finance law presentation

An experimentA broad view of finance theory, law and securities regulation.

Louis Plowden-Wardlaw, 2nd March 2011

2nd March 2011 Finance Law Presentation "An Experiment" © Louis Plowden-Wardlaw 2011

A Short Primer in Finance for Lawyers

The Legal Perspective on Financial Instruments

● Contrast the lawyer's and the financial professional's view of financial instruments.

● For the lawyer: combinations of ownership rights (rights to underlying assets after payments of debt) and debt obligations (fixed financial claims upon a person, usually with an interest element being the “price” of money paid by the borrower to the lender)


But it all looks so complicated.

Is that all there is?● The complexities and acronyms used by

market professionals tend to obscure these basic building blocks

● Another taxonomy might be ownership or rights to future ownership, debt in the sense of borrowing and derivatives contracts (options and futures for example), which are also debt in the legal sense, but are fixed money contract claims derived from eg reference to an underlying debt or ownership interest. Rights in specie such as contracts for delivery of a cargo also exist.

● Look at the contract, title or security to decompose it


How does the finance professional see the same bundles of rights, obligations and assets?

The lens through which the same legal entitlements and obligations are viewed is different

● Cashflow is what matters.

● Ownership rights and debt claims lead to present or future cash payments


How much is a future cash payment worth?

Any financial instrument is worth the discounted value of the future payment which it will give rise to.

● How much less than a present payment is a future payment worth?

● Riskiness in calculating a discount rate

● Alternative investment opportunities


What is the arithmetic of the discount rate?

£1 today is worth £1● (where r is the

discount rate)● £1 this day next year

is worth 1/(1+r)● £1 the year after next

is worth 1/(1+r)²● And so on: PV of an amount is

amount/(1+discount rate) to the power of the period of payment

● So, at a 10% discount rate, £1 next year = 0.909091p now.

● £1 the year after next is worth 0.826446p

● Driven by alternative investment opportunities


More risk = higher discount rate

A riskier proposition needs a higher discount rate. Say 40%

● So, at a 40% discount rate, £1 next year =

0.714286p now.● £1 the year after next

is worth 0.510204p


A riskier proposition needs a higher discount rate.

● So, how do we choose a discount rate for a future cashflow?

● Start off with a riskless proposition● This means government debt denominated in

the currency of that government, where the government concerned is able to issue that currency (normal fiat money – not the euro)

● This provides the risk free interest rate.● For everything else, add a premium (ie use a

higher discount rate.)


How do we determine the risk premium?

A bit of a science ● Use comparables (who else has got money on what terms, and how risky are they compared to the investment proposition in question)


How do we determine the risk premium? (2)

A bit of an art● CAPM assumes,

amongst other things, that markets are completely efficient, that there are no transaction costs, that there si frictionless borrowing, and that returns are normally distributed.

● These assumptions are not necessarily true.


But at least we know that equities should yield more than debt

On bankruptcy, creditors get paid first owners last from the underlying assets

● This is the “equity risk premium”

● Various studies demonstrate different sizes for the equity risk premium. In liquid markets, it is surprisingly small (2-6%).


Choices of discount rate make enormous differences to valuationsThe scope for differences of opinion as to discount rate renders the process of valuing assets or securities inherently uncertain.Interest rate changes renders even technically “risk-free” government bonds risky in real terms – interest rates up, bond prices go down.

● While the ability to formulaically calculate present values of future cashflows allows the building of complex financial models, lending a satisfying air of precision to financial decision making, the world is inherently complex.


More on sovereign debt

If sovereign debt in the sovereign's own currency is risk free, why should sovereigns pay interest?

● Investors have alternative investment opportunities.

● Sovereigns need to borrow money – public spending – fiscal shortfalls, external imports – etc.

● Inflation is inevitable – or is it?


More on sovereign debt (2)

Long term interest rates are usually higher than short term ones.

● Different maturities of government debt allow for the construction of an interest rate curve.

● Banks and brokers reprice their portfolios and lending rates according to government rates


Propagation of interest rates

Different central banks have different mechanics (auction of bonds, repo operations) for propagating interest rates through the economy

● But essentially, the central bank lends money to banks against the security of their assets and therefore provides liquidity to the monetary system, and banks buy and sell government debt to manage their liqudity


Fundamental v relative pricing

Pricing applicable to financial securities methodologies can broadly be divided into fundamental and relative pricing

● Fundamental pricing optimal – assuming one has a way of correctly judging the discount rate.

● Markets price securities relative to riskless sovereign debt


Markets best at relative pricing

Markets are said to be good at relative pricing

● Mathematics of relative pricing can be complex. Derivations informed by assumptions about fundamentals that are often wrong

● Reference to facts underlying cashflows and their stability not always so strong


Factors driving real cashflows

A lot of real world issues drive cashflows

● Demographics● Consumption patterns● Saving patterns● Market performance

of businesses● Supply and demand

of different asset classes


States of the world change

Sentiment leads to changes in market actor behaviour

● Consumption v saving

● Credit availability● Trade barriers● Pure politics – wars

and so on.● Too complicated to

model


Dramatic corrections

Financial returns not normally distributed; breakdown of many statistically based mathematical pricing models

● Excessive occurrence of outlier events

● Kuznets cycles – infrastructure 14-20 year cycles associated with high credit/employment


So real valuations combine

Maths and judgment● Logical deduction

based on maths, price and interest rate data, efficient markets theory

● Critiquing the maths by concluding when the market is misreading fundamental cashflows


Critique

Judgment means understanding when

● market agents are forced sellers

● buyers are subject to liquidity constraints

● Organisational constraints compel behaviour

● Bargaining power dynamics take effect


Efficient markets theory

Efficient markets theory critique

● Assumes inter alia that all publicly available information is factored into the price of a security

● In practice, many think propagation of competing ideas amongst market participants takes time

● Markets have many actors, and so early adopters of ideas with access to capital can make money


Why investors invest

Why not just buy the index?

● If market participants did not believe they had superior insights they would not invest in individual securities – they would just buy indices

● However unfortunately there is no universal index comprising all asset classes in all currencies – so no investor can rely on MEH to abrogate responsibility completely

● Choices must be made.● Defined currency liabilities to

satisfy, masters to report to


Options

A debt contract ● A contract for the right but not the obligation to buy or sell something in the future (an asset or a security, itself a debt or equity interest)

● Contract itself has a value


How to price an option● Traditionally difficult ● Attempts to use

probabilistic cashflows discounted to present

● Black Scholes equation● Binomial tree - integral

problem● Inputs – asset price;

volatility over time; time to expiry; price of exercise; interest rate


All financial instruments combinations

● Only 3 things ● Debt● Ownership● Options

however long the acronym, or complex the structure, it will decompose into these elements


Ownership harder to value than debt

Debt is defined in money terms – only worry about interest rate and creditworthiness

● Ownership is a complex bundle of rights which will ultimately result in cashflows if things go well

● For equities, value now plus present value of growth opportunities – infinite scope for optimism


A time capsule from late 2007“Why Efficient Market Theory Derived Prices and Fundamental Prices May Differ

In the broadest terms, efficient market theory demands of its proponents something of an act of faith in the infallibility of markets as to pricing. Since efficient markets theory assumes they incorporate all the available price sensitive information relating to that asset (for if they did not someone with that information would immediately, if the price was too high, borrow the asset from someone with it for cash collateral, sell it, wait for the price to drop, rebuy it at the lower price, return it to the lender and so take the profit; and if the price was too low, borrow cash to buy the asset, wait for the price to rise, sell it, repay the loan and so take the profit) the question is not whether prices are right, but on what set of assumptions are they right?

Sometimes it is hard to discern the link between market prices and fundamental prices. For example, many are of the opinion that much of the world is in the middle of a property boom, where the present value of the rental incomes that are expected from many properties is much less than the present value of the interest that one would expect to pay if one bought the relevant property on credit. This implies that the normal relationship between rent and interest has broken down since normally one would earn a profit for borrowing cash to buy a rental property or one would not do it. Instead one would keep the money in the bank and lend the money risklessly for a higher return, or look for another asset that does not require painting and repairs and other payments, like a stockmarket index or a government bond. In looking for an explanation of this, arguments are made about supply and demand and demographics to justify the world of perpetually rising prices that is required to balance the equation. This may be true, but many think it may be more that the drivers of such prices are (a) that people have to live somewhere, a (b) there is imperfect substitution between a rented and an owned property, so (a) and (b) effectively create forced buyers, (c) banks are keen to inflate their balance sheets by offering cheap money on collateralised loans and are driven by their stockholders to increase market share and assets rather than conduct fundamental analysis of their customers, (d) there are tax incentives to buy this asset class (for example

in the US deductibility of interest from income, in the UK tax free capital gains) and (e) there is no other way for private individuals to take substantial geared bets on a generally prosperous economy, and the fact that they all take it at once leads to some self-fulfillment, unless and until the perpetually rising prices part of the equation becomes hard to believe in due to a period of price stagnation or interest rate rises or a raising of lending criteria reverse the whole process.

Such apparently aberrational pricing offers an opportunity to the person who wishes to put their or their institution’s money behind their view. Many financial instruments are designed to allow people to take a view cheaply; for example the person with the view that the property market is overheated might look for a supplier of a property company which they could short sell, or buy put options for property stocks. In either case, they would buy the instrument at the current market price on the hope that it would change as more people came to share their view and underlying asset prices adjusted to reflect that view.

Stock prices and trends in interest rate movements can develop similar mechanics in the institutional market.“


What's changed?

Limited reversion to fundamentals● Why limited?

– Extreme uncertainties– Inputs eg price of oil– Outputs eg savings and consumption rates

● But most importantlyWe saw earlier that the bankruptcy waterfall was the key determinant of pricing as between debt and equity; bank rescues (and motor car companies and who knows what else) subverted bankruptcy law


Pricing now has a much larger political element

● Banks comprise a unique part of the economy

They:● Disintermediate risky

investment decisions between capital owners and users

● Deal in non tradeable loan assets

● Engage in maturity transformation

● Create money


Bank rescues● An ongoing task● Why couldn't they be

left to fail?

Ongoing taxpayer guarantee – how should it be priced and paid for

● Equity shored up● Replacement of interbank

lending● Tardy and confused

regulatory response● See HM Treasury paper Feb

2011 “A new approach to financial regulation: building a stronger system”


Whatever happened to mutuals?

Wave of demutualisation in 90's

● What did savers and borrowers gain and lose?

● Approx 0.5% advantage on savings and borrowings – NPV's down to about the demutualisation benefit

● But arguably left lending and deposit ecosystem much poorer


Crisis fatigue

CDO's, investment banks, AIG, Greece, Iceland, Ireland, PIGS in general, bankers remuneration etc etc

● Calls for a regulatory response quieting but won't go away

● What should it be?


Key issues

A number of ideas which happily lived between the pages of finance textbooks are now on the front pages

● Agency issues● Assymetric

information● Moral hazard● The virtues and

hazards of securitisation

● Structured bonds of one sort or another


What is money?● Unit of account● The units in which

corporate accounts are reported and wages bargained

● A store of value● Repository of social

trust

● Fiat money v commodity money

● The bank multiplier effect

● That which is accepted for payment of taxes

● Clearing of credits and debits more important than tokens


The traditional story“What is money and where did it come from?

We all know the traditional answers to these questions. Our homogenous-globule-of-desire forefathers were inconvenienced by barter until they spontaneously hit upon the idea of using tobacco, furs, huge rocks, landmarks, and wives as media of exchange. Over time, greater efficiency was obtained as homo economicus coined precious metals, and market efficiency was enhanced by free banks, which substituted paper money backed by precious metal reserves. All would have been fine and dandy except that evil governments came along, monopolizing the mints, creating central banks that debased the currency, and interfering with the invisible hand of the market. This finally resulted in abandonment of commodity money, substitution of a fiat money, and central bank-induced inflation. If only we could return to that Peter Pan and the Lost Boys, Never-Never (Laissez-Faire) Land, free of Captain Hook and the Crocodile (Central Bank and Government), with privately supplied free bank money greasing the mighty wheels of entrepreneurial commerce!” Wray, L. R. Modern Money (1998)

Wray, a post-Keynesian advocate of government as employer of last resort goes on to look at the history of money to conclude that the barter => valuable token or commodity based standard => fiat money is erroneous.


Conflicting ideas of monetary policy● Fiscal prudence● Public spending as a

balance of tax and borrowing

● Monetarism (Friedman) v intervention (Keynes)

● NAIRU (Non-Accelerating Inflation Rate of Unemployment)

● Central banks target inflation not money quantity

● Print money to prevent people being idle and a stalled economy

● Danger of inflation and devaluation of currency

● To whom does this matter (savers v borrowers, exporters v importers)

● Demographics and pensions


The euro – risky sovereign debt

Treaty of Maastricht 7/2/92

● Euro into being 1/1/99, 1/1/02 physical predecessor currencies phased out

● A lot about how to get in, application of lex monetae (how old debts in predecessor currencies are dealt with in successor currency)

● Silent about how to get out

● Euro countries have lost monetary policy tools


Euro not an optimal currency area

Economists have a concept of the sorts of shared characteristics geographies should have to share a currencyproductivity, inflation, deficits as % of GDP

● Euro imposed rules on countries entering – largely ignored or fudged

● Consequences now being experienced

● No way out without political difficulty


Capital markets v banks

Different characteristics

● Capital markets (bonds/equities) – tradeable, liquid, low transactions cost, low information

● Banks – specialise traditionally in non-tradeable loans, where they have high relationship information

● Except recent adventures with mass securitisation (from 80's)


Pre-2008 truisms that aren't

Prior to the credit crisis, finance theory was a strong idea in terms of core ideas such as market efficiency and value of relative pricing

● It used to be the case that, on the security of property, individuals could borrow at almost capital market rates with negligible capital (5% down, LIBOR +1)

● Now 25%-30% down, relationship between base, LIBOR and consumer borrowing unpredictable


But some things are timeless

There are no free lunches


Back to the law

Finance is a creature of law

● The 19th Century innovation of Limited liability gives rise to agency issues

● Money is what the state says it is

● Taxes need money to pay them

● A financed state juggles private and public demands with laws

● Finance is not in a vacuum


Finance law

Only works as a whole package

● Companies permit minutely divided ownership

● Effectiveness of division of the enterprise cashflow requires strong minority protection and management probity, related party rules etc


Black letter law useless without institutional pillars

Matters such as minority protection and debt enforcement are technical and hard to enforce, and require commercial courts of merit

● Back to pillars of constitutional law, separation of legislature, executive and judiciary, or abuse will surely follow


Offshore

Nicholas Shaxson – Treasure Islands 2011

● Attacks the offshore industry as a harbour of emerging economy elite money derived from capital and syndicated lending and development budgets and resource drain.

● Hollowing out of tax base● Has the corporate veil

gone too far?


Cartelisation of states

Need for fiscal escape routes

● Or what will keep the state honest?

● What proportion of the world lives somewhere where the state can be trusted

● Value of private enterprise● Dangers of overreaction● Pain of trimming back the

state


Financial regulation

Systemic risk ● Who poses a systemic risk?

● Banks?● Hedge funds?● Particular contracts?● AIFM – leverage

controls


Dangers of Reversion to law by prerogative

Russia as a case in point

● Khodorkovsky and Yukos

● Browder, Magnitsky and Hermitage

● Tax and penal codes bent to pursue policy

● The dual state – prerogative and administrative law side by side


Contracts as plumbing for money● Finance lawyers write

the debt and equity relationships that make money flow

● Helpful if one understands the framework

● Only works at all within an institutional framework

● Fundamental legal principles and concepts are key to workability and stability


China v Russia● Gradualism● Human rights● Apparently

succeeding● But failure to grow

domestic demand● Banks very opaque● Not terribly open

● Big bang● Human rights● Struggling – reserves

versus required investment

● The natural resource curse

● Arch games players


International demographics and environmental pressures

Overwhelming youth in presently unstable Middle Eastern countries

Price of bread a key feature of discontent

● Harbinger of future causes of instability?


Egypt 2011


Don't cry havoc● Again, things are complicated and over

apocalyptic scenarios are unhelpful● However, there are severe managerial issues in

resource allocation and distribution compounded by confusion in what underlying outcomes are desirable.

● A steady grip on finance and law interrelationships will be required to solve these issues in ways that have acceptable human and environmental outcomes.


More experiments needed

Questions● Unfortunately cannot be

conducted in a laboratory● What regulatory structure

is best? One size fits all?● Rein in or let rip?● Inflate or not?● Policy expressed in law

and institutions

finance law presentation

Documents

finance law presentation

amount1 discount rate

future payment worth

finance professional

future ownership

future cash payment

debt claims

debt obligations