The government and banks can share in any upside.
Tag Archives: Wall Street Journal
There’s a Better Way to Prevent ‘Bear Raids’ [The Wall Street Journal]
The SEC should restore the uptick rule.
How to Unfreeze Bank Lending [The Wall Street Journal]
The government should guarantee interbank activity.
How to Revive Securitization Markets [Wall Street Journal]
Most markets for securitized debt have dried up. The cause is uncertainty: Since no one knows exactly who owns the potential losses from securitized mortgages, many investors stay away. When the Securities and Exchange Commission Advisory Committee on Improving Financial Reporting meets on Friday, it can take a big step toward reviving this critical part of our financial market. It should recommend that the regulators require someone to “own” the securitization process as well as require more disclosures about who will bear the losses from the assets underlying these securities.
Here is how securitization works (or used to work). A bank creates a trust, which acquires long-term subprime and other mortgages with money borrowed by the trust issuing short-term commercial paper. This paper must be resold every 60 or 90 days to take advantage of the lower interest rates on very short maturities. However, since the trust’s assets and liabilities remain off the sponsoring bank’s balance sheet, they are relatively opaque.
Bank sponsors could keep these trusts off their balance sheets as a result of certain accounting rules that emerged after the Enron fiasco. When Enron set up off-balance sheet trusts in the 1990s, it followed the accounting rules of the time by purporting to have an independent investor hold at least 3% of the voting equity. Critics claimed that the company violated the 3% rule; they also argued that independent investors should have larger stakes in the trusts to assure that they were not controlled by their sponsors.
In response, the Financial Accounting Standards Board (FASB) introduced new rules for enabling a trust sponsor to keep the trust off its balance sheet. Unfortunately those rules set the stage for today’s liquidity crisis.
Under the new FASB rules, you looked first at whether any investor held 10% or more of the trust’s voting equity. If so, the trust had to be placed on the balance sheet of the investor, if any, with voting control of the trust. But almost every type of trust used in the subprime crisis – e.g., SIVs and conduits – made sure that no one ever held more than 2% of the trust’s voting equity.
Next you looked at what party held the majority of the trust’s risks and rewards, to see if that party had to put the trust on its balance sheet. But the risks and rewards of these trusts were widely dispersed. And so, the trust appeared on no one’s balance sheet.
Nevertheless, under FASB’s revised rules, the bank sponsors were supposed to disclose any “significant” interests they had in these trusts, including formal or informal obligations to buy up the short-term commercial paper if it could not be remarketed every 60 or 90 days. These disclosures were thin until November of 2007 when HSBC became the first large bank to take on its balance sheet billions of dollars of troubled trust assets and associated liabilities.
In limiting their disclosures, the sponsoring banks made judgments that their remarketing obligations were contingencies unlikely to be drawn upon. The trusts were also viewed as low-risk investments by the rating agencies, which were paid by the sponsoring banks to issue AAA ratings to the senior securities sold by the trusts. Neither the banks nor the rating agencies fully appreciated the vulnerability to liquidity risks inherent in a trust with a mismatch between long-term assets and short-term liabilities.
So what should be done? First, FASB should again revise its rules to allow a sponsor to keep a trust off its balance sheet only if an independent party has sufficient voting equity to fund the trust’s normal operations – presumptively at least 10% – and that party has a substantial role in the governance of the trust.
Second, this large holder of the trust’s voting equity should have the right to select a rating agency for the trust and negotiate a fee arrangement with the agency. The rating process needs to be driven by an investor with a significant stake in an accurate rating, not the sponsor marketing the trust.
Third, the FASB and the SEC should be more specific about the disclosure requirements of trust sponsors with formal or informal obligations to buy up the trust’s unsold debt securities, especially if the long-term assets of the trust are mismatched with its short-term liabilities. The sponsor should disclose the nature of such obligations, as well as the size, quality and geographic concentration of trust assets. If there is more than a reasonable possibility of consolidating the trust over the next year, the sponsor should also disclose the financial impact of a possible consolidation.
The market for securitized assets can revive if trust sponsors make these disclosures and an independent holder of substantial trust equity is given some governance powers. Under these conditions, FASB can safely continue to allow bank sponsors to keep the trusts off their balance sheets – a necessary step lest we go back entirely to banks holding mortgages to maturity and lose the increased funding available for home purchases generated by the securitization process.
Mr. Pozen is chairman of MFS Investment Management.
Target-Proof Your Company [Wall Street Journal]
The increasing number of buyouts of public companies by private equity — 202 this year (so far) from 35 in 1997 — is putting more pressure on corporate boards to enhance shareholder value. Although private equity funds are currently on hold because of the credit crisis, they are very large and will return to action. During the hiatus, public companies should improve their performance and avoid being a future target by taking a few pages out of the private equity play book.
Of course, some private equity deals have succeeded because of excess leverage, quick flips or onerous fees. However, several careful studies, including research published in the McKinsey Quarterly in 2005, have shown that the majority of companies acquired by private equity funds have outperformed thanks to substantially improved operations and better designed incentives.
A broad analysis of this outperformance reveals five key factors. While some may be unique to the privately held company, public directors should ask the following five questions, and consider the extent to which they can apply the answers to their particular company:
- Is there too much cash on the balance sheet? Firms acquired by private equity keep idle cash to a minimum. Yet there is a record amount of cash sitting on the books of public companies in the S&P 500 — $2.7 trillion in 2006 versus less than $900 billion in 1996. Is this cash hoard larger than needed as a safety cushion, or to finance merger “synergies” that may not materialize? While a share buyback can make sense in specific circumstances, raising a cash dividend is a much more reliable way to increase shareholder value. Citigroup research shows that stocks in the top quintile for dividend growth have on average outperformed those in the bottom quintile for dividend growth by 12.6% per year since 1990.
- Is the capital structure optimal? Private equity funds are well-known for increasing debt and reducing equity in companies they acquire. Historically, public companies have resisted adding leverage for fear it would damage their credit rating and lower their stock price. But the impact of a lower credit rating on a company’s market multiple (the price of a share of stock divided by its earnings per share) has shrunk sharply over the past five years. In 2001, companies rated A- or higher had market multiples of 22.6 and companies rated BBB had a market multiple of 17.0. As of 2006, the corresponding multiples were 17.4 and 17.3, respectively.
- Does the operating plan significantly increase shareholder value? In a 2005 study of 100 businesses owned by private equity in Europe, Ernst & Young calculated that the value of these businesses grew at twice the average annual rate achieved by public companies in the same country and the same sector. Why? According to the report, “Making long term improvements in the profit growth and value of businesses does not come from cost cutting or financial engineering. It comes from focused investment, making the few key changes happen fast, and the benefit of shared incentives of investors and management.” Some of these practices could be adopted to capture gains for public shareholders, with the right incentives for public company executives and directors.
- Is executive compensation tied closely enough to shareholder value? A relatively small group of senior executives at companies owned by private equity have much larger equity stakes than those in public companies. However, these senior executives will not actually receive any rewards unless the private equity fund owning the company actually realizes a substantial gain. Private equity funds also do not allow top executives to leave with large exit packages despite poor performance.
- Do directors devote enough time and have enough incentive to increase shareholder value? Private equity boards tend to be smaller, with a greater number of retired industry experts putting in more time on average than public boards. They deserve a much higher level of compensation — but not through annual fees. Directors of private equity companies hold substantial equity in them, and share in the performance fees of the private equity funds — typically, 20%-30% of the returns realized by these funds.
Such small boards may be particularly effective in smaller public companies, which have trouble recruiting outside directors. Large public companies could learn a lot by creating internal SWAT teams, who would play the hypothetical role of a private equity fund taking over the company. In either case, public directors would do well to pre-emptively apply some of the lessons of private equity now before the next deal cycle.
Mr. Pozen is chairman of MFS Investment Management. This op-ed is adapted from “What Public Companies Can Learn From Private Equity,” in the November 2007 Harvard Business Review.
Insuring China’s Future [Wall Street Journal]
The Senate Banking Committee just approved a tighter definition of currency “manipulation” and the Finance Committee recently increased the penalties for alleged currency manipulators. While both committees are trying to reduce the large U.S. trade deficit with China, it would be more fruitful to examine the reluctance of Chinese consumers to buy imported goods and services. They understandably have deep concerns about their country’s weak social safety net. And without adequate retirement security or catastrophic medical insurance, rational Chinese consumers will continue to be aggressive savers and reluctant spenders.
In response, the National People’s Congress is about to consider a major overhaul of China’s social insurance laws: This presents a unique opportunity to put China’s social security system on sound financial footing. But the NPC will have to overcome two formidable barriers — the financial drag of legacy pensions from the pre-1997 economy and the local administration of a pension system for an increasingly national workforce.
In the communist era of the “iron rice bowl,” state-owned enterprises regularly promised pensions to workers, who made no pension contributions. In 1997, as China moved toward a market-oriented economy, it adopted a two-tiered payroll tax to finance social security (primarily in urban areas). Employers now should contribute 20% of wages to support a defined retirement benefit. Employees also are now required to contribute 8% of a worker’s wages to a personal account, with a variable retirement benefit based on investment returns.
The responsibility for paying social security benefits rests with local governments — provinces, cities or townships — which also collect the payroll taxes. Unfortunately, these local governments are using much of the employers’ 20% payroll taxes to pay pre-1997 legacy pensions to workers who never made any contributions.
Many local governments have even paid legacy benefits with some or all of the 8% in payroll taxes contributed by workers, which are supposed to be invested in personal accounts. Despite recent pilot programs by the national government in several provinces, a substantial portion of these personal accounts are not funded with actual investments — they are “notional” accounts with only paper credits. If these personal accounts remain “empty” until participating workers reach retirement, the result will be a new set of large, unfunded liabilities for local governments.
The solution is to pre-fund retirement benefits by holding the contributions in separate trusts and investing them. This would avoid the huge unfunded liabilities of pay-as-you-go social security systems, like those in the U.S. and Europe, where the number of active workers supporting each retiree is declining. China will face a particularly steep decline because the government is holding down population growth through its one-child-per-family policy.
Researchers Yaohui Zhao of Peking University and Jianguo Xu of Duke University have estimated that China could reduce the employer portion of its payroll tax to below 16% if it pre-funded the social security system. Such a reduction would broaden the participation of Chinese employers in the system. Right now, faced with a 20% payroll tax on top of other employment-based taxes — which together exceed 60% of payroll — only half of China’s urban employers make social security contributions. The system is virtually non-existent in rural China.
The present system, which uses current payroll taxes to pay legacy pension benefits, also undermines China’s heightened efforts to crack down on corruption. If local officials do not have to deposit all taxes in a separate trust, some will be tempted to divert the money for personal gain. Chinese prosecutors recently brought criminal actions against two senior officials in Shanghai for allegedly diverting pension funds to corrupt entrepreneurs.
To facilitate pre-funding, the NPC should shift the responsibility for paying legacy pensions to the national government. To finance legacy pensions, the national government could allocate a modest portion of its $1.3 trillion in reserves to the national social security fund. This fund already invests the proceeds from certain privatizations of state-owned enterprises to help local governments defray their pension obligations. In return, the NPC should insist that social security become a national system. Provincial officials are pushing hard to become the consolidators of social security for local governments because of the significant economic and demographic differences among regions. However, provincial officials in China are not well positioned to invest payroll taxes in diversified portfolios. More fundamentally, as workers move in response to changing employment demands in different regions, they need benefits that are easily portable and financially secure.
With social insurance legislation on the table, now is the time for the NPC to negotiate the grand bargain — relieving local governments of legacy pension obligations if they cede social security to the national government, and persuading the national government to invest all payroll taxes in trusts or other accounts dedicated to pre-funding the social security system.
Mr. Pozen is chairman of MFS Investment Management.
The SEC’s Fuzzy Math [Wall Street Journal]
Almost 10% of U.S. public companies announced a record 1,420 financial restatements in 2006. It was a record — but continues an accelerating trend of financial restatements, from 2% in 2000 and more than 4% in 2004.
These restatements impose large costs on the capital markets. The GAO estimated that, between July 2002 and September 2005, the market capitalizations of restating companies decreased by a total of $36 billion in the days immediately following the initial restatement. Two academic studies have shown that stock prices decline not only for the restating firm but also for its direct competitors — presumably because of fears about the financials of the whole industry. More broadly, as the SEC has noted: “Restating financial statements of prior periods may dilute public confidence in financial statements and may confuse those who use them.”
The initial spurt of restatements during 2002 to 2004 was related partly to the more intensive reviews of internal controls mandated by Section 404 of the Sarbanes-Oxley Act. However, Sarbox is not the main problem. From 2005 to 2006, there was a 14% decrease in the number of financial restatements by the larger public companies required to perform internal control reviews under Section 404, according to a Glass Lewis study. Yet for the same period, that study found a 40% increase in the number of financial restatements by smaller public companies not yet required to implement Section 404.
The main problem is that many public companies are being forced to restate their financials for technical accounting reasons of dubious significance to investors. On March 12, 2007, for example, a Nasdaq company called Isle of Capri Casinos announced a delay in filing its SEC reports to complete the restatement of its financials for the prior three years because of adjustments to the amortization of its space leases.
Yet, Standard & Poor’s concluded that “we do not believe the issue causing the restatement and the filing delay to be material.” No wonder ordinary investors are confused: how should they react to a financial restatement caused by an accounting adjustment to a non-cash item, which is declared immaterial by an expert firm?
To be sure, some financial restatements are certainly justified, most importantly those resulting from the negligent or intentional misapplication of well-established accounting standards. Nevertheless, others are the result of significant reinterpretations of complex accounting standards that could not realistically have been foreseen by company executives.
While such reinterpretations may be an appropriate response to changing markets or new accounting perspectives, they should be adopted only with advance notice by the regulators together with an opportunity for public comment. Moreover, significant reinterpretations of accounting standards should be applied prospectively, not retroactively, to reduce the number of unnecessary financial restatements that damage companies and confuse investors.
The adoption and amendment of U.S. accounting standards occurs through a formal process led by the Financial Accounting Standards Board. This process, which often takes several years, involves the promulgation of a detailed draft, a lengthy period for public comment and careful decision-making by a board of distinguished members. By contrast, significant changes in interpreting existing accounting standards have episodically been announced through speeches or informal communications by the SEC staff — without any advance notice or public comment.
For example: A speech by the SEC’s Chief Accountant, followed by a letter in February of 2005, articulated a significant reinterpretation of the accounting standard for leases. This speech led to a wave of financial restatements by retailers, restaurant chains and other companies with a substantial amount of leased space. Indeed, revisions to lease accounting were the most frequent cause of financial restatements in 2005. Then, all these companies were cited by their auditors for material weaknesses in their internal control systems — because the companies had not previously applied this new perspective on lease accounting.
In 2006, the SEC settled an enforcement case with Fannie Mae based on its misapplication of FAS 133, a standard requiring companies to recognize quarterly changes in the value of derivatives used for hedging. Although Fannie Mae had undoubtedly committed material violations of FAS 133, this standard is so lengthy and complex that there is much debate about its application in many situations.
In settling with Fannie Mae, the SEC included a few sentences about its views on the proper interpretation of certain aspects of FAS 133. This precipitated a round of restatements at other financial institutions.
Over the last decade, the SEC has unilaterally imposed significant reinterpretations of accounting standards by issuing Staff Accounting Bulletins (SABs). Most dramatically, SAB 99 changed the widely accepted practice that the materiality of an accounting error should be judged by a quantitative test — i.e., whether the impact of the error exceeds 5% of a company’s net income for the relevant period.
According to SAB 99, even quantitatively immaterial accounting errors should be considered material — and therefore would require a restatement — if they had certain qualitative effects (e.g., they would allow the company to meet analyst earnings consensus or avoid a debt covenant violation). This change alone has led to hundreds of more financial restatements, as explained to me by a former head of the SEC’s enforcement division: “I couldn’t believe that the staff replaced years of accounting cases based on the objective 5% test with a subjective approach that had no clear boundaries.”
Everyone agrees that financial restatements are necessary to correct errors in applying established accounting standards where the results are material to investors. However, the recent flood of financial restatements includes many that are not actually material to investors, or that flow from new interpretations of existing accounting standards.
Two changes need to be made to restrain this latter category. The SEC should accept the 5% net income test for the materiality of accounting errors. And it should follow the procedures for rulemaking in the Administrative Procedure Act — including advance notice and opportunity for comment — before introducing a significant reinterpretation of any accounting standard.
Mr. Pozen is chairman of MFS Investment Management.