Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma

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Tue, 21 Apr 2009

Away on vacation

I am away on vacation for about six weeks. I will not be posting on my blog till mid-June. Comments on my blog during this period will also be moderated only after I come back.

Posted at 12:13 on Tue, 21 Apr 2009     View/Post Comments (4)     permanent link

Mon, 13 Apr 2009

Satyam sale and the walk away option

Now that the government appointed Board of Satyam has sold a controlling stake to Tech Mahindra, it is useful to examine how the implicit walk away option can prove so damaging to the current Satyam shareholders and how it can be hugely beneficial to Tech Mahindra. This analysis confirms what I have been arguing for some time now: the decision to sell a partial controlling stake instead of selling the whole company was not in the interests of the shareholders.

The implied valuation of probably less than six months revenues for the transaction is quite low except for the unknown liabilities of the company in several US class action law suits. It is these unknown liabilities that make the walk away option hugely valuable. What makes walk away feasible is the fact that Satyam’s value is not in the form of tangible assets, but largely in the form of its customers and employees.

Over a period of two to three years, Tech Mahindra which is itself in the same industry could transfer the entire Satyam business to itself. This could be done as new contracts are signed or existing contracts are renewed. Over the same time frame, the employees of Satyam could also be shifted to the Tech Mahindra payroll. Once this process is complete, Satyam would have some cash and other assets and potentially huge liabilities.

The walk away option is that if the liabilities turn out to be larger than the cash and other assets, Tech Mahindra can walk away and put Satyam into bankruptcy. If the liabilities turn out to be small, then Tech Mahindra can merge Satyam into itself and absorb the surplus assets. Option pricing theory teaches us that the more the uncertainty (volatility) the greater the value of this walk away option. Since the uncertainty today is huge, the option is hugely valuable.

The fact there were (as some people put it) only two and a half bids for Satyam suggests that a number of potential bidders who thought that they would never exercise the walk away option (for reputational or other reasons) chose not to bid at all. Without the walk away option, the risks were simply too high.

There are two other reasons why Tech Mahindra would prefer to transfer the Satyam business to itself. First, it owns only 51% of Satyam and therefore earns only 51% of the revenues of Satyam. If the contract is renewed with the parent company itself, it gets 100% of the revenues. Second, Satyam commands a low valuation in terms of price-revenue multiples (less than 0.5 at the bid price) while Tech Mahindra commands a higher valuation (about 1.0). Moreover with the Satyam acquisition, Tech Mahindra would try to position itself in the league of the top tier software companies which command multiples of about twice revenues.

Even if we consider a price to revenue multiple of 1 for the parent and 0.5 for the subsidiary, a dollar of revenues at the parent adds a dollar to the market capitalization, while a dollar of revenue at the subsidiary adds only 0.25 to the parent’s market capitalization. The financial motivation for shifting business to the parent are very high even without the walk away option.

What this means is that while today’s sale is great for the employees and customers of Satyam and for the Indian software industry, it is not so great for the shareholders. They get very little money now (except for the 20% open offer) and might find after three years that they own shares in a shell company that has little or no value.

The shareholders would certainly have preferred a sale of 100% of the company that gives them cash now.

Posted at 12:00 on Mon, 13 Apr 2009     View/Post Comments (10)     permanent link

Tue, 07 Apr 2009

Lessons from Overend Gurney after 150 years

In 1866, the then privately owned Bank of England allowed the largest discount house in the world, Overend and Gurney to fail. In its time, Overend and Gurney was clearly far more systemically important in world finance than Lehman was when it failed. It was not the Lehman of its day, not even the Goldman, but something bigger. It was second only to the Bank of England itself. Its discount business was probably equal to the other big three discount houses (Alexander, Bruce Buxton and Sanderson) put together (W. T. C. King, “The Extent of the London Discount Market in the Middle of the Nineteenth Century” Economica, New Series, Vol. 2, No. 7 (Aug., 1935), pp. 321-326). Milne and Wood (“Banking Crisis Solutions Old and New”, Federal Reserve Bank of St. Louis Review, September/October 2008, 90(5), pp. 517-30) give an even bigger estimate: “its annual turnover of bills of exchange was equal in value to about half the national debt, and its balance sheet was ten times the size of the next-largest bank.”

Its failure caused a panic which used to be described (until the current crisis) as the last true panic in London. In the long run, however, the financial system was hugely strengthened by the decision not to create moral hazard by bailing out the insolvent Overend and Gurney in 1866.

I would like to end with quotes from two well known Austrian economists. First from Israel Kirzner: “every mistake made in the market by one entrepreneur represents an opportunity for another.” Second from Ludwig Von Mises “Those fighting for free enterprise and free competition do not defend the interests of those rich today. They want a free hand left to unknown men who will be the entrepreneurs of tomorrow.” The regulatory mistake of the last decade or more has been defending the interests of those rich today; this is a mistake that continues today with all the bail outs that we are seeing.

Posted at 05:25 on Tue, 07 Apr 2009     View/Post Comments (3)     permanent link

Wed, 01 Apr 2009

Do not blame the efficient market hypothesis

I have a piece in today’s Financial Express arguing that we should not blame the Efficient Market Hypothesis (EMH) for the current crisis. I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously.

In the run up to the G20 summit, several global regulators have put out blueprints for reforming global financial regulation – apart from the Turner review in the UK, we have had proposals by the US Treasury, the People’s Bank of China, former Fed Chairman, Alan Greenspan and several academics and practitioners.

Several of these proposals make eminent sense: greater capital requirements for banks and near banks; orderly bankruptcy process for systemically important financial institutions; more robust regulation and supervision.

The emerging consensus is however wrong in asserting that mistakes in financial regulation were caused by the belief in the Efficient Market Hypothesis (EMH). The Turner review says for example that: “The predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational.... In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism.”

I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously. Had they done so, regulators would not have been as complacent as they were during the last decade. The EMH very simply states that there is no free lunch; whenever you see an abnormally high return, EMH warns us that there must be an abnormally high risk lurking behind it.

For example, an EMH believer would not have invested in a Madoff fund because according to the EMH, Madoff style returns are not possible. In fact, critics say that an EMH fanatic would not pick up a hundred rupee note from the road because according to the EMH, that note cannot be there – either the note is fake or somebody must already have picked it up. Yes, EMH can make you miss some investment opportunities, but it will also protect you from hidden and unknown risks.

What would the EMH have told Greenspan when he saw the profits of the financial sector rise from 15-20% of total corporate profits in the 1970s and 1980s to over 40% in the last decade? EMH would have told him that there are only two possibilities: either financial institutions were becoming impregnable monopolies or they were taking incredibly high risk. The former hypothesis could be easily ruled out because financial deregulation was making the financial sector highly competitive particularly when one considered competition from the shadow financial system and from foreign players. If Greenspan actually believed in the EMH, he should have been very very worried.

When banks tried to make money with “arbitrage CDOs” by tranching pools of securities in different ways, the EMH would have argued that the value of a pie does not depend on how it is cut. Investors and regulators who believed in the EMH would have been sceptical of some of those AAA ratings.

Again, when banks increased their leverage ratios to absurdly high levels, a regulator who believed in the Modigliani-Miller (MM) theory of capital structure would have mulled over Miller’s own words (way back in 1995): “An essential message of the MM Propositions as applied to banking, in sum is that you cannot hope to lever up a sow’s ear into a silk purse. You may think you can during the good times; but you’ll give it all back and more when the bad times roll around.”

The MM theory implies that banks seek higher leverage mainly to exploit the subsidy provided to them in the form of deposit insurance and lender of last resort. Greater capital requirements for banks do not therefore have a significant social cost though they are costly to the shareholders and managers of the banks.

As Nouriel Roubini points out: “people are greedy in every industry, people in every industry try to avoid regulation sometimes with lies, sometimes by cheating or avoiding, whatever. But there’s only one industry, the financial industry, in which this thing leads, over and over again, to financial crisis. It happens for two reasons. One because banks have deposit insurance and deposit guarantees.... Two, we have lender of last resort support”.

The point is that regulators who believed in the EMH and the MM theory would have regulated banks far more tightly. Alan Greenspan claims that prior to 2007, the central premise was that “the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency.” Sorry, the EMH says no such thing. In fact, the theory says that if owners and managers can keep the profits and pass on losses to the taxpayers, they would be selfish enough to avoid keeping a sufficient buffer. The EMH would have disabused Greenspan and other regulators of the naïve assumption that bankers could be trusted.

Posted at 05:34 on Wed, 01 Apr 2009     View/Post Comments (11)     permanent link