Fishing for clues in troubled waters

Government action to rescue financial institutions mollifies investors, but regulation stifles economic prosperity and raises the cost of equity compared with the price of corporate debt.

So AIG was too big to fail, while Lehmans was not – simple as that, eh? Not really. What is more likely is that an AIG Chapter 11 was more politically sensitive than watching Lehmans disappear down the plughole and therefore warranted political intervention.

To the average person on the street, the prospect of collateralised debt obligation (CDO) and credit default swap (CDS) trades potentially not settling means little. Not getting an insurance payout or annuity payment is something else altogether.

Chapter 11 or not, the effect will be the same. When loaning AIG $85 billion (£46 billion), the Federal Reserve claimed to be unwilling to see a “disorderly failure” of the group. An “orderly” failure, therefore, seems acceptable and will trigger a further wave of investment selling with equivalent pressure on other financial institution balance sheets as assets of all descriptions take further marks in value.

Writing this article has been somewhat akin to salmon fishing with bare hands. The market is fast, slippery and the target never seems to be quite where you thought it was. As we stand at the moment, the authority’s response to the crisis has resulted in a ban (of sorts) on short selling and plans to roll out the Resolution Trust Corporation once again in a replay of the savings and loan crisis. Described as the Mortgage and Financial Institutions Trust, or MFI, by John McCain, market participants in Britain will be hoping that any such structure is robust.

Investor reaction, for the moment, is one of hope and the return to some semblance of normality. Rather than drawing a line under the problem, it does feel that we have at least thrown a net over it.

Back in Britain, competition laws have been ridden roughshod to allow Lloyds TSB to consume HBOS. Whether this was the “private sector solution” that we are led to believe or whether Victor Blank and Eric Daniels (Lloyds’ chairman and chief executive respectively) were frogmarched to HBOS headquarters remains to be seen. But once again the chancellor rolled out his promise to guarantee all customer deposits at all British banks – a huge insurance commitment made all the more amazing given that he still has not received a penny of premium for writing such a policy.

And therein lies the problem. If politicians are willing to commit public funds to the private sector via such risk transferral, then there has to be a cost to the private sector. Whether in the form of higher industry levies, increases in corporation tax, higher costs of capital or greater regulation, once the dust settles and society comes to appreciate that the risks have not disappeared but have been redistributed, we should expect a combination of all the above.

The implications of this will be far reaching. The combination of lower profitability and potentially higher tax burdens will have the effect of lowering returns on capital. Combined with a higher cost of capital and less available leverage this development will hit returns on equity, particularly in the financial services industry.

While the above consequences may be merely a prediction, there are bound to be yet higher levels of regulation. Though it is not easy to be such a resolute backer of the free market system at the moment, the post war era has proved beyond doubt that capitalism is by far the most efficient method of allocating capital.

In Alan Greenspan’s biography, “Age of Turbulence”, he makes the same argument, only far more eloquently than I could ever, via use of post-war Germany as the world’s largest-ever economic experiment.

While West Germany adopted a market-based economy, East Germany established an authoritarian government with Soviet-style planned economics. Then, 28 years (and one day) later, during the dismantling of the Berlin Wall, the world was able to observe the stark impact of state intervention on economic prosperity and the quality of life of the two groups.

The level of government intervention will determine the extent of state involvement in the private sector – for our own purposes we need to tread carefully. In the long-run, economies grow only via the labour force or more productive use of labour and capital.Shows annual sterling BBB corporate bond yields in percentage terms from December 31 2006 to September 18, 2008. Source: iboxxSince state intervention is proven to act as an impediment to productivity gains, the impending slowdown in the growth of working populations in the western world will require less, not more, state involvement if we are to continue to witness rapid improvements in the quality of living standards.

What does this mean then for asset allocation? Well, while the turmoil has led to a suspension of some of the more sacred rules (client funds allowable for investment banking operations being just one), one tenet of the capitalist system has remained intact – that of seniority.

Seniority of capital essentially says that as residual claimants of a company’s assets, equity shareholders need to be wiped out before debtholders are eaten into. Witness the outcome of the American nationalisation of Fannie Mae and Freddie Mac where equity and preference shareholders were left with worthless paper while senior debtholders were made whole for proof that the concept still works, and it becomes obvious that especially during times of stress, the cost of equity – the discount rate, if you prefer – must be higher than the cost of debt.

I have only ever witnessed the principle of seniority being ignored once (during the Eurotunnel debt restructuring) and thousands of occasions where it has been observed.

It seems strange, therefore, that with perfectly sound British industrial companies paying 8.5% for debt, the equity markets are valued with a cost of equity of about 9% themselves. Either corporate debt is cheap or equity is expensive – and that really is as simple as that.