Month: March 2009

There has been some discussion on this blog site about the value of the secret deal provided by Anglo Irish management to a circle of ten wealthy Anglo clients.  The deal was done last summer, in order to prop up the Anglo Irish share price.  Each of the clients was lent Euro 45,100,000 by Anglo Irish with the requirement that all the loaned funds be spent on Anglo shares. Clients were only responsible for repaying one-quarter of the loaned amount (Euro 11,275,000) in cash; they were permitted to repay the remainder of the loan by returning the shares.

At the time of the deal, the Anglo share price was approximately Euro 6.01 per share.  The share price has since collapsed to zero.  Each of the wealthy clients in the secret circle has lost Euro 11,275,000 (unless they now avoid repaying through bankruptcy or restructuring).  Meanwhile, the “shareholders” of Anglo have lost the remainder of the loaned cash (Euro 33,825,000 for each of the ten circle members).  Everyone has lost on this deal ex post.  It is particularly vexing since the Irish taxpayer now serves as the Anglo Irish “shareholder” and suffers a loss of Euro 338,250,00 on this secret deal. 

It is worthwhile to analyse, under reasonable assumptions, the ex ante value of the deal, both to the clients and to the Anglo management acting on behalf of shareholders (as if).  An accurate valuation is not possible with the information available to me, but a reasonable approximation can be made, and also a reasonable analytical framework provided for anyone who wishes to substitute other parameter values.

Last July Anglo had total shares outstanding of 749,585,405 and a share price in the range 4 – 7 Euros (quite volatile during the month), see the data here.  If we use a share price of Euro 6.01 then this gives a total cost of Euro 451,000,000 to purchase 10% of shares outstanding, which corresponds to the stated amount in later government reports.  Hence I assume that this is the share price at the time of the deal.  The one-year LIBOR interest rate last July was 3.2796% so I use a slighly higher interest rate of 3.75% as the two-year borrowing/lending rate.

Suppose that the clients have no insider information telling them that Anglo Irish shares are over-valued.  Also suppose that they are not liquidity-constrained.  In this simple case, the loan-plus-share-purchase is window-dressing designed to hide the real value of the deal. The client takes a loan of Euro 45,100,000 from the bank, and puts the proceeds in an interest-bearing account which exactly pays off the loan.  The client also purchases Euro 45,100,00 worth of Anglo Irish shares with true value of Euro 45,100,000.  Neither of these transactions adds or subtracts any value for the client.  The real value of the deal comes in the free put option which Anglo management has provided to the client.  If the client’s Anglo shares fall in value, the client can pay Anglo only ¼ of initial loan value, plus hand over the shares, in full restitution of the loan.  This put option constitutes the only source of value in the deal (admittedly under these strict assumptions).

The put option can be valued reasonably well using the Black-Scholes option pricing model; see here for details.  These estimates of value are conservative since empirically the Black-Scholes model tends to undervalue out-of-the-money put options.  I assume that the loan is for a two-year period and that the Anglo Irish shares have annualised volatility of 60% per annum.   The put option has an exercise price of (1-.25)(Euro 6.01) = Euro 4.512.  Using normdist and exp in excel it is easy to compute that the value of the put option for each client was Euro 6,757,469.  The put option is given to the client for free, in exchange for acting as a go-between to allow Anglo Irish management to secretly use bank-deposited funds to purchase their own shares.

The client is earning excess return of Euro 6757469 on risk capital of Euro 11,275,000 which is 59.93% or 29.97% abnormal return per year.   So even allowing for some liquidity-constraints or client nervousness about Anglo Irish share values, it seems a good deal.  Admittedly, it turned out disastrously for the clients, but this was due to a worldwide bank share meltdown plus the emerging scandals (notably this one) at Anglo Irish.

Perhaps Anglo Irish management raised the borrowing rate on the loans to account for the free put option.  This seems unlikely.  Again using the case of 2 years and 60% volatility, in order to recoup an option value of Euro 6757469.675 on a loan with principle value of Euro 45,100,000 they would need to add roughly (1/2)( 6757469.675/45,100,000) = 7.49% to their  base interest rate.  So if the base rate is 3.75% they would need to use a loan rate of 11.24%.

Bob Dylan has a song “The Lonesome Death of Hattie Carrol” about a shameful incident in the early twentieth century when a wealthy, well-connected young man bludgeoned to death a poor, African-American female servant, and escaped with virtually no punishment.  In his lyrics, Dylan makes the point that the truly horrifying aspect of this event was not the murder (there will always be violent individuals) but the reaction of the judicial establishment in ignoring it.  Analogously, in the Anglo Irish scandal, it is not the presence of greedy, underhanded individuals in Irish financial services (such people exist around the world in all countries and all industries) but the horrifying approach of the Financial Regulator, condoning and even encouraging such behaviour.  To quote from Dylan’s song:

In the courtroom of honor, the judge pounded his gavel

To show that all’s equal and that the courts are on the level

And that the strings in the books ain’t pulled and persuaded

And that even the nobles get properly handled

Once the cops have chased after and caught ‘em

And that the ladder of justice has no top and no bottom,

Stared at the person who killed for no reason

Who just happened to be feelin’ that way without warnin’

And he spoke through his cloak, most deep and distinguished

And handed out strongly, for penalty and repentance

William Zanzinger, with a six-month sentence.

Oh, but you who philosophize disgrace and criticize all fears,

Bury the rag deep in your face

For now’s the time for your tears.

 

Fitch said….
“Fitch Ratings has today placed the Republic of Ireland’s ‘AAA’ Long-term foreign currency Issuer Default Rating (IDR) on Rating Watch Negative.
The rating action reflects recent disappointing news on government revenue performance which points to very sharp declines in tax receipts across the board in January and February. This will intensify the policy challenges facing the government as it seeks to tighten fiscal policy further than anticipated in the midst of a steep recession and raises the risk of fiscal slippage.
In the first two months of this year revenues were again below the already low expectations built into the government’s January forecasts. In response to these forecasts Government took action designed to produce savings this year of EUR2bn and thereby reduce the government’s deficit to 9.5% of GDP. The latest information suggests, in the absence of any further Government action, the 2009 deficit could be increased by another EUR4bn, equivalent to over 2% of GDP, implying a revised deficit of 11.5% – 12%. The Prime Minister has said that new tougher measures on both taxation and public expenditure to rectify the further slippage in the fiscal position will be announced and a supplementary Budget is scheduled for the first week of April.
Fitch will re-assess the medium term prospects for Ireland’s public finances in light of the deterioration in revenue prospects, forthcoming policy announcements and worsening economic conditions, which could raise the potential call on government funds to support the Irish banks. A Rating Watch Negative is typically resolved within three to six months.”

As a reminder, there are 2 stages in the process of changing ratings with S&P and Fitch (Moody’s is a bit different).
“Rating Watch Negative”
This means action imminent in days (max 4 weeks), and is typically almost certain.
“Negative Outlook”
This means action possible within months (sometime years for sovereigns).
(Ireland is still AAA/Aaa neg outlook with S&P, Moody’s)
The worst damage to spreads is done with the Outlooks… but if the day wants it, any statement is as good an excuse as any to sell risk…
Irish – Bund 2013 and 2018 back to near their highs in terms of yield spread, at 262bp and 284bp respectively.

Athough I don’t detect that much interest in the expansionary fiscal contraction hypothesis, I think it is important we don’t try to reinvent the wheel.   The determinants of successful fiscal consolidations was the subject of a large research effort in the 1990s.   The following passages from a paper by Alesina, Perotti, and Tavares give a flavour of the findings:

“Empirical work on the effects and sustainability of fiscal adjustments has consistently reached two conclusions.  First, long-lasting adjustments rely mostly (or exclusively) on spending cuts, in particular, in government wages and social security and welfare; by constrast, short-lived adjustments rely mostly on revenue increases.  Second, fiscal adjustments are not always associated with reduced growth, or with a deterioration in the macroeconomic environment in general.” (p. 200)

“Fiscal adjustments that rely on cuts in government transfers and wages and are implemented in periods of fiscal stress are long lasting and not contractionary.  On the demand side, the expansionary aspect of such fiscal adjustments works through an expectation effect, which is stronger the worse are initial fiscal conditions.  On the supply side, the interaction of certain types of adjustment — those without tax increases but with cuts in government employment and wages — lead to wage moderation, reduced unit labor costs, and increases in profitability, business investment, and production.” (p. 214)

The Minister for Finance might be interested in this:

“Furthermore, governments do not seem to be systematically punished at the ballot box for engaging in fiscal adjustments, nor do they lose popularity, as measured by opinion polls.  In principle, one can think of two explanations for this result.  One is that voters do not like fiscal profligacy.  The other is that governments are particularly skillful at choosing the appropriate moments to implement unpopular policies   While it is difficult to decide definitively, we conclude in favor of the first interpretation.” (p. 241)

Alesina, Alberto, Roberto Perotti, and Jose Tavares. (1998). “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity, 1998.1, pp. 197-266.