Electricity, Inversions and Research
One of my favorite financial markets is the electricity market. Most markets consist of basic human economic activity -- buying stuff you want, selling stuff you don't -- overlaid with a set of market-structure rules and norms. In some markets the rules are intuitive, almost invisible, and participants look like they're mostly just doing economic stuff. Other markets seem to be mostly about the rules; economic activity occurs, but it feels like a byproduct of a strangely designed computer game. The wholesale electricity markets -- creatures of regulation designed to price and allocate an invisible commodity that can't be stored -- feel particularly game-like. The game is not intuitive, but if you figure out the rules, it can be richly rewarding.
The basic framework of the rules is that electricity is priced based on its marginal cost of production at any given time. If you turn on your computer at 2 a.m. when everyone is asleep, some nuclear plant is generating electricity that no one else needs, so it will give it to you for almost nothing. If you turn up your air conditioner at 2 p.m. in August when everyone else is also turning up air conditioners, all the cheap power is already spoken for, and some horribly inefficient gas peaker will turn on and charge you an arm and a leg for your electricity. (Or it will charge your power company, anyway; one odd fact about the electricity markets is that the wholesale price paid by power companies is not necessarily directly reflected in the retail prices they charge to consumers.) And everything is mediated through a regulated auction, so at 2 p.m. that efficient nuclear plant is getting paid just as much as the inefficient gas plant.
But you know who else can get paid just as much as a gas plant? You, for turning off your air conditioner. (I mean, not literally you, but "demand response aggregators," who might share some of the money with you.) This is called "demand response," and a new-ish rule of the electric markets allows for it. The idea is that demand-response companies can submit offers to provide electricity on an equal footing with actual electric generators; if the demand-response offer is cheap enough, it is "turned on," as it were, and the companies provide electricity to the grid not by generating more electricity but by reducing the amount that would otherwise be used. For the system, this is as good as generation -- better, really, since it doesn't pollute and doesn't overload transmission lines -- but it is in some ways a very strange way to run a market. In normal markets, the way demand responds to price is, just, you buy less of a thing when it's more expensive. In the electricity market -- where auctions are regulated, prices vary quickly and the retail price to end users does not necessarily reflect the wholesale marginal price -- that price signal doesn't quite work. So the regulators have built it back in, by paying non-consuming consumers as though they were producers.
It's weird in concept, and in details. Like: How do you measure how much electricity you're not using? As I type this, I am not using billions of megawatts of power, compared to how much power I'd be using if I were running an extra sun out of my apartment. You need some baseline measure of, like, normally I set my air conditioner to High, but now I will set it to Medium, so pay me. Or: How much should I get paid for not using electricity? I mean, sure, I should get paid the market price, same as any generator. But I am also not paying for the electricity that I'm not using. So in a sense I'm getting paid more than the generator -- I get the marginal price, plus I save the retail price I don't pay. The rule -- it's called FERC Order No. 745 -- says basically that I get the full price, and that my savings on the other side are my business. But there are those who think I should only be paid the full price minus the retail price, because I'm saving the retail price too.
Anyway, yesterday the Supreme Court upheld the demand-response rule, deciding both that the Federal Energy Regulatory Commission was allowed to make the rule in the first place, and that FERC's decision to pay demand-response companies the full marginal price for generation, rather than the price for generation minus the retail price they're avoiding, made sense. There is a pleasingly specious dissent from Justice Scalia, but otherwise the decision is straightforward. As a matter of statutory construction and regulatory authority, it makes sense. But the market that it regulates is so very odd.
If you were planning to do an "inversion" merger to move your tax domicile to a foreign country and reduce your tax bill, would you want to do it in the middle of an election campaign? On the one hand, a lot of politicians are going to shout at you. On the other hand, the U.S. legislative process basically shuts down for a year of campaigning, so no one is actually going to pass any laws stopping inversions. And if you wait until after the election, President Trump or Sanders might use his mandate to pass comprehensive anti-inversion rules, so you might as well get yours in now.
“We’re well within the guidelines that the I.R.S. has established, so we feel really good on it,” Mr. Olson said. “I know there have been some other deals about tax synergies, but this is really about the operating potential of the two companies.”
I suspect the chief financial officers in those other deals would say much the same thing. Everyone thinks his own deal is about operating potential, and that it's the other guys who are dodging taxes. Though to be fair there's usually something to that; Bloomberg Gadfly's Brooke Sutherland points out that "tax savings and bargains aside, the primary goal of this transaction is to make Johnson Controls a true multi-industrial company and tap into the higher valuation that goes along with that classification." Here is a history of Tyco's "tax-driven dealmaking." Here is Andrew Ross Sorkin on the political reaction, which is, as you'd expect, negative. "I have a detailed and targeted plan to immediately put a stop to inversions," says Hillary Clinton, which is all the more reason to do them now before she is elected.
Here is Delaware Chancellor Andrew Bouchard on the proposed settlement of a lawsuit over the acquisition of Trulia by Zillow:
The proposed settlement is of the type often referred to as a “disclosure settlement.” It has become the most common method for quickly resolving stockholder lawsuits that are filed routinely in response to the announcement of virtually every transaction involving the acquisition of a public corporation. In essence, Trulia agreed to supplement the proxy materials disseminated to its stockholders before they voted on the proposed transaction to include some additional information that theoretically would allow the stockholders to be better informed in exercising their franchise rights. In exchange, plaintiffs dropped their motion to preliminarily enjoin the transaction and agreed to provide a release of claims on behalf of a proposed class of Trulia’s stockholders. If approved, the settlement will not provide Trulia stockholders with any economic benefits. The only money that would change hands is the payment of a fee to plaintiffs’ counsel.
That sounds bad. People have been criticizing this stuff for years, and the Delaware Chancery Court has been just trucking along, approving these settlements, making plaintiffs' lawyers rich. But no more! Chancellor Bouchard rejected the settlement, and while he is not the first Delaware judge to reject a settlement like this, he might be the most important:
“This is really the end of the easy, automatically approved settlement,” said Sean Griffith, a professor at Fordham Law, calling the 42-page decision “a nail in the coffin.”
The market for merger strike-suit settlements is particularly a creature of rules, almost entirely divorced from useful activity, and it's hard to imagine we'll miss them.
There's a wonderful puzzle in investment bank research, which is that the thing called "research" is heavily regulated with the goal of making it objective, honest, fair, free of conflicts of interest, not disseminated early to favored investors, etc. But then there is another thing, which you could loosely call "sales," in which people at the bank call up customers and say things like "hey you should buy this stock" or "boy this company's bonds look undervalued, do you want some?" or "you know what's hot right now? Iron condors, that's what." Sometimes the sales tactics go a bit beyond breezy phone calls to encompass "desk commentary," in which a salesperson or trader or analyst on a desk writes down some thoughts about a stock or bond or strategy or whatever, pops them into e-mail, and sends them to clients. The job of a vast swath of the bank is to buy and sell securities, and the way you do that is by providing some intellectual content to customers. This content is not necessarily objective (the goal is to get you to do the trade that the desk wants to do), nor is it necessarily fair (different customers get different ideas from different salespeople). It is just, you know, trying to get customers to do trades by saying smart things, the same way a car or art or real estate or whatever salesperson does.
There is no obvious conceptual distinction between the thing called "research" and the non-research "desk commentary." Here is an article from two Davis Polk & Wardwell lawyers asking if new Finra rules and enforcement efforts will kill desk commentary: "If desk commentary is deemed research and its authors deemed research analysts, then the application of the new equity rule and the debt rule will likely force many firms to either stop distributing desk commentary or limit it to groups of 14 or fewer customers." Their proposed solution is a safe harbor for desk commentary -- sent only to institutions and prepared by someone whose main job is sales or trading, not producing research reports -- that would not be subject to all the research rules.
Chart looks like other chart.
Speaking of research, Tracy Alloway writes about a Bank of America Merrill Lynch note on the parallels between the price of oil and the Markit ABX Index. Come for the overlaying of one chart on another chart (lagged seven years), but stay for the note itself, which includes the beautiful sentence "Consider how things tend to work." Elsewhere in charts, "U.S. Stocks, Once Among World's Priciest, Now Cheapest": U.S. stocks were among the most expensive in the world five years ago, at a price-earnings ratio of about 16; now, at a ratio of about 17, they are among the cheapest. "The others' multiples grew faster." I don't know what to tell you about that, but just consider how things tend to work for a while.
So Bernie Sanders has a new Ben & Jerry's flavor. Sort of. He has a new flavor invented for him by Ben Cohen, a co-founder of Ben & Jerry's, who no longer works there. It's a Ben's Best flavor. It's called "Bernie's Yearning":
The entire top of this pint is covered with a thick disc of solid chocolate. Underneath is plain mint ice cream. The chocolate disc represents the huge majority of economic gains that have gone to the top 1% since the end of the recession. Beneath it, the rest of us.
There are eating instructions. You have to "let the ice cream soften up a bit," then mix. I have questions. Is it to scale? Is the chocolate only one percent of the ice cream? Or do they cut off the y-axis? Serious Eats' "Best Mint Chip Ice Cream" recipe, which I have no reason to doubt, calls for four ounces (roughly 156 milliliters) of dark chocolate for one quart (946 milliliters) of ice cream, or about 16.5 percent chocolate. So one percent chocolate is quite stingy. Or perhaps it's scaled by share of wealth, but then the pint would be more than one-third solid chocolate, which seems impractical. You'd need, like, a drill. The flavor's appeal seems mostly symbolic.
"Let's put our optimism goggles on": "Speed is the new currency of business," and "you can always go faster than you think you can." "Every country needs a Minister of the Future," and "we need less regulation and more innovation in Europe," but "we are working tirelessly to achieve a mutually acceptable solution." "Goals are only wishes unless you have a plan." Those were some of the official best quotes from Davos this year, I hope you liked them, imagine the other quotes.
People are worried about unicorns.
I feel like "Renaissance Florence Was a Better Model for Innovation than Silicon Valley Is" probably counts as unicorn worrying. We were promised a revival of humanistic literary studies and a newly rational outlook on the world, and all we got were photo-sharing apps.
People are worried about stock buybacks.
Here is Nick Bunker on buybacks, the "corporate savings glut" and the decline of corporate investment. He cites two Fed economists who "think the corporate savings glut is a sign that companies are quite pessimistic about the future. They don’t see any feasible investment opportunities around, so they are passing money out to shareholders."
People are worried about bond market liquidity.
My rough working hypothesis has been "that bond market liquidity worrying is procyclical: In boom times, people worry about hidden dangers in the bond market, while when markets are down they have more pressing things to worry about." That has not exactly panned out in early 2016: People have had plenty of real things to worry about, but we've nonetheless had plenty of fairly official worrying about bond market liquidity. But then there is this:
BlackRock Inc., the world’s largest asset manager, said investors are turning to more-illiquid holdings such as real estate and private credit as they seek to generate returns and combat market volatility.
Even bonds are too liquid for them; they want the really illiquid stuff. Perhaps they've been burned by the liquidity illusion in bonds. Elsewhere: "DoubleLine's Gundlach Says Junk Issuance Likely to Collapse."
SEC Expected to Give Unusual Refund for Insider-Trading Penalty. Mr. Shkreli Goes to Washington and Mocks Ghostface Killah. Paulson Pledges Personal Holdings to Back Firm After Assets Fall. Revealed — the worst investment funds of the past three years. Automated Hedge Funds Make Millions in January’s Market Selloff. The Trader Who Made 6,200% on China Stocks Has Some Advice For Investors. Germany’s Cautious Savers Find New Taste for Risk. Deutsche Bank Convicted With Trader for Korea Stock Manipulation. Wider China-Hong Kong Discrepancy Revives Fake Trade Doubts. Lending Club paves way for rivals. Merger of Huntington and FirstMerit to Create Banking Giant in Ohio. Twitter’s Shake-Up Casts More Doubt on Product. Marc Andreessen: "2016 tech definition: 'Private blockchain that we control' = 'Oracle installation.'" The Bronx takes on Mumbai for IT outsourcing. Zimbabwe has deflation. Olive Garden now caters. Folktale phylogeny. Michael Jackson did some of the music for Sonic the Hedgehog 3. Sloth rescue. Half-marathon dog is a very good dog.
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