Finance law presentation

An experiment
A broad view of finance theory, law and securities regulation.
Louis Plowden-Wardlaw, 2nd
March 2011

2nd March 2011 Finance Law Presentation "An Experiment" © Louis Plowden-Wardlaw 2011
A Short Primer in Finance for
Lawyers
The Legal
Perspective on
Financial Instruments
● Contrast the lawyer's
and the financial
professional's view of
financial instruments.
● For the lawyer:
combinations of ownership rights
(rights to underlying assets after
payments of debt) and debt obligations
(fixed financial claims upon a person,
usually with an interest element being
the “price” of money paid by the
borrower to the lender)

But it all looks so complicated.
Is that all there is?
● The complexities and acronyms used by
market professionals tend to obscure
these basic building blocks
● Another taxonomy might be ownership
or rights to future ownership, debt in
the sense of borrowing and derivatives
contracts (options and futures for
example), which are also debt in the
legal sense, but are fixed money
contract claims derived from eg
reference to an underlying debt or
ownership interest. Rights in specie such
as contracts for delivery of a cargo also
exist.
● Look at the contract, title or security to
decompose it

How does the finance professional see the same
bundles of rights, obligations and assets?
The lens through
which the same legal
entitlements and
obligations are
viewed is different
● Cashflow is what
matters.
● Ownership rights and
debt claims lead to
present or future cash
payments

How much is a future cash payment worth?
Any financial
instrument is worth
the discounted value
of the future payment
which it will give rise
to.
● How much less than
a present payment is
a future payment
worth?
● Riskiness in
calculating a discount
rate
● Alternative
investment
opportunities

What is the arithmetic of the discount rate?
£1 today is worth £1
● (where r is the
discount rate)
● £1 this day next year
is worth 1/(1+r)
● £1 the year after next
is worth 1/(1+r)²
● And so on: PV of an amount is
amount/(1+discount rate) to the
power of the period of payment
● So, at a 10% discount
rate, £1 next year =
0.909091p now.
is worth 0.826446p
● Driven by alternative
investment
opportunities

More risk = higher discount rate
A riskier proposition
needs a higher
discount rate. Say
40%
● So, at a 40% discount
rate, £1 next year =
0.714286p now.
is worth 0.510204p

A riskier proposition needs a higher
discount rate.
● So, how do we choose a discount rate for a
future cashflow?
● Start off with a riskless proposition
● This means government debt denominated in
the currency of that government, where the
government concerned is able to issue that
currency (normal fiat money – not the euro)
● This provides the risk free interest rate.
● For everything else, add a premium (ie use a
higher discount rate.)

How do we determine the risk
premium?
A bit of a science ● Use comparables
(who else has got
money on what
terms, and how risky
are they compared to
the investment
proposition in
question)

How do we determine the risk
premium? (2)
A bit of an art
● CAPM assumes,
amongst other things,
that markets are
completely efficient,
that there are no
transaction costs, that
there si frictionless
borrowing, and that
returns are normally
distributed.
● These assumptions are
not necessarily true.

But at least we know that equities
should yield more than debt
On bankruptcy,
creditors get paid first
owners last from the
underlying assets
● This is the “equity risk
premium”
● Various studies
demonstrate different
sizes for the equity
risk premium. In liquid
markets, it is
surprisingly small (2-
6%).

Choices of discount rate make
enormous differences to valuations
The scope for
differences of opinion as
to discount rate renders
the process of valuing
assets or securities
inherently uncertain.
Interest rate changes
renders even technically
“risk-free” government
bonds risky in real terms
– interest rates up, bond
prices go down.
● While the ability to
formulaically calculate
present values of
future cashflows
allows the building of
complex financial
models, lending a
satisfying air of
precision to financial
decision making, the
world is inherently
complex.

More on sovereign debt
If sovereign debt in
the sovereign's own
currency is risk free,
why should
sovereigns pay
interest?
● Investors have
alternative investment
opportunities.
● Sovereigns need to
borrow money –
public spending –
fiscal shortfalls,
external imports –
etc.
● Inflation is inevitable –
or is it?

More on sovereign debt (2)
Long term interest
rates are usually
higher than short term
ones.
● Different maturities of
government debt
allow for the
construction of an
interest rate curve.
● Banks and brokers
reprice their portfolios
and lending rates
according to
government rates

Propagation of interest rates
Different central
banks have different
mechanics (auction of
bonds, repo
operations) for
propagating interest
rates through the
economy
● But essentially, the
central bank lends
money to banks
against the security of
their assets and
therefore provides
liquidity to the
monetary system,
and banks buy and
sell government debt
to manage their
liqudity

Fundamental v relative pricing
Pricing applicable to
financial securities
methodologies can
broadly be divided
into fundamental and
relative pricing
● Fundamental pricing
optimal – assuming
one has a way of
correctly judging the
discount rate.
● Markets price
securities relative to
riskless sovereign
debt

Markets best at relative pricing
Markets are said to
be good at relative
pricing
● Mathematics of
relative pricing can be
complex. Derivations
informed by
assumptions about
fundamentals that are
often wrong
● Reference to facts
underlying cashflows
and their stability not
always so strong

Factors driving real cashflows
A lot of real world
issues drive
cashflows
● Demographics
● Consumption patterns
● Saving patterns
● Market performance
of businesses
● Supply and demand
of different asset
classes

States of the world change
Sentiment leads to
changes in market
actor behaviour
● Consumption v
saving
● Credit availability
● Trade barriers
● Pure politics – wars
and so on.
● Too complicated to
model

Dramatic corrections
Financial returns not
normally distributed;
breakdown of many
statistically based
mathematical pricing
models
● Excessive occurrence
of outlier events
● Kuznets cycles –
infrastructure 14-20
year cycles
associated with high
credit/employment

So real valuations combine
Maths and judgment
● Logical deduction
based on maths,
price and interest rate
data, efficient markets
theory
● Critiquing the maths
by concluding when
the market is
misreading
fundamental
cashflows

Critique
Judgment means
understanding when
● market agents are
forced sellers
● buyers are subject to
liquidity constraints
● Organisational
constraints compel
behaviour
● Bargaining power
dynamics take effect

Efficient markets theory
Efficient markets
theory critique
● Assumes inter alia that all
publicly available
information is factored into
the price of a security
● In practice, many think
propagation of competing
ideas amongst market
participants takes time
● Markets have many actors,
and so early adopters of
ideas with access to
capital can make money

Why investors invest
Why not just buy the
index?
● If market participants did not
believe they had superior
insights they would not invest
in individual securities – they
would just buy indices
● However unfortunately there
is no universal index
comprising all asset classes
in all currencies – so no
investor can rely on MEH to
abrogate responsibility
completely
● Choices must be made.
● Defined currency liabilities to
satisfy, masters to report to

Options
A debt contract ● A contract for the right
but not the obligation
to buy or sell
something in the
future (an asset or a
security, itself a debt
or equity interest)
● Contract itself has a
value

How to price an option
● Traditionally difficult ● Attempts to use
probabilistic cashflows
discounted to present
● Black Scholes equation
● Binomial tree - integral
problem
● Inputs – asset price;
volatility over time; time
to expiry; price of
exercise; interest rate

All financial instruments
combinations
● Only 3 things ● Debt
● Ownership
● Options
however long the
acronym, or complex
the structure, it will
decompose into these
elements

Ownership harder to value than debt
Debt is defined in
money terms – only
worry about interest
rate and
creditworthiness
● Ownership is a
complex bundle of
rights which will
ultimately result in
cashflows if things go
well
● For equities, value
now plus present
value of growth
opportunities – infinite
scope for optimism

A time capsule from late 2007
“Why Efficient Market Theory Derived Prices and Fundamental Prices May Differ
In the broadest terms, efficient market theory demands of its proponents something of an act of faith in the infallibility of markets as to pricing. Since efficient markets theory
assumes they incorporate all the available price sensitive information relating to that asset (for if they did not someone with that information would immediately, if the price was too
high, borrow the asset from someone with it for cash collateral, sell it, wait for the price to drop, rebuy it at the lower price, return it to the lender and so take the profit; and if the
price was too low, borrow cash to buy the asset, wait for the price to rise, sell it, repay the loan and so take the profit) the question is not whether prices are right, but on what set of
assumptions are they right?
Sometimes it is hard to discern the link between market prices and fundamental prices. For example, many are of the opinion that much of the world is in the middle of a property
boom, where the present value of the rental incomes that are expected from many properties is much less than the present value of the interest that one would expect to pay if one
bought the relevant property on credit. This implies that the normal relationship between rent and interest has broken down since normally one would earn a profit for borrowing
cash to buy a rental property or one would not do it. Instead one would keep the money in the bank and lend the money risklessly for a higher return, or look for another asset that
does not require painting and repairs and other payments, like a stockmarket index or a government bond. In looking for an explanation of this, arguments are made about supply
and demand and demographics to justify the world of perpetually rising prices that is required to balance the equation. This may be true, but many think it may be more that the
drivers of such prices are (a) that people have to live somewhere, a (b) there is imperfect substitution between a rented and an owned property, so (a) and (b) effectively create forced
buyers, (c) banks are keen to inflate their balance sheets by offering cheap money on collateralised loans and are driven by their stockholders to increase market share and assets
rather than conduct fundamental analysis of their customers, (d) there are tax incentives to buy this asset class (for example
in the US deductibility of interest from income, in the UK tax free capital gains) and (e) there is no other way for private individuals to take substantial geared bets on a generally
prosperous economy, and the fact that they all take it at once leads to some self-fulfillment, unless and until the perpetually rising prices part of the equation becomes hard to believe
in due to a period of price stagnation or interest rate rises or a raising of lending criteria reverse the whole process.
Such apparently aberrational pricing offers an opportunity to the person who wishes to put their or their institution’s money behind their view. Many financial instruments are
designed to allow people to take a view cheaply; for example the person with the view that the property market is overheated might look for a supplier of a property company which
they could short sell, or buy put options for property stocks. In either case, they would buy the instrument at the current market price on the hope that it would change as more people
came to share their view and underlying asset prices adjusted to reflect that view.
Stock prices and trends in interest rate movements can develop similar mechanics in the institutional market.“

What's changed?
Limited reversion to fundamentals
● Why limited?
– Extreme uncertainties
– Inputs eg price of oil
– Outputs eg savings and consumption rates
● But most importantly
We saw earlier that the bankruptcy waterfall was
the key determinant of pricing as between debt and
equity; bank rescues (and motor car companies and
who knows what else) subverted bankruptcy law

Pricing now has a much larger
political element
● Banks comprise a
unique part of the
economy
They:
● Disintermediate risky
investment decisions
between capital
owners and users
● Deal in non tradeable
loan assets
● Engage in maturity
transformation
● Create money

Bank rescues
● An ongoing task
● Why couldn't they be
left to fail?
Ongoing taxpayer guarantee
– how should it be priced and
paid for
● Equity shored up
● Replacement of interbank
lending
● Tardy and confused
regulatory response
● See HM Treasury paper Feb
2011 “A new approach to
financial regulation:
building a stronger
system”

Whatever happened to mutuals?
Wave of
demutualisation in
90's
● What did savers and
borrowers gain and
lose?
● Approx 0.5% advantage
on savings and
borrowings – NPV's
down to about the
demutualisation benefit
● But arguably left lending
and deposit ecosystem
much poorer

Crisis fatigue
CDO's, investment
banks, AIG, Greece,
Iceland, Ireland, PIGS
in general, bankers
remuneration etc etc
● Calls for a regulatory
response quieting but
won't go away
● What should it be?

Key issues
A number of ideas
which happily lived
between the pages of
finance textbooks are
now on the front
pages
● Agency issues
● Assymetric
information
● Moral hazard
● The virtues and
hazards of
securitisation
● Structured bonds of
one sort or another

What is money?
● Unit of account
● The units in which
corporate accounts
are reported and
wages bargained
● A store of value
● Repository of social
trust
● Fiat money v
commodity money
● The bank multiplier
effect
● That which is
accepted for payment
of taxes
● Clearing of credits
and debits more
important than tokens

The traditional story
“What is money and where did it come from?
We all know the traditional answers to these questions. Our homogenous-globule-of-
desire forefathers were inconvenienced by barter until they spontaneously hit upon the
idea of using tobacco, furs, huge rocks, landmarks, and wives as media of exchange.
Over time, greater efficiency was obtained as homo economicus coined precious metals,
and market efficiency was enhanced by free banks, which substituted paper money
backed by precious metal reserves. All would have been fine and dandy except that evil
governments came along, monopolizing the mints, creating central banks that debased
the currency, and interfering with the invisible hand of the market. This finally resulted in
abandonment of commodity money, substitution of a fiat money, and central bank-induced
inflation. If only we could return to that Peter Pan and the Lost Boys, Never-Never
(Laissez-Faire) Land, free of Captain Hook and the Crocodile (Central Bank and
Government), with privately supplied free bank money greasing the mighty wheels of
entrepreneurial commerce!” Wray, L. R. Modern Money (1998)
Wray, a post-Keynesian advocate of government as employer of last resort goes on to
look at the history of money to conclude that the barter => valuable token or commodity
based standard => fiat money is erroneous.

Conflicting ideas of monetary policy
● Fiscal prudence
● Public spending as a
balance of tax and
borrowing
● Monetarism (Friedman) v
intervention (Keynes)
● NAIRU (Non-
Accelerating Inflation
Rate of Unemployment)
● Central banks target
inflation not money
quantity
● Print money to prevent
people being idle and a
stalled economy
● Danger of inflation and
devaluation of currency
● To whom does this
matter (savers v
borrowers, exporters v
importers)
● Demographics and
pensions

The euro – risky sovereign debt
Treaty of Maastricht
7/2/92
● Euro into being
1/1/99, 1/1/02
physical predecessor
currencies phased
out
● A lot about how to get
in, application of lex
monetae (how old
debts in predecessor
currencies are dealt
with in successor
currency)
● Silent about how to
get out
● Euro countries have
lost monetary policy
tools

Euro not an optimal currency area
Economists have a
concept of the sorts
of shared
characteristics
geographies should
have to share a
currency
productivity, inflation,
deficits as % of GDP
● Euro imposed rules
on countries entering
– largely ignored or
fudged
● Consequences now
being experienced
● No way out without
political difficulty

Capital markets v banks
Different
characteristics
● Capital markets
(bonds/equities) –
tradeable, liquid, low
transactions cost, low
information
● Banks – specialise
traditionally in non-
tradeable loans, where
they have high
relationship information
● Except recent
adventures with mass
securitisation (from 80's)

Pre-2008 truisms that aren't
Prior to the credit
crisis, finance theory
was a strong idea in
terms of core ideas
such as market
efficiency and value
of relative pricing
● It used to be the case
that, on the security of
property, individuals
could borrow at almost
capital market rates with
negligible capital (5%
down, LIBOR +1)
● Now 25%-30% down,
relationship between
base, LIBOR and
consumer borrowing
unpredictable

But some things are timeless
There are no free lunches

Back to the law
Finance is a creature
of law
●
The 19th
Century
innovation of Limited
liability gives rise to
agency issues
● Money is what the state
says it is
● Taxes need money to pay
them
● A financed state juggles
private and public
demands with laws
● Finance is not in a vacuum

Finance law
Only works as a
whole package
● Companies permit
minutely divided
ownership
● Effectiveness of
division of the
enterprise cashflow
requires strong
minority protection
and management
probity, related party
rules etc

Black letter law useless without
institutional pillars
Matters such as
minority protection
and debt enforcement
are technical and
hard to enforce, and
require commercial
courts of merit
● Back to pillars of
constitutional law,
separation of
legislature, executive
and judiciary, or
abuse will surely
follow

Offshore
Nicholas Shaxson –
Treasure Islands
2011
● Attacks the offshore
industry as a harbour of
emerging economy elite
money derived from
capital and syndicated
lending and development
budgets and resource
drain.
● Hollowing out of tax base
● Has the corporate veil
gone too far?

Cartelisation of states
Need for fiscal
escape routes
● Or what will keep the state
honest?
● What proportion of the
world lives somewhere
where the state can be
trusted
● Value of private enterprise
● Dangers of overreaction
● Pain of trimming back the
state

Financial regulation
Systemic risk ● Who poses a
systemic risk?
● Banks?
● Hedge funds?
● Particular contracts?
● AIFM – leverage
controls

Dangers of Reversion to law by
prerogative
Russia as a case in
point
● Khodorkovsky and
Yukos
● Browder, Magnitsky
and Hermitage
● Tax and penal codes
bent to pursue policy
● The dual state –
prerogative and
administrative law
side by side

Contracts as plumbing for money
● Finance lawyers write
the debt and equity
relationships that
make money flow
● Helpful if one
understands the
framework
● Only works at all
within an institutional
framework
● Fundamental legal
principles and
concepts are key to
workability and
stability

China v Russia
● Gradualism
● Human rights
● Apparently
succeeding
● But failure to grow
domestic demand
● Banks very opaque
● Not terribly open
● Big bang
● Human rights
● Struggling – reserves
versus required
investment
● The natural resource
curse
● Arch games players

International demographics and
environmental pressures
Overwhelming youth
in presently unstable
Middle Eastern
countries
Price of bread a key
feature of discontent
● Harbinger of future
causes of instability?

Egypt 2011

Don't cry havoc
● Again, things are complicated and over
apocalyptic scenarios are unhelpful
● However, there are severe managerial issues in
resource allocation and distribution
compounded by confusion in what underlying
outcomes are desirable.
● A steady grip on finance and law
interrelationships will be required to solve these
issues in ways that have acceptable human and
environmental outcomes.

More experiments needed
Questions
● Unfortunately cannot be
conducted in a laboratory
● What regulatory structure
is best? One size fits all?
● Rein in or let rip?
● Inflate or not?
● Policy expressed in law
and institutions

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