Tuesday, October 23, 2007

Superfund, SIVs, and Firesales

Having been declared bankrupt, despite sitting on a cash balance of $1.3bn (a "technical" insolvency one lawyer told me), the Cheyne Finance structured investment vehicle (SIV) has found a saviour in the Royal Bank of Scotland.

According to the FT if RBS can refinance the SIV, it will be rescued. Furthermore, the FT opines

"A successful deal would mark the first time an entire SIV portfolio has been sold and is likely to provide hope for the other vehicles controlling more than $40bn in assets that have had their debt downgraded by ratings agencies. It would also demonstrate another possible method of avoiding a firesale of assets from the SIV sector, after the mooted plans for a super-SIV being promoted by Citigroup, JPMorgan and Bank of America."

All of this looks good and augurs well for the financial services industry. I noted in my previous posting that SIVs were not going to be well helped by the new Superfund. But if others can pitch in so much the better.

But perhaps the glasses are tinted too rosily. This deal has a sting:

"No price range has been disclosed for the deal but it is highly likely that the value of the junior creditors’ notes and some part of the mezzanine, or middle-ranking, creditors’ notes will be wiped out, according to those involved."

In other words the high risk elements are not being saved. The junk will be just that. It begins to sound more like a firesale to me than otherwise. Pick out the good bits and dump the rest. Maybe some distressed debt traders will buy, but no one seems to be really developing a market.

Given the unpredictability of the rescue culture that's growing up, if the SIVs start to unwind, we have no way of knowing how far the mess will spread. We know it doesn't take much to initiate panic in the markets. A fairly obscure sector of the mortgage market (subprime) wobbling has demonstrated that most lucidly. It looks possible something similar could recur if rescuers don't think beyond high class assets. Of course not all junk is worth saving but not all of it is worthless. If efforts are made to develop a secondary market in distressed debt, it might save considerable pain that will reverberate around some economies for years to come.

We have lost the commonality of cause that was apparent in the London Approach. The number of players in the market has multiplied enormously and any effort at coordination will run into tremendous difficulties. And it seems in the UK at least that the regulatory institutions have shied away from proactive behaviour under the guise of creating moral hazard.

But this is how rescue cultures have evolved and emerged: crisis begets solutions. It occurred with the collapse of Barings in the 19th century; it occurred with the collapse of the secondary banking market in the 1970s; and it occurred with the collapses of the property markets and technology markets in the late 20th and early 21st centuries.

For some reason the impetus doesn't appear as strong this time. While this is not a plea for more formal regulation--it won't work--more informal creativity is called for.


Thursday, October 18, 2007

Superfunds, Reinsurance and the Big Unwind

My colleague, Joe Tanega, compared the new Superfund put together by Citigroup, JPMorgan and Bank of America as a reincarnation of the Lloyds reinsurance brouhaha some years ago that resulted in the formation of Equitas.

The job of Equitas is (it's just had its 10th anniversary) to reinsure the syndicates that were caught short and achieve a solven run-off. The independence of Equitas allows Lloyds to continue without these accumulated liabilities. The key to the success of Equitas was that it took over all liability.

The Superfund is clearly not buying all the distressed debt in the credit-squeezed market. It wants only the "good" assets to help avoid firesales in the market. According to Gillian Tett in the FT, "They have estimated that the scheme will need $75bn to $100bn of back-up liquidity lines, and will only buy high-quality assets."

While a super-conduit may help reinvigorate the market and restore some liquidity, it omits from the equation the low-grade assets slopping around in structured investment vehicles. It's these that have the capacity to wreak havoc if not dealt with.

SIVs are meant to be separate from their so-called parent institutions, ie. orphan entities off the balance sheet, but because of the credit squeeze, these supposed barriers are being breached as money is pumped in.

They are already causing trouble. Cheyne Finance (an offshoot of a hedge fund) is the first SIV to stop paying its short term debt. Even though it has $1.3bn of cash its administrator has managed to persuade the court that it is breach of insolvency tests. According to the administrator this will avoid a firesale. Would a Superfund buy its assets? Supposedly four banks are bidding for them.

There will at some point need to be a stronger concerted effort by the major financial institutions to deal with this problem. There will be more SIVs and SIV-lites heading towards insolvency. The Equitas solution might not provide the answer here, so what will, if anything?

Wednesday, October 17, 2007

Discriminating Lawyers

Usually lawyers are the ones fighting battles over discrimination rather than being the subject of them. But two recent age discrimination cases make an interesting comparison--one in the US and the other in the UK, and both in large law firms.

Peter Bloxham, a former partner of Freshfields, was caught in the law firm's restructuring trap. The firm has been going through major changes to increase its profitability over the last few years. One was to reduce the number of partners by 100. The other entailed revising the firm's pension plan.

The partner reductions have occurred. This was the infamous "Size & Shape" programme.

The pension changes have been made too. Essentially, Freshfields paid pensions out of current earnings, with a cap. As the firm has grown this has become unsustainable, the firm has claimed. Imposing an arbitrary cutoff point of 55 years, those below would take a big hit (20%) on their future pensions. At 54 years old, Bloxham objected.

Testing out the new age discrimination law, Bloxham claimed he was, in effect, "constructively retired" from the firm. He sued, and others are in the queue.

The Industrial Tribunal decided he would lose this claim saying that the firm's actions were proportionate in achieving its proposed pension reform. It seemed to suggest as partner he had freedom to choose. Bloxham had said he wasn't treated fairly as other partners were offered better terms.

In Chicago Sidley Austin agreed to settle its discrimination suit by 32 former partners (reduced to of counsel by the firm in 1999) for $27.5 million. The EEOC had won an appeal court ruling stating that the parners were actually employees because of the law firm's closed management style. Sidley didn't want to risk going to trial.

Some believe that the Freshfields decision was the correct one--"a victory for common sense". And in a way it is. As is Judge Posner's ruling in Sidley. Because the fundamental mistake that Peter Bloxham made was to think he actually was a partner in a law firm. On paper yes, but in reality he was an employee just like those Sidley lawyers. Our courts have not got round to stating it quite so baldly. But it will happen.

There is a fiction that partners in professional service firms are autonomous, independent beings who are severally and jointly liable. That may be what partnership law says, but if a partner were to act autonomously he or she would soon be asked to leave. And that would not mean dissolving the partnership. It would be a straight firing, but discreet.

In the Financial Times (Monday 15 Oct) KPMG announced that it had made up 810 new partners globally. Yet if you look at KPMG's website you will see its proud boast of 113,000 professionals on staff led by global leaders on the board. At this point it's obvious that the term partner is being used in the loosest of ways. It really means someone who is now paid more than the others with the kudos of being labelled partner without any concomitant power.

Large law firms are the same. Partner equals impotence. The era of professionalism is dead; the era of being a member of a partnership has disappeared. A partner is another stratum in the geology of corporate organizations.

Partnership is no longer morphology--it's pathology.

There is, however, nothing wrong with this as institutions evolve, mutate according to environmental and internal pressures. Professional service firms, so called, are no different to any other kind of corporate enterprise. But rather than attempt to maintain fictions derived from 19th mores, it would be preferable if law firms and other professional service firms just told the truth about what they really are. Then we could hold them to account for full transparency and they could no longer hide behind the "professional" veil.

This is why Peter Bloxham was doomed to fail in his case. (And I haven't addressed the age concerns.) He thought he was a partner in a law firm, a professional man. Sorry Peter, the dream is over.