The Sovereign Ceiling

Let's say you're a well run company with a low debt to capital ratio and a high interest coverage ratio. Your bondholders sleep soundly at night, knowing that their principal and interest is coming back to them. However, you happen to be located in a country that is not known for its fiscal conservatism, such as Argentina. If your home country is only rated BBB by S&P/Moody's, what's the best rating your company can hope for?

The sovereign ceiling says that the private sector should not be able to borrow on better terms than the government, since the government has the most senior claims on the firm's earnings (priority ahead of both debt and equity). If the government runs into economic trouble, it may be more likely to expropriate assets. Additionally, the government's problems may reflect broader economic issues that will also impact the firm. Therefore, lenders should not offer better terms to a private company than they would to its host country. The country's credit rating is a cap on all firms' credit ratings.

A graphical representation of the federal budget

April 15 has come and gone, but that's no reason not to look at where all those tax dollars go (and all those Treasuries we sell). WallStats has created an image that does exactly that. Click on the image below to expand (it's quite large), or use the previous link for an interactive graphic.

The foreign profits tax "loophole"

Since it is April 15...Much political hay has been made about the supposed "loophole" that allows companies to defer US taxation on profits earned overseas until those profits are repatriated. Is this really a loophole, or is it simply consistent with how most profits on investments are treated? Consider the following.

Scenario 1: You're an individual investor and who buys a share of stock in Toyota in January for $100. Over the course of the year, the company earns $5/share in pre-tax profit. They pay corporate taxes of 20% on their earnings, so your share of the after-tax profit is $4. The local government collects $1/share in tax revenue. The company pays no dividend and reinvests those $4 profits into developing new products, hiring workers, expanding factories, etc. At the end of the year, your share is now worth $104. You haven't sold your share, so your profits are unrealized, and the tax you owe is $0, because although your investment is worth more on paper, you haven't actually received any cash. You have deferred your tax burden until you either sell the shares or receive a dividend.

Scenario 2: You're a corporation who buys a small company that owns several companies in Estonia for $100 million. Over the course of the year, the subsidiary earns $5 million in pre-tax profit. They pay corporate taxes of 20% on their earnings, so your share of the after-tax profit is $4 million. The local government collects $1 million in tax revenue. The company pays no dividend back to the US and reinvests the $4 million profit into developing new products, hiring workers, expanding factories, etc. At the end of the year, your investment is now worth $104 million. Your company in the US hasn't received any cash or profits and under the current system you wouldn't owe any additional tax on top of what the subsidiary already paid the local government.

However, if the tax laws were changed to make foreign income taxable, you would have to immediately pay US taxes on the entire $5 million, even though the parent corporation never received any cash from the foreign subsidiary - all the cash and profits were either paid in the first round of local taxation or reinvested in growing the company.

This is a highly simplified example. Obviously there is a distinction between normal foreign earned profits and truly abusive tax shelters in some countries that should be eliminated. But this example shows that foreign earned profits are not much different than profits earned on other similar investments. So is it equitable to treat them differently? Investors who have a 401k or IRA also take advantage of tax deferral - is that a "loophole"?

This paper talks about the impact of collateral levels on the economy, not just interest rates. I particularly like this quote:

"Over 400 years ago Shakespeare explained that to take out a loan one had to negotiate both the interest rate and the collateral level. It is clear which of the two Shakespeare thought was the more important. Who can remember the interest rate Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed on as collateral. The upshot of the play, moreover, is that the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral level. The Fed too should sometimes decree different collateral levels."

Risk Management

Bling & your computer's input devices

If you've been watching late night TV commercials, or the afternoon fare on CNBC, you're probably convinced that this is the right time to invest in gold. Inflation is bound to return at some point. But how do you advertise your goldbug proclivities to friends and coworkers without actually spending $900/oz? The gold bullion wireless mouse is just what you need. It contains no actual gold, and can be purchased for around $35.

Divergence: Job losses and time to recovery

From a WSJ article on the job market. The interesting thing is at the bottom of the chart - the divergence between the percentage of jobs lost from peak to trough versus the number of months it took to recover post-recession. Until the most recent downturn, there is a clear trend of job losses becoming less and less severe (the great moderation?), going from 7.9% to 1.2%. In spite of this, the time to recovery shows the opposite trend, increasing from 18 months to 48 months.

Cap-and-trade market structure, lessons from the past

From an article in the JACF on Designing a US Market for CO2. Most interesting are the lessons learned from the US SO2 (sulphur dioxide)market, a successful cap-and-trade system that began in 1995. How did the market's design and structure affect trading and contribute to the massive price spike in 2005-2006 (see graph below)? Prices increased from $220/ton to over $1600/ton before declining back to $200/ton. One explanation points to a change in the EPA's regulations in 2005 (CAIR) that put a tighter cap on emissions starting in 2010 and tightening more through 2015. Since emissions credits can be banked, expectations of increased demand in the future should be reflected in the current price. However, this regulation was only supposed to increase the cost to ~$600/ton, and while it might explain the spike it cannot explain the subsequent drop. A second explanation relies upon a shortage of low-sulphur coal due to railroad outages. This shortage increased demand for allowances and correspondingly, the price. While the shortage might have increased demand in the short-run, credits were available that could have been drawn upon to reach a slightly higher price equilibrium rather than a massive spike. So why didn't anyone step in and sell their credits at a massive profit? The answer lies in the restricted float - a low number of credits available for trade - which is due to the way the market was designed.


First, the credits were initially distributed to natural shorts (e.g. a power plant that produces SO2) that expected to use them at some point in the future. Except for relative emissions reductions (a plant installs a better scrubber and thus needs fewer credits), most of the market participants will stay long the credits to offset their natural short exposure. Thus, incentives to trade are reduced and the market is less liquid. Lower liquidity means that small changes in supply or demand can have a magnified effect on price.

Second, the credits were distributed for free, and were held on the firms' balance sheet at zero tax basis. When a credit is redeemed, the increased value is recognized as a gain, but offset by the increased environmental liability from generating the SO2, so it's a wash for tax purposes. If a firm believed the price spike was temporary, it could sell some of its banked credits while prices were high, then buy them back once the market returned to normal, netting a profit. But this action creates a taxable gain today, while the liability is still off in the future. The potential gains from this arbitrage must be weighed against the acceleration of the tax liability.

Third, many of the firms with credits are publicly regulated utilities. If the firm were to profit from selling credits high and buying them back low, regulators might force the firm to pass the profits along to customers (rather than letting shareholders and management keep them). On the other hand, if the arbitrage failed and the firm lost money, regulators might view this as speculation and punish management for being imprudent.

Thus, the owners of SO2 credits failed to create a viable market for them. Note that financial intermediaries, such as the much maligned short sellers and speculators, could help provide liquidity to a market like this and thereby enable more efficient price discovery, reducing the risk of disruptive price spikes.

Law and Economics: The Bimodal Distribution of Lawyers' Salaries

A New York Times op-ed recently reminded me of the graph below, showing the bimodal distribution of lawyers' salaries: public service on the left, private law firms on the right. Time for more two year law schools? Lower biglaw salaries? People don't think of law firms as highly leveraged institutions but while they don't usually have much debt, they do have operational leverage from the partner-associate structure. Each associate is a fixed cost that has to be paid (debt) before the partner gets his earnings (equity). So a firm with 1:1 partner:associate ratio is about 50% leveraged. Of course, associates can be laid off during bad times, while debt is defaulted on.

Cross-listed Shares and the Bonding Hypothesis

A foreign company can issue shares on the US equity markets, if it agrees to comply with the US regulatory regime. The bonding hypothesis says that this improves corporate governance by forcing the firm to respect minority shareholder rights and increasing the amount of information that's disclosed about the firm. Thus, a company from a country with low investor protections can "bond" itself with the US, where investor protections are high. In turn, this could lower the firm's cost of capital and allow it greater access to capital markets. However, some challenge the bonding hypothesis because enforcement actions by the SEC against cross-listed firms are rare.

Encyclopedias and the Pace of Change

Last week, Microsoft announced that they are shutting down Encarta, the digital encyclopedia that was originally released on CD-ROM. A brief history:

• 1778-1993 (215 years): Encyclopædia Britannica rules the day
• 1993-2009 (16 years) Microsoft's Encata quickly takes over
• 2009-?: Volunteer-edited Wikipedia ascends to the throne

The question is, how long will Wikipedia reign? If the average lifespan of encyclopedia technology continues to shrink at the speed implied above, a challenger may already exist. Ironically, Microsoft helped force Britannica's capitulation by giving away free copies (excuse me, "bundling") of Encarta when you bought a new computer with the Windows operating system. Wikipedia's product managed to undercut them on price while offering greater value and a lower cost of production.

Trop50: An Orange Juice Ripoff

Tropicana (a wholly-owned subsidiary of PepsiCo) recently released a new juice drink product called Trop50. The sales pitch: it has 50% fewer calories and 50% less sugar than regular orange juice. I'm all in favor of reduced calorie/sugar beverages, but do the economics of this make sense?

I spotted a container of Trop50 at the store and although it is the same shape and price as the regular Tropicana ($2.96), the Trop50 package is 8% smaller by volume (64 ounces versus 59 ounces). The problem compounds when you flip the carton around and notice the statement "contains 42% juice." The back panel reveals that the primary ingredient is water, followed by reconstituted orange juice, then some vitamins, and finally stevia (a non-sugar "natural" sweetener). So Trop50 expects you to pay an 8% premium for a product that contains 58% less juice (58% more watered-down) than regular OJ?

Here's a cheaper alternative: fill your glass halfway with regular orange juice, then add water until it's full (cost per 12 oz serving: $0.28). Or, buy Trop50 (12 oz for $0.60), and pay a 117% premium for the 30 seconds it will save you in the morning.

The MBA Job Market for the Class of 2009

As of mid-March, anecdotal evidence from three schools: Emory (Goizueta), SMU (Cox), and Georgetown (McDonough) indicates that about 40-50% of the full-time MBA students set to graduate in May have accepted job offers. The pace of hiring is well below last year. First-year students (the class of 2010) are having an even tougher time securing internships for the summer.

In what could be mistaken for a headline from The Onion, Harvard Business School is launching a case study to determine why their case studies didn't keep us out of our current mess.

New York Times: Now the Long Run Looks Riskier, Too

From a recent New York Times article: a new academic study shows that equity investment volatility actually increases over time. Although there is evidence that returns are mean reverting, which reduces volatility over longer time horizons, the authors identify several other factors which more than offset this reduction in risk. These factors include uncertainty about future expected returns and estimation risk. Traditional portfolio theory uses sample statistics (e.g. the average return on stocks over the last 100 years) and assumes they represent the true population of possible values going forward. This approach leads you to believe that volatility of returns decreases as your investment horizon increases (i.e. the standard deviation of your portfolio goes down if you invest for 30 years instead of 1 year). In contrast, this study uses Bayesian statistics, which separates predictive variance (which includes parameter estimation error) from true variance (which has no estimation error).

If you estimate future stock market returns using historical averages, that average has some estimation error in it. As your time horizon increases, parameter estimation risk compounds which leads to an increase in volatility (rather than a decrease). To put it another way: traditional theory says that predictors are perfect and parameters are certain. This theory says that predictors are imperfect and parameters are uncertain. Over time, these imprecisions and errors add up to substantially increase the volatility of your portfolio. The authors use 206 years of data to calculate that the volatility of your stock portfolio over 30 years is about 1.5 times greater than it would be over 1 year. Their conclusion is that stocks are less appealing than they would appear to be under the traditional view of historical risk and return.

Consider: if you started investing in 1979 through 2009, would you have done better in 20 year treasury bonds (rolled over each year) or the S&P 500 with reinvested dividends? An upcoming study (Bonds: Why Bother?) shows that regardless of which month you started in, treasuries outperformed stocks over this period. This is further evidence that the conventional wisdom, that stocks are "safe" as long as you're holding them for 20 years, is wrong. In reality, it doesn't matter how long you plan on holding stocks, they're inherently risky. They may still be a good investment, but you are not guaranteed a higher return just because you took more risk.