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.

Basel Three: Some Links

Basel III, as many of my readers presumably know, is the latest round of the internationalization of banking regulation. The Basel Committee on Banking Supervision consists of regulatory and central bank representatives from nearly 30 countries, who sometimes hobnob in the Swiss city of that name and work on common rules and principles. Here's a link to a pre-crisis book on the Accords from Wiley Finance.

The banking crisis of 2008 gave several of the central bankers involved the idea that there was more work for them to do.

The core of it is deciding how much "Tier 1 Capital" (which, roughly speaking, means what accountants mean by the word "equity") that a bank should have, in order to ensure that it will not require a public bail-out.

Instead of saying anything substantive about Basel III now, I'll just offer some links. Sometimes I'm lazy that way.

Felix Salmon has had a lot to say on the subject, as for example or again here.

My understanding is that the gist of a Basel III Accord has been developed, and this weekend the world's banking mandarins are sweating the fine print so they can announce a done deal.

Under Basel II, the existing system, a bank must have "capital" equal to 8% of the weighted at-risk value of its assets. Never mind for now how the risk weighting is done. The point here is that under Basel II, the capital necessary to reach that 8% figure can be both Tier I and Tier II capital, though at least 50% of that must be Tier I.

Tier II Includes things like hybrid debt-equity instruments and subordinated long-term debt. In other words, it is not obvious that Tier II capital is available to address the sorts of emergency that banks faced in 2008. Since the idea is to ensure that banks can face and overcome such emergencies without taxpayer bail-outs, the natural impulse is to re-write the rules to put more emphasis on Tier I.

Not all Tier I capital is alike, though. There is a "core" of Tier I, and more peripheral components thereof. The new accord seems likely to say that banks will have to maintain a capital ratio of 8% in Tier I, effectively rendering Tier II irelevant. Futhermore, most of that capital a (7% ratio to at-risk assets) will
have to be from the core.

What is more confusing still is that the Basel system works not only through distinct Tiers, but through distinct "Pillars". The whole issue of regulatory capital as discussed above is only "Pillar 1". Pillar 2 deals with how risks are weighted and Pillar 3 with disclosure matters. Here's one final link just for fun.

Abu Dhabi Buys Into Carlyle

The Carlyle Group has just sold 7.5% of its equity to an arm of the Abu Dhabi government.

Specifically, the buyer is the Mubadala Development Co., which paid $1.35 billion for the stake. Oddly, the two parties announced that this deal values the whole of The Carlyle Group at $20 billion.

Really? If 7.5% of an enterprise's equity is worth paying $1.35 billion, then a straightforward calculation suggests the parties implicitly value the whole enterprise at $18 billion. Is my math wrong, or is theirs?

My math is right, backed up by my trusty Texas Instruments toy. Their calculation isn't so straightforward, though. They've announced that Mubadala is getting a 10% "liquidity discount" off what would otherwise have been the fair market value for their purchase. A liquidity discount? As in "Carlyle needs the money NOW"???

Carlyle is a very prominent private equity firm -- it owns Dunkin' Donuts, Nielson, and a maker of automobile seats, Britax. This spring, around the time of the Blackstone frenzy, there was talk that Carlyle, too, would go public. But the great market volatility of the summer seems to have put the kibosh on that, so it's evidently selling itself piecemeal.

Actually, there's a lot else that might have had the effect of putting on ice Carlyle's hopes for an IPO this year. There's the continuing debate in Congress about the taxation of carried interest. That debate seems to have been stoked by Blackstone and the honchos at Carlyle simply may not wish to be similarly provocative.

So, yes, Carlyle does need the money NOW. They can't wait until markets calm down and/or the political heat goes away to have their IPO and raise their hypothetical $20 billion. And the 10% liquidity discount is a disturbing sign of how bad the credit crunch has become.