Levine on Wall Street: Energy Bonds and Lawsuit Dividends

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Will there be massive energy high-yield defaults?

Isn't this sort of exciting?

Should oil prices fall below $65 per barrel and stay there for the next three years, Tarek Hamid, a high-yield energy analyst at J.P. Morgan Chase & Co., estimates that up to 40% of all energy junk bonds could default over the next several years.

He goes on to walk that back a bit -- "energy companies will take steps to avoid falling into bankruptcy, including cutting spending and selling assets," so the real default rate will be like half that -- but still. Energy makes up 18 percent of outstanding high-yield bonds, and an even bigger chunk of some funds, and the current high-yield default rate is around 1.7 percent a year, way below historical averages. So it's an asset class that's due for a little excitement. Elsewhere, U.S. producers "probably won't slash American oil output anytime soon," in part because they've already hedged a lot of production at much higher prices. And what do banks do with fracking deposits? (Put it into liquid assets mostly.) And Warren Buffett still knows how to be greedy when others are fearful.

A special dividend.

A while back Freeport-McMoRan Copper & Gold bought Plains Exploration & Production and McMoRan Exploration in a deal that was notable for a BlackRock portfolio manager telling the company: "Congratulations on making one of the worst teleconferences I’ve ever heard to justify a deal." The deal seemed strategically odd (Freeport had spun off McMoRan exploration to get out of energy, and then bought it back to get back in), overpriced, and rife with conflicts of interest including that McMoRan chief executive Jim Bob Moffett was also Freeport's chairman and that Freeport's directors owned about 6 percent of McMoRan's stock. So, as always happens, there was a lawsuit, and, as rarely happens, this one seems about to settle for a large cash payout to shareholders:

Under the preliminary settlement agreement the parties have reached, Freeport would pay more than $130 million, with much of that earmarked for a special dividend for its shareholders, some of the people said. After legal fees and other costs, the dividend likely would amount to more than $100 million, or 10 cents a Freeport share, those people said.

"This appears to be the first example of such a payout" in a shareholder derivative lawsuit, and I guess it makes sense. The shareholders sued the conflicted directors, and so now those conflicted directors will pay $100 million to the shareholders for ... oh wait:

Most of the cost of the settlement would be paid for using a special type of corporate insurance policy that covers directors and executives, according to some of the people. Freeport would pay for the rest.

So Freeport is going to pay a special dividend to shareholders for its own directors' conflicts of interest, out of its own funds and the funds of its directors' and officers' insurance (which it pays for). Two things that you can say about special dividends are:

  • in classical Modigliani-Miller theory, they are irrelevant to shareholders, though no one entirely believes this, but
  • in any case they are certainly not a punishment for directors.

I guess a third thing you can say about special dividends is that they don't usually come with millions of dollars of lawyers' fees, but here we are.

Should banks accelerate vesting of deferred compensation for people who leave for government?

The AFL-CIO says no. Andrew Ross Sorkin says yes:

But perhaps the A.F.L.-C.I.O., the nation’s main union federation, has it backward. Shouldn’t we be trying to encourage more public service? And shouldn’t other industries adopt similar pay practices to allow our most talented people from the broadest array of backgrounds to participate in government?

Sure, maybe, whatever, though one should be careful about taking the phrase "public service" at face value. But who's this "we"? The AFL-CIO raises the question in its capacity as a bank shareholder, and the shareholder value of people leaving for government is less obvious. (I mean, other than "they'll go to government and regulate us nicely.") Sorkin gives the argument that the practice "helps to attract concerned people who may want the option to pursue public service work someday," which "helps instill a kind of ethos and culture to the firms," but it's non-obvious that the best bankers are the ones who'd rather be politicians. (It's plausible though.) In any case, this would look less corrupt if banks accelerated vesting for a broader class of people than just those who leave for government. Various forms of nonprofit work are at least as public-spirited as going to work for Treasury. Or blogging. The real scandal is that banks don't accelerate vesting for people who leave for blogging.

Some leaks.

If you work at the Fed, and you have secret information about the Federal Open Market Committee's deliberations, whom should you tell about those deliberations? "No one" is of course an option, but a boring one. "Your former colleagues at Goldman Sachs, who were nice enough to accelerate the vesting of your restricted stock so you could afford to go work at the Fed," is I suppose also an option. But what about Wall Street Journal Fed reporter Jon Hilsenrath? He seems to get a lot of information from the Fed, and then publish that information, and you could argue that this is annoying for the Fed but good for democracy and/or markets. But in October 2012, then-Fed chairman Ben Bernanke asked the Fed's general counsel and the secretary of the FOMC "to look into sources behind a Sept. 28, 2012, article in the Wall Street Journal" that described the Fed's September 13 meeting, because Hilsenrath's information was a bit too good.

Or what about "Regina Schleiger, a former financial journalist who is now a senior managing director at Medley" Global Advisors, a political intelligence firm owned by FT Group? You can see Schleiger being on the same continuum as Hilsenrath -- a former journalist, working for a company owned by a newspaper group -- and yet. Her report, published after that Sept. 13, 2012 meeting but before the minutes were released, described the meeting with eerie accuracy, and was sent only to Medley clients, who would then presumably trade on it. Bernanke was even more keen to have his lawyers look into the sources behind that report, both because of its specificity and because it looks more insider-trader-y than journalism-y. But it's unclear if they ever found anything. "The Fed has never disclosed the findings," nor, it seems, have they leaked.

Elsewhere in leaks, "Hackers with Wall Street expertise have stolen merger-and-acquisition information from more than 80 companies for more than a year, according to security consultants who shared their findings with law enforcement," and I remain suspicious of any news about hackers that comes from security consultants. Though I guess stealing merger information and then trading on it is a pretty good way to do your hacking without getting caught immediately.

Bidders and activists.

Here's a good summary of the lessons learned from Valeant's cooperation with Pershing Square to try to buy Allergan. One is that Pershing's and Valeant's interests differed significantly:

Pershing Square was almost certainly better off if a competing bidder emerged and won—the price would be higher and the terms agreed with Valeant would not apply (such as, the initial agreements to provide up to $400 million of additional financing for the Valeant bid if requested and to retain the equity interest in Allergan for a year after the acquisition; and the later volunteered commitments to take all stock in the offer even if other shareholders were offered cash and stock and the give-back to Valeant of $600 million of the proceeds on its Allergan shares if the Valeant bid succeeded). Thus, Pershing Square appears to be approximately $1.2 billion better off, on an immediate basis, with the Actavis transaction than it would have been had Valeant’s bid succeeded.

The authors suggest an alternative model, in which the bidder buys a big chunk of stock secretly itself before recruiting activists, and then gives them much lower economics in exchange for support. But my guess is the same as it was when the Valeant/Pershing partnership was announced: Activists are good at the actual process of buying up a lot of shares secretly and in compliance with the laws, while strategic acquirers mostly aren't, and so they bring in activists not just for economic reasons but also for pure mechanical expertise. Also economics though: There is some risk involved in buying billions of dollars of a rival company's stock, and activist hedge funds may be more comfortable with that risk than are strategic bidders.

The effects of short selling.

One effect of short selling is price efficiency: If people who like a stock can buy it, and people who hate it can short it, then there will be incentives for everyone to find out information and the price of the stock should reflect all that information. But there are second-order effects on how much information there is to find out. Here's a fun study based on the 2005-2007 pilot period of Regulation SHO, which allowed more short selling of a randomly selected batch of U.S. stocks. The researchers "find that the pilot firms significantly reduce their bad news forecast precision by about 17% relative to the control group upon adoption of Reg SHO," without reducing the precision of their good-news forecasts, as managers react to the increased threat of short selling (and its effect on the managers' stock-based compensation) by trying to conceal bad news. "We find that pilot firms with bad earnings news also reduce the readability (or increase the textual complexity) of their annual reports around implementation of Reg SHO."

Investment advice.

Here's a paper from Canada finding that investment advisers "induce their clients to take more risk, thereby raising expected returns," but charge an average of 2.7 percent a year in fees and thus take "all of the equity premium gained through increased risk-taking." So that's at best a wash. Also:

A unique feature of our data is that we observe the portfolio allocations for advisors who maintain investment portfolios at their own firm (over half of advisors in our sample do so). For these advisors, we find that their own risk-taking and home bias are far and away the strongest predictor of risk-taking and home bias in their clients’ portfolios even after controlling for advisor and client characteristics. The picture that emerges here is that no matter what a client looks like, the advisor views the client as sharing his preferences and beliefs.

On the one hand, I guess it's good if the advisers are eating their own cooking. On the other hand, why would you eat at a restaurant that can only cook one dish? 

Things happen.

Dodgy Home Appraisals Are Making a Comeback. Some ECB stress test skepticism. An investment banking scorecard. Michael Steinberg is appealing his securities-industry ban for insider trading. The economics of law schools. And of "Seinfeld." And of "Blank Space." You can get Girl Scout cookies online. Eat some berries. A poem. A novel. A flop. Harvard football. Private jets are ​for pets. Follow me on Ello.

(Corrects spelling of Warren Buffett's name in second paragraph.)

  1. Disclosure: One, I'm kidding, but two, let's just say that I have some interests in this view, or would have if it was broadly accepted a few years ago. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net