for riskier exposure that they take. The reference asset(s) are a basket that should ideally have low Co relation ( Co relation signifies the probability that one reference asset will default given that one reference asset has defaulted; Obviously, if the reference basket has assets from same sector or related sectors, there is high probability that if one defaults, the other defaults; therefore Ideally, the reference basket should be diversified. It is clearly inferred however that the equity tranche holders will prefer high Co relation because of the higher coupon that it carries as High Co relation port folios are more volatile for obvious reasons and the senior tranche holders will prefer low Co relation).
More on CDOs will follow but for now the newagegrotius will take your leave!

Not Such A Rock Anymore!

It’s been three weeks since I posted the last one. The past weeks have seen lull in capital markets In India followed by a slight rally. The budget is a bit of red herring really; I am still punting on a non-populist budget; (there is another one next year before the Country goes to polls, I reckon the populism would be saved for then!)
Across the frontiers, the world of finance especially Banking is passing through quite a turbulent time; what with trouble brewing both sides of English Channel!
On the English side the saga seems to be nearing completion with the Chancellor taking the decision to nationalize the troubled Rock.
Such nationalization is quite rare in England that has taken pride in its Darwinian traditions and in the past has let the most prestigious symbols of British finance to die when it became clear that their death would not have any systemic effects; (remember Barings). Two issues need to be high lighted.
Firstly does Northern Rock have a claim over the assets it hived off to Granite via a securitisation deal?
While nationalization undoubtedly hurts the shareholders ( it should), if the nationalized institution does not have strong portfolio, it pinches the tax payer as well. (In the case of Northern Rock, the Government is all along maintaining that the mortgage lender has a strong asset base- A Claim that might not stand scrutiny. In fact, the bank has hived off its best assets to SPV Granite through securitisation. Which means that entity is bankruptcy remote and it cannot be affected by the bankruptcy of Northern Rock, the originator). If its a true sale, (such transactions generally are) the entire port folio is lost; although technically, the SPV has no assets to manage and is a mere conduit. Equitable doctrines might thus fetch Northern Rock its strongest portfolio.

There is an additional perspective to State intervention, the one having anti trust implications- If Northern Rock is going to run by the state, this acts as an incentive for the depositors to park the funds with it. This has anti competitive effects and tends to create a monopoly for the bank as the “ State Run” tag acts as an implicit Credit enhancement. Clearly other mortgage lenders are not amused. To my mind, it does look that the Authorities might find themselves foul of the “Promote Competition” covenant of EU law.

Clearly we are not through yet. Watch this Space!