FATCA and Hobby Lobby

The Economist ran a good article in its June 28-July 4 edition, "Dropping the Bomb," on the burdens FATCA (Foreign Account Tax Compliance Act) has placed on financial institutions and expat Americans ( and other, poorly defined "US persons") around the world. "In essence, FATCA turns foreign banks and other financial institutions into enforcement arms of America's Internal Revenue Service (IRS). They must choose between turning over information on clients who are "US persons" or handing over 30% of all payments they receive from America to Uncle Sam. The threat appears to be working. More than 77,000 firms have signed up. Over 80 countries have struck agreements with America to allow their banks to hand over data."

The compliance costs that FATCA imposes on those financial institutions are substantial relative to the income to be earned by a foreign bank from servicing Americans' banking needs. "[T]he overall costs of complying, borne mostly by non-American banks, are likely to far exceed the extra tax receipts." No rational economic actor will just absorb costs of compliance without looking at how it can change its behavior to mitigate those costs. So, "of the 7M Americans who live abroad, thousands have been told by their local banks and investment advisers that they no longer want their [business] because it is too much hassle. Many others will have to spend thousands of dollars to straighten out their paperwork with the IRS, even if they owe no tax (and most do not, since they will have paid a greater amount abroad, which counts as a credit against tax owed in America)."

So, what does this have to do with Hobby Lobby, the Supreme Court case decided last week holding that a closely held, for-profit business is a "person" as defined in the Religious Freedom Restoration Act, enacted during the Clinton Administration, and is entitled, under that law, to be excluded from the mandate in the Patient Protection and Affordable Care Act that employers who provide health insurance to employees must include free contraception in that coverage?

This: both laws -- FATCA and that contraception mandate -- represent a growing and problematic trend of the US government forcing private sector organizations to carry out government policies unrelated to their business without compensation (subject to whatever tax reductions result from deducting the costs of compliance).

This practice is the mirror image of the problem complained about on the left of "tax expenditures", i.e., the dollar cost of allowing taxpayers to take deductions, exclusions and credits for an assortment of activities that are, says the left, functionally equivalent to collecting taxes under a regime with no such deductions etc., and then appropriating government spending on those activities in the amount of the lost revenue. The mortgage deduction is the largest example of such a "tax expenditure"; if it were eliminated from the Internal Revenue Code, it is hard to imagine Congress passing a housing subsidy that gave wealthier homeowners more money every year than middle-class homeowners, although that is the economic equivalent of what the deduction does.  It's a question of framing and hiding the perquisite (and probably also, to be cynical, a question of the extent to which the deduction benefits the finances of members of Congress and the inside-the-beltway class).

The compliance costs of laws like FATCA and the employer mandate should be seen the same way. As with tax expenditures, the government could appropriate money directly to fund its enforcement objectives. If it wants citizens to receive free contraception, it could appropriate funds to manufacture or purchase various forms of contraception and to distribute them directly. Or it could send vouchers to citizens who request them.  It's not essential to the policy to involve private sector firms in its implementation. Justice Alito makes this point very well in his majority opinion.  

Similarly, if it wants foreign banks in their non-U.S. operations to maintain records, it can pay them for the cost of keeping the records, or hire a staff of IRS agents to go overseas and make the records. Of course that would be expensive and the cost/benefit of the proposal would have to be confronted. But that is the point of the “tax expenditure” argument as well. No one disputes that Congress has the power to pursue the policy in question; it's the obfuscation of the tax/subsidy, in contrast with the transparency that representative government needs to achieve, that is the objection.

These aren't the only laws that impose costs on the private sector.  In another article, the Economist cites a Competitive Enterprise Institute estimate that American businesses spend more than $1.86 trillion to comply with government mandates.  To put that in perspective, recent CBO estimates put the tax expenditure revenue loss at over $900 billion.

This is not a question of whether the substantive policy, promoting contraception or combating tax evasion, is one that government should pursue.  I happen to support both.  Nor is it a question of whether regulation of the private sector is good or bad, in any instance.   Many costs of compliance relate closely to the activity of the private sector organization in question: environmental regulations, for instance, and it is obviously sensible to internalize to those businesses the costs of the externalities they generate.  But tax collection is a quintessential governmental function, not a private-sector operation.  Contraception has nothing to do with selling craft kits to hobbyists.  The question, rather, is the loss of transparency a supposedly democratic government should maintain toward the electorate.  By shifting the costs of pursuing policy objectives off of its budget and onto the private sector’s, the political class hides from the electorate the costs of those objectives -- which is even worse than the tax expenditure practice, which, since 1974 at least, has been reflected in annual CBO and other budget reports. 

Imagine if a government said, if you want to open a restaurant, you have to feed government employees at a discount, to help keep the fisc’s expenses down.  Or, if you want to start up a moving company, you have to donate a truck to the army.  Or if you want to remodel your house, you have to take responsibility for potholes on your street for the next year.  All these are the same thing as FATCA or the contraception mandate, the government dragooning private sector actors into carrying out its functions so as to avoid presenting to the electorate a budget process with integrity that forces a debate over the tradeoffs the electorate needs to understand.

Ironically, after I had drafted this, I was traveling back from Europe and I went through immigration control in Europe, and at a relatively quiet time in the airport, so I wound up having a fairly long chat with the U.S. customs officer who processed my passport. He has a great job, getting to live for several years at a time, at taxpayer expense, in various European nations.  One of the things I asked him about was if it had become harder recently to be an American national opening up bank accounts in foreign nations.  He said, “not for me.  The US has diplomatic arrangements for all of its employees overseas and works all that out for us with the foreign banks.”

NML v. Argentina, Post 4

In the spring of 2013, I wrote three posts on the litigation between NML and the Republic of Argentina which was then at the Second Circuit.   In the last one, March 31, 2013, I predicted that NML would win hands-down at the Circuit and wrote:

"Argentina will probably file a cert petition, but the issue here is really just one of state law contractual interpretation and doesn't belong in the Supreme Court at all.  I can't imagine how anyone expected anything else from Argentina.  When its senior government officials attended the oral argument at which its counsel took a hardline position, it was obvious that Argentina was perfectly happy to default on the exchange bonds as well."

And, in the wake of the Supreme Court's denial Monday of that cert petition, it appears that Argentina is indeed headed toward yet another default on its bonds.  It's important to remember that Argentina has been in default on the non-exchange bonds, the ones NML and others "fondos buitres" hold since 2003 so a default is not a new default, and apparently intends to remain in default on them forever, based on the remarks of finance minister Axel Kicillof, President Cristina Fernandez de Kirchner and their counsel.  Earlier today, according to Reuters and Clarin, the leading media company in Argentina, the Second Circuit lifted the stay of judgment that had been in effect pending the Supreme Court review, and supposedly the parties are now in chambers with Judge Griesa.  Argentina has supposedly agreed to negotiate with NML but I think that is just one of those negotiations for the sake of appearing reasonable and avoiding further sanctions than anything likely to lead to a substantive result.

A few weeks ago, a strategy memo from Argentina's law firm, Cleary Gottlieb, to Argentina's finance minister somehow made its way into the Argentine press and from there to the world at large.  Although Judge Griesa later ruled the memo remained privileged and thus outside the record, there is nothing in there that isn't otherwise in the public record or irrelevant.   The memo (1) assumes Argentina cannot or will not pay NML and other holdout bondholders, which everyone already knew; (2) observes that the exchange bonds (the ones issued to those bondholders who agreed to restructure Argentina's debt back in 2003) contains clauses requiring Argentina to sweeten their terms if it ever awards the holdouts a better deal, which clauses give the exchange bondholders the same veto over payments to the holdouts that the pari passu ruling gives the holdouts over the exchange bondholders, which again has been in the public record for years; (3) observes that three-way settlement talks among the Republic, the holdouts and the exchange holders to figure out how much NML will take to go away and then how much the exchange holders would require to allow Argentina to pay that would be cumbersome and unlikely to resolve by the June 30 coupon payment date on the exchange bonds, and (4) closes with the observation that was brought to the attention of Judge Griesa and the press that "the best option" is to "immediately restructure" all of the bonds Argentina wants to pay "so that the payment mechanism and the other related elements are outside of the reach of American courts."  Which is as obvious as it is brazen.  But Kicillof has said as much this week: "We are going to initiate a swap of debt with payment in Argentina ..."  And "La Nacion" describes that swap as "the steps the government will follow after the adverse judgment of the Supreme Court of the United States."

The one solution I could see taking place, which is not laid out in the Cleary memo, is for the holders of a very large proportion of exchange bonds, motivated to avoid a default on their own bond holdings, to buy out NML and the other major holdouts at something close to the amount owed, then exchange the acquired bonds for a combination of new exchange (or other) bonds at a much higher ratio than in the 2003 exchange, and for Argentina to pay them cash in U.S. dollars equal to the difference between the amount they paid and the face amount of the new exchange bonds.  Then, with the impasse eliminated, Argentina could do a second, new issue of bonds to replenish the foreign exchange reserves it had to pay out to get the deal done.  That would allow Argentina to save face by, formally at least, not paying NML directly, but instead paying their friendly creditors for doing them a favor, and being able to do so, ultimately, just with paper, not foreign reserves.   Because the holdout bonds are not that large an amount relative to Argentina's debt capacity, this seems economically feasible.  But the ability to pull it off hinges on one big unknown, which is whether a supermajority group of exchange bondholders can be pulled together (a supermajority being needed  to waive the clause in the exchange bonds that restricts Argentina from exchanging the defaulted bonds at a better ratio than was set in 2003.  

FT Alphaville has kept the best running tab, now up to 58 stories, on the subject.  They seem skeptical the exchange will succeed.  It faces two big hurdles, even assuming that the exchange holders want to participate at a high level:  1) obtaining legal, professional and financial assistance with the mechanics of the exchange entirely from people not subject to U.S. jurisdiction, since an intentional violation of the injunction would expose violators to the risk of prosecution for contempt of court; and 2) somehow hoping that Judge Griesa does not extend the injunction to bar holders subject to U.S. jurisdiction from tendering bonds in the exchange.

In addition, Linette Lopez at Business Insider had a sharp analysis of the political / historical context of bond defaults within Argentina this week: "The One Thing You Need to Know About Argentina is Everyone in Argentina is a Bond Geek".

There is, however,  one more thing you need to know, which Lopez doesn't address, and that is to see how the dispute arises out of the fundamental clash between the populist philosophy that Kirchners's Argentina runs on, and the rule of law, which U.S. courts run on.  I touched on this in my March 31 post, and the speech Kirchner gave this week in the wake of the cert denial exemplifies it.  When you read the speech, she constantly emphasizes how over 90% of the bondholders in 2003 exchanged into the restructuring and that the holdouts, a small minority, would make a lot of money if paid off in full. The classic populist argument  --any time a small minority makes a lot of money in finance, in and of itself, that is not morally legitimate. That they had a contract, and a freedom to decline the exchange, as would be unquestioned under Anglo-American common law, is not acknowledged as a legitimate right.  This is what Kirchner means when she says, in Lopez's translation, "it's not a judicial or legal problem; it's the result of a business model on a global scale that, if it continues, will produce unbelievable tragedies." Contract rights, the return of money borrowed, and private property are just obstacles to a populist political philosophy.  Contrary to the Anglo-American notion of individuals and minorities having inalienable rights against the state, embodied in the Bill of Rights for instance, in Kirchner's mind, nothing can be allowed to interfere with the agenda of a government once it wins an election.  This is how Argentina has been run under the Kirchners (it's also the rationale Maduro gives for everything he has done since taking power in Venezuela, including imprisoning political dissidents). They have used their electoral majority (acquired by promising unsustainable consumption subsidies to the lower earning portion of the electorate) to whittle away at all forces that might constrain their political power, like eliminating the independence of the judiciary and breaking up the largest media company, as retribution for political disagreements, after having spent the first ten years in power confiscating private property left and right, as I outlined in the March 31, 2013 post.   That's why this is an important issue of principle for the U.S. courts, because Argentina's stance is fundamentally an assault on the rule of law and on the most basic tenets of the Anglo-American legal system.

While I was typing this, the story came out that Judge Griesa said in court today that Cristina Kirchner's speech did not inspire confidence in him regarding the Republic's negotiating good faith. Quite so.  But I think the final word on the Kirchner speech deserves to go to the arbolitos, the Argentine citizens who exchange Argentine pesos for U.S. dollars in the black market in Buenos Aires, who bid the U.S. dollar up more than 4% the day after her speech.

Further on the Effect of the GM Bankruptcy on New GM's Exposure to Ignition Defect Litigation

The Wall Street Journal website has recently run a series of posts about “GM’s liability for claims related to the recall of cars with defective ignition switches” from various persons with knowledge – some professional, some academic - about chapter 11 matters, whom the Journal has labeled “The Examiners”.

I was quite stunned at the extent to which certain of the posts contained wildly inaccurate or inapposite observations about the matter.   In particular, that from a tenured professor at Harvard Law School who teaches bankruptcy, Mark Roe, seemed remarkably disconnected from both  the facts and the applicable law, and left me to ponder what his students actually learn from taking his course. 
Roe writes:  “Bankruptcy law says that an ‘old GM’ was sold to a ‘new GM’ and the ‘new GM’ excluded product liability from the debts it picked up in the sales agreement. But it’d take a bankruptcy expert to know the difference between the old and the new GM; GM today is the same organization as the one that put the bad switches into its cars and, the media reports, knew about it years ago.”

Most of that is just wrong.   Bankruptcy law does not say that an “old GM” was sold to a “New GM”.   First, obviously, bankruptcy law states general legal rules not specific facts.  Second, “old GM” was not “sold”, it was the seller.  It was an asset deal, not a stock deal.  Old GM sold certain of its assets to “New GM”, a newly formed company that was owned by the Department of the Treasury of the United States,  a Canadian government agency, a trust for UAW retirees and 10% by Old GM, but which had no prior operating existence.  Secondly, one does not have to be “a bankruptcy expert” to know the difference between the two companies.  One was owned by public shareholders, and was bankrupt.  One was 90% owned by two North American governments and some UAW retirees, and was solvent, with access to fresh capital to pay its debts in full on time.  It simply isn’t true that they are “the same organization”.  There were completely different directors and shareholders; the CEO has changed twice since the filing; there are different creditors; and  a different cost structure.  Plants, employees, brands and dealerships were all reduced, generally by more than 20 percent of the pre-filing total.  As President Obama said the day GM filed for bankruptcy, “the GM of the future will be different from the GM of the past.”  In any relevant legal sense, it is.

Roe goes on to write: “GM’s sale was no arms-length deal with a third-party organization, as a sale to Toyota or Fiat or a hedge fund would be.  So it’s not so clear what bankruptcy law ought to be here.  If anyone bought GM, the government did, and it’s doubtful the government would have cut out the tort claimants had it focused on them.”

Regrettably, every one of those statements is factually wrong.  How someone makes so many errors in so few lines just boggles my mind.  Judge Gerber’s decision approving the sale says at page 40: “To the contrary, the evidence establishes that the 363 Transaction was the product of intense arms’-length negotiations.”  And that order became final.  Therefore, contrary to the professor’s post, the sale was “arms’-length” and it is quite evidently “clear what bankruptcy law should do here.”  It shouldn’t rewrite, ignore or deny the facts, as the professor chooses to do.
 
When Roe writes “it’s doubtful the government would have cut out the tort claimants had it focused on them”, that is also manifestly false.  Had Roe "focused on the facts and the doucments, perhaps he wouldn't have mischaracterized them.  The government as buyer did indeed "focus" intensively on the issue of which tort liabilities to assume, as the Judge recited in his opinion, and deliberately modified the purchase agreement to specify the scope of them, agreeing to assume only those tort liabilities “arising from operation of GM vehicles occurring subsequent to the closing of the 363 Transaction“ (see page 15 of the decision linked to above).   So, beyond a shadow of a doubt, the government “focused on” the tort claimants and “cut [them] out” contrary to the professor’s unmoored assertions.  As the Judge wrote at 51: “in a 363 sale … the bankruptcy court is invariably asked to provide, in its approval order, that the transferee does not assume liability for the seller’s pre-sale conduct.  …  New GM would not assume liability for any injuries or illnesses that arose before the 363 Transaction.” Judge Gerber considered at length (pages 50-61 of the decision) the objections of numerous tort claimants to New GM’s request for an injunction against them pursuing New GM under theories of successor liability and overruled them all.
 
Roe’s next paragraph completely slips the bonds of earthly reality and becomes one of the weirdest pieces of legal gibberish I have ever read.  “Bankruptcy courts should worry about a company selling its assets back to itself, or its ongoing owners, to wash itself clean of preexisting tort liabilities. Such sales may really be reorganizations of existing debts, not true sales to third parties.  What if GM were viewed as being reorganized, rather than sold? Concealed debts do not get the same full discharge as debts that were fully listed and disclosed. Whether the judge who oversaw GM’s “sale” to itself would backtrack and consider it a reorganization will be interesting to watch.”

Roe uses the name “GM’ in those sentences but, other than that, what he wrote bears no relation to what actually happened in the bankruptcy case of “GM” but seems to be the product of his imagination.  Yes, I suppose a bankruptcy court “should worry about a company selling its assets back to itself or its ongoing owners” and proposals like that were in fact made and litigated in the early days of business reorganizations in the US.  Based on the well-developed case law that resulted, which included, inter alia, the absolute priority rule (see here for an excellent summary), I am quite confident, however, that if Old GM had actually proposed to do that, Judge Gerber would have stopped it and probably appointed a trustee, but that isn’t close to what Old GM proposed or Judge Gerber approved; it simply didn’t happen in our universe, as explained above.  So, whether “such sales may really be reorganizations” is irrelevant to analyzing the consequences of the GM sale that took place in the real world. 

Roe’s reference to “concealed debts” is also ridiculously inaccurate and misleading as it rests of multiple false premises.   The first false premise is that the law he refers to dealing with the discharge of “concealed debts” has anything to do with the liabilities assumed in the GM 363 order.   It doesn’t.  New GM assumed what it assumed; what it chose to assume was disclosed to the world (that's why the plaintiffs were objecting!); and the court’s order bars everything else from passing over to New GM.  If something was “concealed”, then New GM didn’t assume it.  The other false premise is that “the debts” were concealed.  Here, Roe seems to confuse the existence of debts with the amount of them, or the evidence in support of the claims.   The existence of product liability suits did not go undisclosed and, even if they did, that has nothing to do with whether the buyer assumed them.   Judge Gerber specifically mentions at page 21 of the opinion that GM’s contingent liabilities “are difficult to quantify” but notes without comment that its then most recent 10-Q “present valued contingent liabilities of $934 million for products liability …”   The ignition defect was alleged in multiple pre-petition lawsuits and the evidence related thereto was discovered in those lawsuits.  Thus, any concealment was of evidence or of the prospective size of the resulting liability, but not of the existence of the debt.  And in any case, whether GM had $934 million or $9.34 billion in products liability exposure, New GM didn’t take any of it. So it’s just a red herring from a legal perspective.

Roe goes on to muse “What if GM were viewed as being reorganized, rather than sold?” and further asks whether Judge Gerber “would backtrack and consider it a reorganization.”   He seems unaware that this question too was also considered at length and resolved by the judge.  See pages 26-38 and 41-47 of the decision linked to above.  The judge decided the transaction was not a sub rosa plan of reorganization and could be authorized under section 363 rather than having to be proposed in a plan of reorganization. As the numerous citations in his decision to pre-existing precedents demonstrate, the GM sale broke “no new ground.  This is exactly the type of situation where under the Second Circuit’s many holdings there is good business reason for an immediate sale. GM does not have the luxury to wait for the ultimate confirmation of a plan, and the only alternative to an immediate sale is liquidation.”  Decision at 39.  Nor does Roe explain how a bankruptcy judge can “backtrack” from a final order that authorized a transaction that closed nearly 5 years ago.   To suggest such an outcome probably implies, to the uninformed reader, that such an eventuality is somewhat plausible when in fact it is one of the most outlandishly implausible outcomes possible in federal jurisprudence.   I went over the reasons why it is so implausible in my prior post on this topic and won’t repeat them here.  

Roe concludes with the lament that “GM’s winning would look to the country, its leaders, and car buyers as hiding behind a bankruptcy technicality.”  I suppose that’s true if persons identified as bankruptcy experts supply the media, as Roe has done, with inaccurate and uninformed “analysis” that supports such a conclusion.  But the truth is that, as Obama himself stated when he announced the Treasury’s commitments on the day GM filed for 11:  “Throughout this process, I wanted to ensure that none of GM's stakeholders receives special treatment because of our government's involvement. That's why I instructed my Auto Task Force to treat all of GM's stakeholders fairly and to ensure that this restructuring was carried out in a way that was consistent with past precedent -- and it was.”  (Italics added).  Following the 363 buyer’s manual gave the then-new Administration a politically essential argument that it was not acting in a suspect manner from an economic or political perspective, neither taking improper risk with  taxpayer money, nor playing favorites with that money  (even though it was, as between retirees and  other creditors).   It was the Administration’s choice, not GM’s, to pattern its assumption of liabilities on the business practices of hundreds of private sector buyers that had made 363 purchases before it.  It was the Administration's considered choice not to privilege all the non-bondholder constituencies and they picked one that -- the UAW -- that carried more weight than plaintiffs and their lawyers.  That’s not a “bankruptcy technicality” nor was it GM’s decision, both facts Roe gets absurdly wrong.   It was a conscious political and financial decision by the government buyer.   That is what “the country” should conclude -- and might, if it were not being misled by gibberish like Roe’s essay. 

Whether New GM chooses to do something for these plaintiffs as a business matter defies legal analysis. It strikes me as mainly a media-driven decision -- there are plenty of Old GM products liability lawsuits left behind; favoring the subset with ignition defect issues has no legal rationale and could only be justified as a response to the effect on the brand of the media focus.  Ironically, that subset of plaintiffs could wind up benefiting dramatically from the alleged concealment of evidence, since, had the facts been brought out years earlier, there would have been no media frenzy to pressure New GM to extract those lawsuits from the mass of lawsuits left behind and give them a better deal than the government bargained for back in 2009.

Castleton Plaza II

Earlier this year, I wrote a series of posts on the flawed understanding behind the extension to chapter 11 cases of Till v SCS Credit Corp.’s “prime plus-” interest rate formula for cram-ups of secured creditors in chapter 13 cases.   In one of those posts, I focused on a recent case, In re Castleton Plaza, as a particularly egregious example of the way the extension of Till to chapter 11 leads to absurd departures from sound financial analysis, decades of precedent and common sense.  At the time I wrote those posts, Castleton Plaza was on remand to the bankruptcy court after the Seventh Circuit, acting with remarkable alacrity, had vacated the order confirming the debtor’s cram-up plan because the plan’s sale of the equity in the reorganized debtor to the existing equity owner had not been subject to competitive bidding.

When I attended the ABI Caribbean Insolvency Forum in San Juan, P.R., back in February, a panel of lawyers from Indiana, where the case had taken place, delivered a presentation about it, and forecast that the debtor would lose on remand, but would appeal the result.  At the time of the conference, the bankruptcy court had sub judice a revised plan and the secured creditor’s motion to dismiss the case, which the court ultimately granted on February 11, 2014.  Whereupon, the debtor did, indeed, appeal directly, with leave, to the Seventh Circuit earlier this month (Case No. 14-1735).  Briefs are to be completed by early June.  Per order of the bankruptcy court, the secured creditor’s exercise of rights is stayed pending resolution of the appeal.

Reading the debtor’s notice of appeal and its argument against dismissal in the bankruptcy court, I thought it would be interesting, as sort of a post-script to the Till posts earlier this year, to examine the position being taken by the debtor, which depend on the extension of Till to chapter 11, although there are other fallacies as well.

The debtor’s revised plan was remarkable for its brazenness.   Notwithstanding the emphasis in Judge Easterbrook’s opinion on the need for an auction where a debtor proposes to sell new equity to an existing equity holder, the revised plan did not contemplate one.  Rather, the debtor revised the treatment of the secured creditor, the claim of which had been bifurcated under the original plan, with the deficiency being discharged at less than par, to provide that it was now fully secured (I discuss later on that this is more a matter of the debtor’s “ipse dixit” than actual economic fact).  The revised plan further proposed a repayment of the secured claim over 10 years on a 30-year amortization schedule with a “fixed market rate of seven percent” (quoting the revised plan).

The debtor then argued, first, that Judge Easterbrook’s opinion was merely an application of the absolute priority doctrine, but the absolute priority doctrine can only be invoked by a dissenting class of unsecured creditors; since the objecting creditor was fully secured, it could therefore not be heard to complain about the continuing lack of an auction.  

Second, the debtor argued, its proposed treatment of the secured claim was “payment in full” because it complied with Till; further, it argued (in one of the most ridiculous arguments I can recall seeing), because a Till-compliant cram-up is within a debtor’s legal rights,  then being crammed-up in accordance with Till is within the “legal, equitable and contractual rights to which such claim or interest entitles the holder of such claim or interest” and, presto, the secured creditor was actually “unimpaired” within the meaning of section 1124, and thus deemed to accept the plan.

The second argument is obviously wrong, regardless what one thinks of Till-in-chapter-11 in that it misreads the word “and” in § 1124(a)’s litany of “legal, equitable and contractual rights”  to mean “or”.  Unimpairment requires that all three kinds of rights be left “unaltered”, not merely one subset of them.  The secured creditor’s debt had come due by its terms and thus the creditor has, but for the automatic stay, a host of contractual, legal and equitable rights to pursue outside of bankruptcy court that the plan, by substituting an extended payout and discharging the terms of the old debt, “alters”.   Also, fairly obviously, to conclude that a cram-down/up leaves a creditor class “unimpaired” would eliminate the role of

The first argument is more competent, also I think it is also wrong, because the “cramdown” section of the Bankruptcy Code, § 1129(b)(2), does not contain the “only if there is a dissenting unsecured creditor class” logic that the debtor reads into it.  Rather, it says the bankruptcy court shall confirm the plan “if the plan … is fair and equitable with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”  The secured claim is such a class under the revised plan, so clearly gets to invoke the “fair and equitable” standard.   The only question is whether the content of that standard is 100% different for different classes, or do overlaps exist.    

The Code then specifies that the “fair and equitable” standard “includes” – which is statutorily defined to be non-limiting – certain criteria which differ by class, but by virtue of the word “includes”, courts can impose additional requirements, and it is clear from Judge Easterbrook’s opinion that it was not tied to the deficiency claim that the original plan would have imposed on the mortgage holder.  And that makes perfect sense as a matter of economic substance because these small to midsize commercial real estate cases are generally all battles between the mortgage holder and the equity holder; there is rarely any unsecured debt to speak of.   In Castleton Plaza, it seems pretty clear that any unsecured debt that existed in the case was consciously created by the debtor’s strategic non-payment of certain trade creditors whose loyalty it could count on (subject to designation of their votes under § 1126 (e)).

But, suppose you disagree with my position on that last issue, and instead believe there are no “cram-up” criteria for secured creditors outside of the ones explicitly specified in § 1129(b)(2)(A)(i).  Then you must confront the “Till in chapter 11” issue.  The proceedings below, it is clear, never proved by way of evidence that the proposed repayment actually delivered to the secured creditor a “value, as of the effective date of the plan, of at least the value of the holder’s interest in the estate’s interest in such property…”, i.e., the foreclosure value of the collateral here.   There was no evidentiary hearing on that issue.  Rather, the debtor simply contended a payout formula compliant with Till delivers that value as a matter of law.  

The plan uses the phrase “fixed market rate of interest”, and thus one might wonder if in fact the repayment terms could be supported by expert evidence, and thus dodge the Till issue, but that phrase is frankly absurd and misleading.  The value of the collateral that was referenced in the proceedings before the bankruptcy judge earlier this year, $8.2 million, is only about 90% of the principal amount of the note to be issued under the plan to the secured creditor (approximately $9.1 million).  There is no credible “market rate of interest” for a 10-year note with a 110% loan-to-value ratio and a 30-year amortization; if there were, the debtor would have found a lender willing to provide it and dispensed with the multi-year cram-up battle.  Thus, to obtain confirmation, the debtor would ultimately have to argue for a rule of law that a note complying with Till satisfies § 1129(b)(2)(A)(i)[1].  As I explained in my posts earlier this year, I think that would be an error of law, not a rule of law, and it will be interesting to see if the Seventh Circuit seizes on the chance to explain why Till should not be applied in chapter 11 cases.

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[1]           Technically speaking, the proposed rate of interest is 375 bps above the prime rate, so slightly more than the conventional Till range of 100-300 bps, but that does not seem to affect the analysis as the LTV ratio is still too high for the note to be equal in value to the secured creditor’s claim.  

Reasoning and Ideologically-Based Reasoning

Last year I wrote a post criticizing an article by Yale Law School professor Bruce Ackerman in which he argued that a third year in law school was more or less essential to any hope one might have to function as an intelligent citizen.  In compensation, I heartily recommend this article from a different Yale Law School blog to everyone. The author is Dan M. Kahan, and if only all law school faculty were of this mind.

http://www.culturalcognition.net/blog/2014/4/9/more-on-krugmans-symmetry-proof-its-not-whether-one-gets-the.html/

It became clear to me a few years ago, as a 30+ year reader of the Times, that the Times had chosen, as a survival measure, in the secularly declining conventional media environment, to follow the Fox News strategy and make sure to forge a tight bond with its audience by consistently telling them what they want to hear and making them feel superior to the rest of the citizenry.  Getting a Nobel Prize holder to do that makes Times Nation feel smart and honorable every time they read him, because Krugman tells them pretty much daily that the people they dislike, Republicans, are stupid and mean.  That is a psychologically enjoyable sentiment, like a massage of one's ego, and makes Times Nation come back for more, which enables the Times to stay in business.  That's all that is going on, and I am not surprised an economist would be in its vanguard.  He is probably paid enormously well!

Systemic Risk of Hedge Funds?

The WSJ “Real Time Economics” blog carried a post Monday, April 14, headlined “Hedge Funds Help Fan Financial Crises: SF Fed Paper” that referred to an article in the San Francisco Fed Letter released earlier in the day.  The article is written by a visiting scholar, Reint Gropp, and summarizes a paper he and others have written that I think I found online ( I will refer to the authors collectively as “Gropp” for expediency). If that is not the actual paper, it is a draft or earlier iteration thereof.

Briefly summarized: the researchers construct their own VaR (value at risk) model for four different kinds of financial intermediaries – commercial banks; investment banks; insurance companies and hedge funds.  Using “daily data”, they derive VaR estimates for each sector (and a control group of REITs, commodities and non-financial stocks) over 2,000 trading days from 2003-2010, which they further divide into periods of tranquility, normality and financial stress.  They then run regressions showing correlations, etc., among the various sectors during these periods, to see whether risk appears to spill over in a persistent pattern from any of the sectors to any of the other ones.   They conclude that, during periods of “tranquility” or “normality,” increases in VaR of the HF universe produce very small (8-9 bps) changes in the VaR of investment banks; otherwise, not much changes.  But in periods of financial stress, they find much greater (71 bps) correlation and impact running from HFs to IB’s and also that the spillover tends to run its course over approximately a two-week period and thus is not detectable when measurements are done using less-than-daily data.

Conversely, they perceive that insurance companies play little role in transmitting risk, as their returns are found to be negatively correlated with the returns of other financial institutions.  Finally, they find very little spillover between commercial and investment banks. The conclusion that hedge funds are the  largest amplifier of risk has implications in relation to the scope of regulation for hedge funds, which are relatively lightly regulated compared to the other sectors.

Their conclusion has an intuitive appeal, in that hedge funds are commonly seen to be more risky and active that the larger institutions and conversely, insurance companies are seen to be the most conservative. As Gropp explains,

Why are the spillovers from hedge funds during financial crises so much bigger, and why do they seem to increase more than those from other financial institutions? Hedge funds are opaque and highly leveraged. If highly leveraged hedge funds are forced to liquidate assets at fire-sale prices, these asset classes may sustain heavy losses. This can lead to further defaults or threaten systemically important institutions not only directly as counterparties or creditors, but also indirectly through asset price adjustments (Bernanke 2006). One channel for this risk is the so-called loss and margin spiral. In this scenario, a hedge fund is forced to liquidate assets to raise cash to meet margin calls. The sale of those assets increases the supply on the market, which drives prices lower, especially when market liquidity is low. This in turn leads to more margin calls on other financial institutions, creating a downward spiral. Another example is investment banks that hedge their corporate bond holdings using credit default swaps. If hedge funds take the other side of the swap and fund the investment by borrowing from the same bank, the spillover risk from the hedge fund to the bank increases. These types of interconnectedness may underlie some of the spillover effects in our study.

 

The paper appears to have crunched on a very sophisticated level through massive amounts of data, producing an analysis that would take a reader a very long time to investigate thoroughly[1].  But I also have two huge reservations.   The quotation above carries the seeds of one of them.   Most of the statements in it are actually wrong to the extent they purport to describe characteristics that are unique to hedge funds; that is, they are not true “if and only if” the subject is a HF.  For example, when the paper states “hedge funds are opaque and highly leveraged”, that is only a partly true statement.  Opaque – yes, but not that much more so than the other institutions, and not as much as you think (and also, as I realized while I wrote this post, it cannot be true of the HFs whose data they rely on – that is, the HFs they analyze cannot be opaque to the extent the paper relies on information about them!

Sure, to most observers and probably regulators, most individual hedge fund trades are opaque, yes.  But there are reporting requirements concerning equity stakes in public companies that provide disclosure on the largest equity positions, and various other ways in which hedge funds’ positions become disclosed, such as shareholder activism, being a member of an ad hoc committee in a bankruptcy, or talking up a position in some conference.  As well, other informal disclosures occur: I often found that traders had a good sense of which hedge funds had been taking positions in a distressed situation.  A prime broker would normally know reasonably thoroughly the positions of its client HFs.  Similarly, when a company goes out for a “drive-by” bond offering, or an equity raise via a private placement, the investment bank(s) running the deal invariably have a very good idea who is interested and who is not, because they have teams of sales people calling on asset managers all the time and staying up to date on what their interests may lie. Finally, to take a position in a financial asset outside of the securities exchanges, an investor must often enter into a contract in which its identity is necessarily divulged:  in loan trading, for instance, when a loan passes by assignment, the admin agent will have to sign off, and the borrower in a non-default context will also, and the identity of the buyer and seller must be disclosed.  So too in derivatives, the counterparty, often a financial intermediary, knows who it is contracting with on an ISDA form.  And, just to reinforce the point, is the “opacity” of an HF portfolio all that different from the opacity of the portfolio and trading books of the largest commercial and investment banks?  From a public investor’s perspective, I don’t think it’s all that different.  An observer of the markets may well be able to name a greater proportion of the positions held by, say, Bill Ackman’s hedge fund, or Dan Loeb’s, than those held by Goldman Sachs.  At the regulatory level, there is a difference, I admit, although I question how much actual or practical insight the regulators truly have over those institutions’ books, given their failure to apprehend any of the insolvencies in 2007-09.  As I said, the statement “hedge funds are opaque…” is indeed partly true, but just partly.

Moving on, what does the statement “hedge funds are … highly leveraged” mean, especially in comparison to the other kinds of institutions Gropp studies?  Although I do recall one memorable anecdote to the contrary[2], many of the hedge funds that I have worked with did not have any permanent leverage at all, because they held leveraged loans, HY bonds, distressed securities, ABS or other debt securities as to which the risk of illiquidity was too high to get into a margin situation in the first place.  But even assuming there are a lot of hedge funds with leverage, what makes them “highly” leveraged compared to commercial banks and investment banks from 2003-2010?  I doubt there was any hedge fund that had a leverage ratio higher than the commercial and investments banks in that period.  I would be surprised if any hedge fund had more than a 4:1 debt/equity ratio, and I would expect the average among the levered funds is less than 2:1, whereas the largest commercial and investment banks have leverage ratios in the 10:1 or higher range, depending on how one counts trust preferreds and other hybrids.  Especially for HFs that are mainly taking positions in equities, Reg U and other rules make it very difficult to do so on a basis as leveraged as a money center bank’s balance sheet is leveraged.

Tying this back to their research: the hedge fund universe that Gropp works with in his paper consists, the 2013 paper says, of 47  of the largest and most liquid such funds which comprise a “Hedge Fund Equally Weighted Index” which is one of the few sources for daily data on hedge fund performance.  But the researchers do not seem to know, and probably it is not disclosed, which, if any of those, are levered and to what extent and did it differ from day to day.  So I think the description of HFs relevant to the paper as “highly leveraged” is not supported in a scientific manner.

Moving on through Gropp’s explanation of his research, the two examples he gives of ways in which hedge funds might amplify risk are loss-and-margin consequences, and hedging credit risk via CDS’s.  But note that, again, these are not at all unique to hedge funds.  As I recall, when the subprime mortgage started, a lot of hedge funds weren’t long that asset class on borrowed money, they were short subprime MBS and indices tied thereto.  This is important because the 2013 paper states unequivocally “The subprime and financial crisis of 2007-2009 spread from mortgage-backed securities and CDOs to commercial banks and on to hedge funds and investment banks.” Think of “The Big Short”, or John Paulson being short the ABACUS vehicle in the Fabrice Tourre lawsuit.  The institutions that were long subprime were investment banks (think Merrill); the GSE’s; commercial or investment banks at home and especially abroad; andinsurance companies (AIG, the various bond insurers like MBIA and FGIC, etc).   And most of all the dozens of originators themselves, like AHM and so on.   There were certainly some mortgage funds, like the Bear Stearns’ funds, that were long subprime, but was the HF universe net long subprime?  I would be skeptical (it’s also an interesting taxonomy question relative to the research, how one should classify a HF managed by an investment bank).  So, both generally and specifically with respect to the financial crisis of 07 onwards, I doubt “loss-and-margin” consequences are particularly unique to hedge funds, especially in reference to subprime-mortgage-related assets. 

The other example Gropp gives, hedging credit risk through CDS, is again, not unique to hedge funds; for example one of the biggest individual players in CDS is the mega-billion PIMCO Total Return fund.  Further, the idea of transmitting risk through CDS raises the question of how matched the intermediary’s book is – it may be the case that the value or risk of one side of a CDS position goes up in value, but whether that intermediary’s overall CDS book loses value or has increased risk exposure depends on whether there is an offsetting position, among other things. I am not even sure how accurate it is relative to the HF sample the paper studies, because the hedge fund index they study appears, as I discuss below, to be heavily weighted toward investments relating to public equity markets, not corporate credit strategies, which are a clear minority of the strategies encompassed by that index.

So that is the first reservation I have about the study, to what extent are HFs that unique in relation to the risks and characteristics identified by the researchers as compared to the other kinds of financial intermediaries studied.

The other major reservation I have is that the study is a construct of constructs with potential for measurement errors or questionable assumptions and choices at each level.  That is, value at risk, as calculated by the authors is, obviously, a construct or a model, as it is for everyone who assays such a calculation.  But on top of that, the underlying data sets their VaR model is analyzing are themselves not the actual assets and liabilities of the subcategories but proxies for those assets and liabilities and thus potentially inaccurate reporters of the underlying value at risk, especially on a daily basis.  As well, there are a variety of financial market sectors that don’t appear to be analyzed in the paper that might have been relevant.

For example, as noted above, the set of  “hedge fund” data comes from a Hedge Fund Equally Weighted Index maintained by Hedge Fund Research.  Its methodology is described here:  http://www.hedgefundresearch.com/pdf/HFRX_formulaic_methodology.pdf.  Fwiw, the “strategies” that are “equally weighted”  in the index are Equity Hedge; Event-Driven; Macro/CTA; and Relative Value Arbitrage; HFR maintains indices in each of those strategies and the HFRX is just the sum of the NAV of the four individual indices.  Each of the underlying indices is comprised, HFR says, of funds that, in the aggregate, have the highest statistical correlation the aggregate performance of all funds with that strategy.  So the index is itself a statistical representation.

I am not going to go into a lot of detail about the underlying index, as the scope of this post is just some high-level observations; plus, I am not pursuing tenure as a professor of finance, nor billing by the hour as an advocate for HFs so someone else is welcome to push the analysis deeper.  The keeper of the index does indeed report it on a daily basis, which I find a bit curious as I don’t know of any HFs that disclose daily NAVs.  I searched the index manager’s website a few times to see if I could confirm it was receiving daily NAV data and not making its own estimates, but could not find any statement one way or the other on the subject.   I have to take them at their word, but this is a cool article from professors at the University of Maryland who tried to create daily VaR measurements for HFs using the same index that Gropp appear to be working with; they have mixed results although their conclusion that intra-month volatility is much higher than month-to-month volatility is similar to the Gropp conclusion.

Mesirow Advanced Strategies put out a paper in 2011 entitled “Understanding Hedge Fund Indices” that  contains a short, user-friendly discussion of some of the issues with hedge fund indices, including the one used in Gropp’s paper.  It also has some eye-popping charts that show wide variances in performance among the various indices that amply illustrate the caution needed in drawing conclusions from them.  A venerable alternative investment firm called Pictet also has a paper available on the Web entitled “Hedge Fund Indices: How Representative Are They?” from which I culled this little quote: “less than 1 per cent of the hedge fund industry reports to all databases, highlighting the unrepresentative nature of hedge fund databases.”  I am sure the keepers of the HFRX would disagree, but the point is, there are intelligent voices suggesting that all HF databases be taken with at least a small grain of salt.

A further complicating factor is that a lot of HF assets are not valued on a Level I basis, but may be Level II or Level III valuations that contain greater human guesswork (link for an explanation of these terms: http://www.iasplus.com/en/standards/ifrs/ifrs13 ) which introduces further potential for measurement errors in the data the authors study.

Finally, the identity of the components of the index are not disclosed in the Gropp paper or on the HFR website; they are only available to subscribers.  The Gropp paper references an appendix that supposedly goes into more detail, but every time I pasted the link into my web browser, I just got a “server error” message, so I could not investigate further.  But the main point is I can’t tell how US-centric they are, which seems to be reasonably important vis a vis the paper’s overarching topic of the regulation of US financial intermediaries.  .  .

The Gropp paper compares the VaR of the HF index to three baskets of equities of various large, publicly traded US-centric commercial banks, investment banks and insurance companies. To a certain extent, I question a VaR comparison between the NAVs  of HF’s and the equity prices of these other kinds of institutions, as equity prices of financial stocks are not equal to their respective NAVs, but are determined by secondary trading.  As well, all these other types of institutions have substantial operating, income-generating businesses in addition to holding portfolios of financial assets.  So, there is something of an apples and oranges comparison here, although I don’t think too much needs to be made of it; the geographical issue I mentioned above is perhaps more worth pondering.  

The Gropp paper states that its rosters of commercial banks and insurance companies is taken from a list compiled by Viral Acharya and others in a paper called “A Tax on Systemic Risk”, but, when I checked that paper for the list, I found the description in the Gropp paper did not quite match the Acharya paper (Gropp: 26 commercial banks and 31 insurance companies; Acharya: 29 commercial banks and 36 insurance companies).  I have no idea what changes were made, or whether they were explained by the link that did  not work.

Turning to the commercial bank subset, assuming it is the Acharya set, it contains the large money center banks which had substantial capital market businesses, like JPM, Citi, B of A (Gropp acknowledges that their classification as “commercial banks” is imperfect).  But this set also has numerous regional banks with no capital market business as well. 

The insurance sector  list oddly contains Countrywide Financial. That oddity is compounded by the fact that none of the largest mortgage insurers – Fannie, Freddie, MGIC – show up on the list (MBIA, AMBAC and AIG do, though).  So how accurate a list is that?

In contrast to the large number of constituents in the insurance and commercial bank sets, it is noteworthy that the investment bank category in the Gropp paper is composed of only 8 institutions (not all of which I can identify; compare the Acharya paper which lists 10 but those 10 include NYMex, Schwab, T. Rowe Price and ETrade, yet omit Jefferies, so I just don’t know how accurate these categories are).  Further, at least two of the investment banks in the Acharya list collapsed (Bear Stearns and Lehman) and one (ML) was merged out of existence, during the period studied.  It jumped out at me that the IB sample, as best as one can understand it, seems to be a little small to confidently draw conclusions from; appears to be  much more tied to equity markets than the other sets; and also a large proportion of the constituents seem to have been the subject of one-time events during the period of study, making a very noisy sample as well. 

Another aspect of “noise” in this data is how much was unknown in real time, but came out later, in the form of fines, penalties, damages, settlements etc, about the amount of contingent liabilities that various financial institutions other than HFs had during the period in question, which leads one to wonder, how accurate were the equity prices of the underlying assets and liabilities of those institutions?

A lot of other financial entities don’t appear in any of the sets Gropp studies, to the extent the paper tracks the Acharya paper’s list.  Fannie, Freddie, MGIC, as mentioned, and also Amex, Annaly, Blackrock, Capital One, CIT, Franklin Resources, Legg Mason, TD Ameritrade.  The exclusion of the mortgage –related entities utterly baffles me since the researchers state “The subprime and financial crisis of 2007-2009 spread from mortgage-backed securities and CDOs to commercial banks and on to hedge funds and investment banks.” I would have thought it would have been essential in the context of that thesis to study correlations between mortgage-centric entities and financial institutions, but no.  Also on the subject of things not studied for correlation, it struck me as odd that whole sectors of the capital markets, like HY indices, leveraged loan indices & MBS indices that are at least as credit-driven as anything the Gropp paper studies were not examined for correlations.

A last observation on the underlying data relates to what sounds like an overstatement in regard to the period studied.  The paper covers 7 years roughly.  Recall that one of its self-described principal innovations, compared to prior analyses, is to break that period up into periods of “tranquility”, “normality” and “distress”.   While I cannot get the link to the backup data to work, so I cannot be sure of what I am about to say, I gleaned from the paper that its repeated references to “periods of financial distress” are really just references to the 2007-09 period, taken as a whole.  As I said before, that was a very noisy period with all sorts of things going on – collapses, bailouts, shotgun weddings --  that had never happened before.  And, in any event, it’s just one period!  So I wind up skeptical about the prescriptive significance of finding some correlations between HF NAV changes and a small set of financial intermediaries in a single period that was complicated by many one-time events.  I don’t see how anyone could ever determine whether this was a phenomenon capable of recurring, or just a one-time confluence of factors, or an artifact of the assumptions and choices the authors made in generating the paper.  It seems impossible to replicate the conditions of the period to test the hypothesis.. 

Often a correlation exists between two data sets because both are displaying the influence of a third variable.  For example, if Mary and Herb live in Scarsdale and work at banks in Manhattan, and Mary leaves her house every morning to catch the 7:16 from Scarsdale, and, Herb leaves his house every morning to catch the 7:34, there is a high degree of correlation between their schedules, but no causation even though Mary consistently precedes Herb.  Their schedules are determined by exogenous variables, namely the schedule people who work in the banks and take Metro North to get there have to keep. 

Here for example, the correlation between the VaR metrics for HF and IB in times of financial distress could simply show, not that one caused the other, but that both categories held assets that were more similar than they were to the portfolios of commercial banks and insurance companies.  That is, IB’s assets may have been more HF-like than CB’s or insurance companies assets were – for instance, it jumps to mind that they may have had more HY and equities as a proportion of total assets than CB’s and insurers did.  The HY part of that conjecture would help explain why the authors found the correlation greater on the downside – being a debt instrument, HY can only go up so much, so starting from a non-distress point, (which is where the Gropp study starts, in 2003, a bull year), HY tends not to provide much return beyond the coupon, while in a distress environment it can fall several multiples of the coupon.

When the authors find that negative changes in HF VaR appeared to lead changes in the VaR of a portfolio of IB equities, that could just be because the HF VaR reflects daily marking to market of the underlying assets (or the index manager’s estimation thereof), undiluted by other factors that may affect the stock prices of IB’s, such as secondary market technical factors, or the market’s evaluation of the advisory and other operating businesses of the IB’s. 

Another possibility could be that hedge funds, as they saw a broad financial deterioration sweeping the developed world, looked to hedge their exposure by finding shorts, and the hugely overleveraged balance sheets of certain brokerage firms were prime candidates, better than insurance companies or FDIC-insured banks .  They are hedge funds after all.  I know I got many calls from HF clients in 2007 asking for an explanation of how SIPC receiverships worked in reference  to a generic or hypothetical brokerage firm where they had repo’d their cash balances or otherwise had exposure from other balances. And everyone remembers David Einhorn’s very public short bet against Lehman Brothers throughout 2008.  So there was definitely worry among them about the health of some brokerage firms.  And recall that the investment banking sector of the Gropp study is only 8 firms, so it is very susceptible to one or two members of the group driving the results in a certain direction. 

All of the above seem plausible to me, yet none of the above would justify any sort of heightened regulation of HFs.  I tend to think that most HFs tend to carry less leverage than money center intermediaries do.  As always, the most appropriate financial-sector-specific regulation that needs to be in place is having enough equity capital in the system to buffer it against the level of loss that might arise from a specified level of financial distress, and to apply the capital requirements broadly throughout the financial markets so they cannot be evaded .  But again I suspect the HF universe would be broadly in compliance with the kind of capital adequacy requirements now imposed on banks and the like.  I'm not necessarily averse to the concept, as I don't work in or for HFs anymore.  All I am trying to do is use my experience to pose some hopefully intelligent questions on the topic, fwiw.

 

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[1]           In part because the authors kept much of the data crunching out of the paper itself, and in a statistical abstract, the link to which unfortunately did not work the three times I tried it.

[2]           In early 2004, I had drinks with a small group that included the number 2 guy at a well-known hedge fund that was focused on below investment grade bonds. I asked him how his fund had done in 03, and he said, proudly, “up 81%” which was incredible for the billions of AUM they had.  My next question, in all innocence, was “did you have any leverage?” and he replied, “yes, 2.7 to 1”.  When I got into the office the next day, I looked up the performance of the relevant HY index, I think it was Lehman, for 03, and, amazingly, it was exactly 30%.  Of course that was unlevered, so what that meant was the brilliant hedge fund had, as far as asset class and security selection go, been just a market performer, and its entire outperformance was due to the leverage ratio.  Of course that is only one anecdote and I have others about guys running even larger amounts of AUM in the same sector with zero leverage, fwiw (but of course they weren’t getting 81% returns).

The Solution to Detroit's Pension WoesTurns Out to be Ipse Dixit

CNBC reports that the City of Detroit has reached agreement with its retired police and firefighters on revised pension terms.  The City apparently went in, asking for 6% cuts in annual payouts and an end to cost-of-living increases.   The retirees apparently went in, asking for no concessions.  With the assistance of mediators, they seem to have settled at: no cuts, but "reduced" cost of living increases, and "As part of the deal, Detroit has reportedly agreed to increase the projected return on its pension funds to 6.75 percent, up from 6.25 percent and 6.5 percent, according to USAToday." 

Now that is definitely not a solution anyone has ever thought of before in relation to pension shortfalls -- assume investment performance will compensate for the gap between what the employer pays in and what the retirees are promised to receive.  This is really an approach that everyone should be able take to a difficult financial situation.  For example, why didn't GM or Chrysler think of it? 

Banker: "I am worried that your cash flow is not going to be enough to enable us to meet our obligations to creditors on time."
CEO: " Yeah, I can see how our forecasts might lead you to think that. Let's fix that by just assuming we sell more cars at higher prices."
Banker: "Oh, wow! I never thought of that. I can see why you deserve to be CEO."

And then the banker can employ this solution with regulators, too. 

Regulator: "I am worried that your loans to the auto companies might be impaired; I want you to establish reserves against potential losses."
Banker: "They won't be impaired if the auto companies sell more cars at higher prices than they have been forecasting."
Regulator: "Why, yes, if that happened, indeed, your loans would be sound.  Let's use that assumption going forward."

Now, it is definitely true that in reorg negotiations, one of the things that  often helps to get deals done is to acknowledge that there is room for upside over the debtor's base case, such that, if the prospective pie is perceived to  be a little bigger, there is more to move around and placate potentially objecting constituencies.  OTOH, Judge Rhodes has stated he will focus on the feasiblity of the City's reorganization plan, it will be interesting to see how much scrutiny he gives to what is ultimately an of unprovable assumption.  Because this assumption is related to feasibility and the judge has announced he will be giving close scrutiny to that issue, I don't think the agreement is reviewed by the usual, lenient, settlement standard of "lowerst level of reasonableness" which it would seem to satisfy. How certain does the city's forecast have to be for him to call the plan feasible in his opinion, and does the plan need to contain any kind of backup protection against future default? Or does he decide to bless the mediated result, after grilling the retirees' representatives over their degree of confidence in the forecast, and getting them to acknowledge that the City is no longer responsible to make up a shortfall if the forecast is not achieved.    It will be interesting to see. 

Update on April 17th: From the website of Detroit's police and fire retirement system, I pulled the following facts: as of the latest (end of 2011), calculations, there were two retirees for every active memember covered by the plan; the average annual benefit payout was over $57,000; the plan considers itself, as of March 2014, fully funded as to all retired members, but only 47% covered as to active members, but the deficiency is mainly due to payments missed during the chapter 9 case; prior to the case, the plan was almost completely funded as to all possible participants (the news reports I read on the settlement do not say whether those missed payments will be cured upon emergence, although I think that is likely; still it would appear that the active force will bear the burden of limits to the cost of living adjustments, since they will live longer than the retirees).  From the standpoint of the health of the reorganzied entity which is what should be the main focus of a reorganization, one would rather the retirees bore the brunt of any sacrifice, so that the City can offer the maximum incentives to the police and firefighters it needs to employ.  But with a 2:1 retiree-to-active ratio, that seems politically impossible.