DISTORTIONS IN THE SECURITIES MARKETS
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Transcript DISTORTIONS IN THE SECURITIES MARKETS
DISTORTIONS IN THE
SECURITIES MARKETS
Wayne Klein
Lewis B. Freeman & Partners, Inc.
October 17, 2008
Five Market Distortions that
Impact Investors and the
Economy Today:
Auction-Rate Securities
Hedge/Pension Fund Trading Practices
Credit Default Swaps
Dark Pools
Synthetic Securities
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1. AUCTION-RATE SECURITIES:
Background
Auction-rate securities (ARS) are longterm bonds and preferred stock whose
interest rates are set by investors in
weekly or monthly auctions.
Issuers are primarily municipalities, closedend mutual funds, student loan companies,
and corporations.
Issuers get lower rates on long-term
money; investors earn above moneymarket rates.
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Marketing of ARS:
Originally, ARS had $250,000 minimum;
recently sold to public investors in $25,000
increments.
$330 billion in ARS outstanding in Jan. 2008.
Institutions held 80% of ARS at end of 2006,
only 30% at end of 2007.
Brokerage firms sold ARS to investors
saying they were liquid, safe, short-term, and
equivalent to cash or money-market funds.
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Design of the auction:
Auction is run by BD selected by issuer.
ARS are auctioned at par (face) value.
◦ The only variable is the interest rate.
Interest rate is determined using a form
of “Dutch” auction: the lowest bids buy
the securities.
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The “Dutch” auction:
Investors submit bids, indicating how many
ARS are wanted – at what interest rate.
The securities will be sold to the investors
submitting the lowest bids.
The highest interest rate required to sell
out the ARS is the “clearing rate.”
All investors who bid the clearing rate or
lower will get ARS at the clearing rate.
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Unwanted outcomes:
If all existing holders submit “hold” bids, it
is an “all-hold” auction. A below-market
interest rate is paid.
If there are not enough bids to buy all ARS
offered, it is a failed auction. A “penalty”
interest rate (up to 20%) must be paid.
BDs want to avoid both results. All-hold
auctions harm customers; failed auctions
harm issuers.
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Quiz – Auction example:
Looking at the 4/18/08 auction results for
Presbyterian Hospital (on the next slide):
◦
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What is the penalty rate?
What is the all hold-rate?
What is the clearing rate?
Who gets the securities offered for sale?
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Answers:
The penalty rate is 15%.
◦ This gives the hospital (the issuer) strong
incentive to make sure the auction succeeds.
The all-hold rate is 1.582%.
◦ This penalizes the investors if they all hold.
The clearing rate is 2.6%.
◦ The clearing rate was determined by the UBS
customer that bid for the entire issue at 2.6%.
The lowest 7 bidders get all 101 shares bid.
◦ The 8th bidder (here, the issuer) gets 192 shares.
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Collapse of auctions:
On Feb. 13, 2008, all major BDs stopped
financial support of auctions.
◦ 87% of auctions failed.
◦ $300 billion in ARS was frozen.
◦ 60% of auctions have continued to fail since.
Penalty rates were triggered.
Even successful auctions and fixed-rate
bonds are now paying higher rates.
Investors cannot get access to their funds.
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(Belatedly) Redeeming ARS:
Municipal bonds with high penalty rates are
redeeming ARS, using new bond money.
Some mutual fund ARS have been redeemed.
Investors could borrow from BD or sell in
secondary market (discounts of 5-50%).
States forced BDs to re-buy ARS in August.
◦ UBS, Morgan Stanley, JP Morgan, Citigroup,
Wachovia, Merrill, Goldman, Deutsch, B of A.
◦ Will repurchase $65 billion in ARS at par.
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Redemption still waits for some:
Mandated ARS repurchase is not complete:
◦ Mutual fund ARS not required to be redeemed;
◦ Holdings by institutions, wealthy not covered;
◦ Purchases through non-auction BDs still open.
Some customers have filed suit/arbitration.
Criminal charges and investigations:
◦ Credit Suisse RRs charged for lying about ARS.
◦ Inquiry: Did Lehman dump ARS on customers?
◦ Inquiry: Insider trading by UBS official who sold.
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The future look of ARS:
Small investors will cease participating.
MSRB plans a website with information on
the outcome of ARS auctions.
◦ MSRB predicts a smaller market will survive.
Mutual funds will offer “put option” bonds.
◦ Guarantors (banks) will agree to buy the ARS
from customers if the auction fails.
◦ These will be sold only to institutional buyers.
Some predict ARS market will disappear.
Rates will be higher.
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2. HEDGE/PENSION FUND
TRADING PRACTICES:
It is a new world! Consider:
Mutual funds frequently were using
derivatives to boost their returns;
42% of pension funds had planned significant
increases in hedge fund investments;
35% of 2006 M&A value was private equity:
◦ 31,825 deals involving $4 trillion in value
◦ $255 billion in going-private transactions.
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Hedge fund influence:
The 8,000 hedge funds existing in early 2008
controlled $1.9 trillion in assets.
◦ 87% of money is in large funds over $1 billion.
Big funds influence business operations:
◦ Icahn’s proxy fight with Yahoo over Microsoft
◦ Battle for board seats at CSX
Hedge funds control more traditional assets:
◦ Largest shareholders of 4 biggest airlines
◦ Control 60% of oil futures.
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What are the concerns?
Unfunded pension liabilities may be
encouraging excessive risk taking.
A higher failure rate for private buyouts.
The investment climate and surfeit of hedge
funds invites insider trading, manipulation.
Speculators, not hedgers, are primary
purchasers of commodity futures contracts.
◦ Much trading is driven by off-exchange swaps.
◦ Exchange trading = $5 trillion, OTC = $9 trillion.
◦ Commodity prices are a speculative bubble.
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Near-term regulatory changes:
CFTC, Congress investigating speculation:
◦ Is institutional trading the cause of price rises?
◦ CFTC now admits high speculator influence.
Financial crisis will result in more regulation:
◦ SEC investigating manipulation by hedge funds.
◦ Hedge fund regulation may be coming.
◦ Regulation of swaps, off-exchange transactions.
Short selling limitations.
Enron and London loopholes will be closed:
◦ Monitoring of electronic and overseas trading .
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Market-induced changes:
Collapse, consolidation of hedge funds:
◦ Less leverage available as result of credit crisis,
◦ Short-selling prohibition impacted many funds,
◦ Negative returns: some funds down 20%
Boone Pickens’ funds are down $1 billion for the year.
◦ High withdrawal rate, low inflows of new funds.
The concern is that an increase in withdrawal
requests will unleash a vicious cycle of funds selling
assets at distressed prices, to cover withdrawals, and
losses on those sales will result in more withdrawals.
Is a commodity bubble collapsing?
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Long-term changes:
Congress may limit swaps, commodity
speculation by hedge/pension funds.
◦ Higher margin rates suggested.
Hedge fund tax rates may increase.
Shine on hedge funds will disappear:
◦ Warren Buffet bet $1 million that stocks will
beat hedge funds over a 10-year period.
More regulation of the markets is certain,
due to the financial upheaval.
Will this drive some trading overseas?
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3. CREDIT DEFAULT SWAPS:
Swaps are private agreements that let
investors bet on companies’ financial health.
◦ In exchange for periodic payments, a swap issuer
agrees to pay if a company defaults on its bonds.
◦ Swaps may be written by insurers or BDs.
◦ Uses: subprime debt, bond insurers, companies.
Swap prices are skyrocketing.
◦ CDS for GM, Ford cost $9 M for $10 M bonds.
◦ Risk premiums have quadrupled since April 2007.
Investors use CDS as proxy for stocks.
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CDS impact:
Greenspan had predicted sale of CDS
would spread risk.
◦ Risk actually was magnified as the same buyers
bought most of the CDS, then defaults rose.
Swaps became a $62 trillion market, are
now driving prices in cash bond market.
◦ Market is over the counter, unregulated.
Many analysts think swap market pricing
overstates the risk of losses.
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Concerns:
CDS are used as proxy for stock purchases.
Trading contributes to massive volatility.
◦ CDS specialists may be gaming the system.
Swap holders often don’t know identity or
creditworthiness of CDS counterparties.
◦ Difficult to properly value a swap when one
does not know if counterparty will perform.
When risks rise, buyers demand collateral.
◦ This precipitates liquidity problems.
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Bear Stearns:
In early March, a run began on Bear Stearns.
Other BDs worried about Bear’s ability to
perform counterparty obligations, so they
started demanding collateral from Bear.
Mar. 14: Fed seized Bear, forced sale to JP
Morgan, guaranteeing $29 billion in credit.
Fed was motivated by counterparty risk –
that Bear’s failure would trigger others.
◦ Vigorous argument about moral hazard.
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Role of CDS in financial meltdown:
Seizure of Fannie & Freddie triggered CDS
default, $1 trillion worth of contracts.
Lehman was large CDS issuer, won’t pay.
◦ $400 Bn in Lehman CDS on $155 Bn of debt.
CDS prices for Morgan, Goldman spiked.
AIG was big issuer of CDS ($400 billion):
◦ As prices spiked, AIG put up $14 Bn collateral.
◦ This capital need hastened AIG’s failure.
New standard: “too interconnected” to fail?
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Short-term effects:
Country credit problems: Iceland CDS at 50%
Higher capital for BDs, become banks, BHCs.
Bond insurers downgraded, might fail.
◦ Issuers cannot get AAA ratings.
Banks are protecting against default risk.
◦ Some banks tie interest rates to swaps prices.
Participants must settle defaulted CDS.
◦ Confidence problem: will sellers pay debts?
◦ CDS issuers may be unable to buy bonds to settle
Zero-sum game: a winner for every loser.
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Regulatory reaction:
SEC has expanded its insider trading probe
to include CDS: focus is on hedge funds.
◦ CDS prices often swing ahead of corporate news.
NY A.G. is investigating whether short-sellers
spread negative rumors, to profit on CDS
bought at cheaper prices.
NY insurance department said certain types
of CDS would be regulated as insurance.
◦ Some sellers must become insurance companies.
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Long-term changes:
BDs are eliminating swaps that cancel each
other out – to improve clearance.
◦ In September, volume dropped by $7.4 trillion.
Clearinghouses being formed to trade CDS,
other instruments having counterparty risks.
◦ Clearinghouses would guarantee performance
More CDS terms will be standardized.
◦ Trading may move to exchanges.
CDS are almost certain to be regulated.
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4. DARK POOLS:
Dark pools are private electronic trading
platforms used to anonymously trade
stocks away from the exchanges.
◦ Operated by BDs, exchanges, ECNs.
Used by hedge funds, private equity to
trade large blocks of stock:
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◦
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Large trades don’t move markets to get filled.
Avoids broker front-running or copycatting.
Hides intentions of buyers and sellers
Faster execution, lower transaction costs.
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How they work:
One pool installs its software on traders’
systems to watch for comparable opposingside orders between firms.
◦ A match pops up for firms with relevant orders.
◦ Price is usually the midpoint of buy-ask spread.
◦ Trades are executed continuously.
Another system aggregates trades for
hourly cross-matching.
“Gray pools” let traders send indications of
interest to other pool participants.
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How prevalent are they?
Represent 12% of U.S. daily stock trades.
◦ There may be over 100 dark pools.
◦ Top five have over half the volume.
17% of NASDAQ trades are dark orders.
The volume of block orders traded on
exchanges has dropped dramatically.
NYSE reported a record 10.27 billion
shares traded Sept. 18:
◦ 1.1 billion shares routed through 3 dark pools.
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Concerns with dark pools:
There are concerns that dark pools:
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Siphon liquidity from the markets;
Distort price discovery;
Mask intentions of traders;
Increase fragmentation of markets;
Reduce efficiency of public markets;
Facilitate manipulation, self-dealing;
Increase volatility.
Exchanges are at a competitive disadvantage.
Pools overstate volumes, to appear “deeper.”
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Recent developments:
Exchanges view dark pools as threats:
◦ Exchanges offer their own dark pools, serve as
portals to route transactions to other pools.
Firms such as Morgan, Goldman, UBS are
granting access to each other’s pools.
◦ While linking improves liquidity and pricing, it
does not increase transparency.
Predators game the pools, learning order
size and intentions, then backing away.
◦ This information could facilitate manipulation.
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Future developments?
Regulators may demand more transparency.
Harder for BDs to ensure best execution.
Pools will trade options, derivatives.
Denial of access to predators/gamers.
Closure, consolidation of pools.
Further consolidation among exchanges.
Big brokerage firms will have advantages.
Continued growth will raise questions that
dark pool trading may cause systemic risk.
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5. SYNTHETIC SECURITIES:
Synthetic securities are used to profit
from price movements, and influence
conduct – without owning the securities.
Synthetic securities are most commonly
created by:
◦ Buying options (puts and calls) on the stock;
◦ Engaging in equity swaps.
CDS are ingredients in many synthetics.
Synthetic securities are used for short
selling, proxy battles, arbitrage, hedging.
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Total Return Equity Swaps (TRS):
Party A (short party) creates TRS swap with
B (long party) based on company X’s stock.
◦ These are privately negotiated OTC agreements.
A
B cash equivalent of:
◦ Dividends paid by X,
◦ Increase in market value of X stock.
B
A cash equivalent of:
◦ Interest payments based on the value of X,
◦ Decrease in market value of X stock.
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Why?
A receives:
◦ Set interest rate, instead of market returns,
◦ Protection against price decreases.
B gets:
◦ All upside benefits of owning stock, except
voting,
◦ Greater leverage because stock is not purchased.
A may buy or borrow stock to hedge risk.
Both have economic interests in the stock,
but not ownership interests.
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Concerns with equity swaps:
Decoupling of economic interest and voting
interests.
Distortion of corporate governance:
◦ Hedgers may withhold votes or ask swap buyer.
Manipulation can be done more cheaply.
◦ If no Williams Act filings, TRS holders can:
Hide their intentions
Concentrate large positions in hands of short parties.
Prevent others from bidding up stock.
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TCIF proxy battle with CSX:
Two activist hedge funds amassed large CSX
position, pushed for changes to boost price.
◦ TCIF bought TRS equal to 14% of CSX stock.
◦ Funds told CSX they controlled $800 M in stock.
TCIF began proxy contest. CSX sued, saying
TCIF failed to make Williams Act filing.
◦ TCIF said because swaps are not stock, no duty.
Court: TCIF broke law; proxy still permitted.
TCIF won four board seats in June.
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Consequences:
Williams Act applies to synthetic securities.
◦ The court called TCIF arguments formalistic, an
apparent effort to defeat purposes of the law.
◦ TCIF still got to vote shares it controlled.
Britain’s FSA increased disclosure duties:
◦ Hedge funds must disclose swap holdings;
◦ Must reveal short positions in rights offerings.
Congress may require disclosure of TRS use.
◦ SEC is being urged to act.
Company bylaws are requiring disclosure.
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Conclusions:
The U.S. securities markets continue to be
dynamic and innovative.
◦ This usually benefits investors and the economy.
Markets innovate faster than regulation.
◦ Regulators should not channel market changes.
◦ Distortions or abuses will occur.
Because Wall Street failed to prevent abuses,
Congress and regulators will intervene.
◦ When our technology outpaces our ability to
regulate, how should regulators react?
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Contact Information:
Wayne Klein
Lewis B. Freeman & Partners, Inc.
_____
3225 Aviation Avenue, Suite 501
Miami, FL 33133
(305) 443-6622
www.lbfglobal.com
_____
299 South Main, Suite 1300
Salt Lake City, UT 84111
(801) 534-4455
(801) 824-9616 (cell)
[email protected]
LBF is a forensic accounting and
litigation consulting firm that:
◦ Acts as receiver and trustee,
◦ Performs forensic accounting,
◦ Conducts due diligence, internal
investigations,
◦ Provides professional advising on
internal controls, SOX compliance,
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workouts,
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