27 January 2011

Equity and Prop Desks

Below is a brief passage from what may become the third chapter of my proposed book as represented in the table of contents I provided on December 10, 2010.

This complements materials I've provided for the two previous chapters, and we will continue our march in a measured pace.

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3. Equity and Prop Desks

The distinction between equity and debt is critical to any serious discussion of modern finance. It is also, not coincidentally, critical to the understanding of corporate liquidations or reorganizations. We will begin there, and soon enough we’ll be discussing corporate governance, government regulation, and the mysteries of federalism.

Think of a newly bankrupt corporation as a see-saw with a much heavier weight on the left and a lighter weight on the right. The right end, then, is up in the air. The left end (the equity) sits on the ground. The fulcrum is in the middle.
In terms of the right to receive a payoff, the most senior debt has first dibs. This is the airiest part of the see-saw. After those debts are paid off, payments follow in a sequence defined by contract and law. In time, the liquidators of the estate come to the fulcrum – the point at which what remains to be distributed is the good will of the ongoing enterprise.

Let’s assume that there is some such value (if not, we’d be dealing with a liquidation rather than a reorganization). On this assumption, the holders of the “fulcrum security” will be reimbursed by the transformation of their securities into the equity of the reorganized company. The classes of security that are lower than the fulcrum security, including the holders of the old equity, will get nothing.

One quick way of expressing all of this is to say that the holders of the equity of a company are the ones who bear the “residual risk.” They are the ones most certain to lose out in the event of liquidation. Thus, their interests are aligned with the interests of the corporation as a continuing, sustainable, entity.

To use a serious maritime image rather than the frivolous playground imagery above, we might say this: it is because the captain would go down with the ship, in accord with maritime tradition, that the captain is the best one to entrust with the task of steering the ship safely. Passengers with secure access to a rowboat in the event of a mishap are less suitable for the task.

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A footnote in there may refer to “Chapter 11 Reorganization Cases and the Delaware Myth” by Harvey R. Miller (2002), an article that sought to rebut the widespread impression, the “myth” that “there is something fundamentally wrong, even reckless, with the reorganization process as it is practiced” in the federal bankruptcy court in bellwether Delaware.

A further theme of the chapter as it develops will be the critical role of speculation in uncovering the real value of assets. Specifically, the equity markets (and their speculators) reveal the value of an ongoing enterprise as its market cap. The difficulties caused by regulations that obscure that process, thus hiding the true value. Prices as data. Leonard Read’s pencil.

From there to the role of shorts, a return to the Enron scandal, what Skilling called a certain short. Hedge funds and the prop desks of banks.

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