defeasance is a technique whereby a corporation discharges old, low-rate debt
prior to maturity without repaying it. The corporation uses newly purchased
securities with a lower face value but paying a higher interest or having a
higher market value. The objective is to produce a more debt-free balance sheet
and increase earnings in the amount by which the face amount of the old debt
exceeds the cost of the new securities.
Exxon shows how
The use of defeasance in modern corporate finance began in 1982 when Exxon
bought and put into an irrevocable trust $312 million of US government
securities yielding 14% to provide for the repayment of principal and interest
on $515 million of old debt
paying 5.8% to 6.7% and maturing in 2009. Exxon removed the defeased debt from
its balance sheet and added $132 million - the after tax difference between
$515 million and $312 million - to its earnings in that quarter. In-substance
defeasance may well the magic bullet to get out from the curse of over
leverage.
Global stock markets staged a historic rally on Monday, September 13, as
European governments pledged a total of 1.87 trillion euros ($2.55 trillion) to
shore up their banking system and the US prepared to unveil its own
comprehensive rescue plan a day later. In New York, the S&P 500, which the
week before fell 18.2%, rose 11.6% - the biggest daily gain since the volatile
trading of the Great Depression. The Dax index of the Frankfurt stock exchange
closed up 11.4% while the CAC40 in Paris rose 11.2%. In London, the FTSE 100
rose 8.3%, its second largest one-day gain in history, and in Hong Kong, the
Hang Seng index rose 10.24%. Yet, the Treasury announcement on Tuesday,
September 14, failed to extend the one-day market rally that had greeted every
one of the government's precedent-breaking previous measures. All the
governmental spectaculars failed to break the secular bear market in which each
rebound fails to breach the previous low.
Three-month sterling Libor (London Interbank Offered Rate) on October 14 was
just two basis points lower, at about 6.25%, still more than two percentage
points above where markets were pricing UK interest rates and higher than where
the rate was set before the coordinated interest rate cuts by major economies
in the second week of October.
Similarly, the euro three-month Libor, which was down 7.37 basis points at
5.225% on October 14, remained high. There were only weak signs of relief in
the frozen credit markets at the centre of the financial crisis, as the
three-month dollar Libor eased to 4.75% from 4.82%, even after the Fed lowered
the Fed funds rate target to 1.5% on October 8 and three-month Treasuries were
yielding 0.5%. This left the so-called Ted spread, which measures the
difference between inter-bank lending rates and risk-free government lending
rates, at a hefty 420 basis points.
Recapitalization, while lowering leverage to protect the market value of debt,
further depresses asset value. Such are the laws of finance in market
economies. For this reason, taxpayers may never recoup their investment in the
Treasury's nationalization program of the banking system if government funds
received by banks are used to 'de-leverage' rather than new lending.
The US government's misguided approach of monetizing illiquid assets held by
distressed institutions to remove insolvency threats is self-defeating. In each
step, it has predictably failed to jump-start credit and capital markets under
seizure because excessive liquidity cannot be cured by more liquidity. Assets
become illiquid because their price stubbornly stays above their market value.
Such assets will stay illiquid until price adjustments bring about market
transactions. Government monetization of illiquid assets will only prolong
their illiquid life span.
Markets are not the best intermediaries of long-term value because, for market
economies, markets are the prime intermediaries of short-term value. This is
why economist Hyman Minsky thought that a substantial public sector is needed
to moderate short-term volatility in the private market sector. When the
private market sector dominates the economy, the price regime will be
excessively tilted by short-term conditions.
Markets can only function when there are matching numbers of willing buyers and
sellers at any one time. When the number of sellers is larger than the number
of buyers, prices will fall, or in a reverse situation, prices will rise until
the number of buyers and sellers match up. Price is the point where willing
sellers and willing buyers meet for a fair transaction. Until the price is
right, the market remains in suspension. Price fluctuation then is the key
factor in addressing imbalances between buyers and sellers in the market. This
is both the strength and the weakness of market economies.
Free markets require an equal degree of market power between buyers and
sellers. Ideally, a truly free market always leaves both buyers and sellers
happy, each being satisfied that the transaction price reflects their differing
judgment of fair market value at the point of transaction. The buyer thinks he
will gain from future appreciation and the seller thinks he will avoid loss
from future depreciation. Only one party in the transaction will turn out to be
right at any future point in time. The probability of being wrong is the risk
in the transaction. That is the basic principle of market fundamentalism, which
is governed by the principle of fluctuating supply and demand through time,
intermediated by fluctuation in price.
When market power is not equally distributed among market participants, a free
market is replaced by a coerced market. A coerced market is one when one side,
either buyers or seller, has more market power. Uneven market power distorted
prices to generate market inefficiency. A failed market is one when there are
no buyers or sellers at any price.
The ultimate coerced market is one where the government, which by definition
possesses overwhelming market power by virtue of its ability to print money by
fiat, is the only buyer or seller. Market fundamentalists are right in their
belief that government should stay away from the market to avoid destroying the
market. Yet they are wrong in thinking that government should deregulate
markets to keep it free. And above all, they are dangerously wrong in thinking
that markets can satisfy all economic needs.
Government does some things better
The truth is that there are large segments of the economy that only government
can handle effectively and efficiently, national defense being one obvious
example. This government economic segment is known in a market economy as the
public sector. As Minsky insightfully pointed out, the public sector performs a
much-needed function in stabilizing the business cycle in the private sector. A
society without an adequate public sector leans towards economic anarchy that
will eventually implode.
In finance, to make a market means maintaining ready, firm bid and offer prices
in a given security by standing ready to buy or sell at publicly quoted prices
in round lots (generally accepted units of trading on a securities exchange -
on the New York Stock exchange, a round lot is 100 shares for stock and $1,000
or $5,000 par value for bonds). The dealer is called a market maker in the
over-the-counter market outside of exchanges. On the exchanges, the dealer is
called a specialist. A dealer who makes a market over a long period is said to
"maintain" a market.
The NASDAQ requires that there be at least two market makers for each stock
listed in the system. The bid and asked quotes are compared to ensure that the
quote is a representative spread. Registered competitive traders in the New
York Stock Exchane (NYSE) are market makers because, in addition to trading for
their own accounts, they are expected to help correct an imbalance of orders.
Registered competitive traders are NYSE members who buy and sell for their own
accounts. Because their members pay no commission, they are able to profit from
even small changes in market prices, thus tend to trade actively with high
volume.
Like specialists, registered competitive traders must abide by exchange rules,
including a requirement that 75% of their trade be stabilizing, meaning they
cannot sell unless the last trading price on a stock is up, or buy unless the
last trading price was down. Orders from the trading public take precedence
over those of registered competitive traders, which normally account for less
than 1% of total volume.
The central bank cannot be a market maker because the central bank is empowered
to create new money. This power to create new money gives the central bank
unequalled market power and turns it from a market maker into a market
destroyer. Throughout history, the sovereign who enjoys the power of
seigniorage refrains from being a market participant for good reasons. When the
sovereign owns everything, there is no way to tell how much the sovereign is
worth. This is why even in a communist society where the people as sovereign
own the means of production, markets are still required to establish prices to
efficiently allocate economic and financial resources.
The government's intervention has created a relative advantage for companies to
raising funds through guaranteed bank paper versus the asset-backed markets.
The ability of banks and other financial groups to raise money via government
guarantees means funding through more traditional routes such as asset-backed
securities will be much more expensive. In the short-term, the government moves
are having an effect. There has not been any issuance in credit cards because
all the major banks now have another, cheaper option. In addition to offering
banks cheaper sources of funding, the explicit government guarantees on many
bank securities have led to a sell-off in bonds issued by mortgage financiers
like Fannie Mae and Freddie Mac, as well as asset-backed securities. As a
result, the cost of borrowing in asset-backed markets has soared, with the
premiums over US government bonds at record highs. This makes private sector
funding even less attractive.
There are also signs that government funds are being used by banks to buy
rivals rather than provide new lending. On Friday, October 14, PNC Financial
became the first bank to make use of the US government's bank recapitalization
program to merge with a weaker rival. In the longer term, credit-card debt
securitization has to be revived because the government programs are not large
enough to cover all the banks' funding needs.
Central banks as market destroyers
The recent opening of the Federal Reserve discount window to borrowings by
commercial banks, collateralized by illiquid assets, and the extension of
discount window access to investment banks have pushed the central bank across
the line of being a lender of last resort to being a market destroyer. It is no
wonder that its liquidity injection moves have failed to moderate seizure of
global credit markets.
This is because the central bank, not constrained by the supply and market
value of money, can set the price of illiquid assets by fiat and thus destroy
the very function of the market in setting meaningful prices that can defuse
market seizure. Central bank
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
