Sunday, March 15, 2009

Nationalization risks for Investors (in Utilities, Banking, Insurance, Communications etc)

Industries like utilities, banking, insurance, telecommunications, and public transportation are crucial to the functioning of modern society. Because they are so critical, many countries nationalize these industries explicitly or impose private ownership restrictions, to ensure that these essential services won't be held hostage to private interests. Services that are monopolistic in nature, such as electricity distribution, are also regulated to prevent their shareholders from extracting undue economic rent on society.

In free-market oriented countries like the United States, these industries are in privately owned but subject to regulation to ensure they continue operating smoothly. In some states for example, electric utilities are regulated so that their shareholders can earn a fixed return on capital, while ensuring that the companies invest the capital needed for maintenance equipment. Usually, this arrangement works well, and shareholders have a safe predictable investment. However it is important to realize that it is not a risk-free investment.

Risk #1 : Eminent Domain intervention that suppresses your earnings stream

These investments run the risk of of "eminent-domain type intervention", where the state changes the "rules of the game for shareholders" in order to serve society's needs. Because of the immense importance of these services to society (and hence the political establishment), any service failure could bring about an overnight change in the regulatory framework and economic ecosystem which sustains your earnings stream. This is irrespective of whether the failure is the fault of the company or because of faulty regulation.

A sudden deterioration in affordability of an essential service can also trigger an eminent-domain type intervention. For example, a sudden rise in fuel prices in a country which relies of public bus services can lead to government mandated price controls, to keep the cost bus fares within the reach of the Average Joe. Likewise, rate-setting-councils could deny regulated electricity distribution companies rate increases during economic downturns. Sometimes political populism comes into play, and a government could force foreign owners of strategic businesses to sell their stakes at fire-sale prices.

Example 1: the Insurance industry after Hurricane Andrew in Florida in 1992

You might be thinking that this sort of thing doesn't happen in a bastion of capitalism like the United States, but you'd be wrong. Consider what happened before and after Hurricane Andrew in Florida in 1992. Prior to the hurricane, there was systemic underpricing of insurance premium as insurers were lulled into a false sense of security. After the hurricane, insurance companies sustained huge losses and tried to reduce the number of customers and/or reduce the amount of coverage they were providing. While this behavior is unfortunate for the homeowners, the insurance industry does tend to behave in this cyclical way. By their nature, natural calamities do not occur in a steady stream. Instead they tend to happen in bursts, probably approximating a power law statistical distribution. This leads short-sighted insurers who experience periods of calm to under price their premiums. Being a commodity product, this tend to force even prudent insurers to match the under priced premiums in order to retain market share. Then when disaster strikes, the weaker insurers fold, and the stronger ones raise their premiums to compensate for the earlier period of underpricing.

The state regulators however, decided that this was politically unacceptable, and wrote legislation that (a) limited the number of policy cancellations to 5% across the state, (b) restricted the size of premium increases the companies could impose, and (c) created the Florida Residential Property and Casualty Joint Underwriting Association to provide residential property insurance coverage. This intervention in pricing and the creation of a state sponsored competitor likely decimated the private sector insurers' profitability in Florida. The regulatory regime did not prevent underpricing during the "upswing" of the insurance business cycle because it benefited Florida residents, but it intervened the moment the insurance industry moved into its overpricing "downswing" phase of its business cycle.

Example 2: the Banking industry during the Financial Crisis of 2008-2009

A more recent example is the financial crisis that started in 2008. During the real-estate bubble prior to 2008, many banks and financial institutions made loans to people who couldn't afford the loans. When property prices were rising, these borrowers could simply refinance their loans based on the increasing paper value of their property, thus never having to actually pay down their loans. They simply enjoyed the initial teaser rates, then refinanced before the real loan payments started kicking in. When property prices started dropping, they defaulted on their loans because they couldn't refinance the loan, and were never actually able to pay the true installment amounts. (It wasn't just a matter of the banks underpricing the loans - some of these loans shouldn't have been made in the first place because there was no way the borrower was able to finance it from his income.)

Banks who made these reckless loans ran into trouble; their borrowers couldn't pay back the loans and they repossed homes. However they couldn't sell the repossessed homes at anywhere close to the outstanding loan amounts. Companies like Countrywide Financial and well-known banks like Washington Mutual became insolvent as they breached capital adequacy ratios (as their diminishing assets became less than the regulatory minimum required to support their liabilities).

Unfortunately, it wasn't just the banks who made reckless loans who were affected. Many of the reckless loans they made were also sold to investors and other banks as mortage backed securities (or collateralized debt obligations, whic are groups of mortage backed securities which have been sliced up and repackaged).

Banks who bought these securities also ran into trouble as the loans underlying these securities started getting into trouble. Some of the securities were so complicated that many investors and banks couldn't figure out how much their securities were worth, and the markets stopped trading them. They became known as "troubled assets" as people generally felt that they were worth far less than what the banks claimed they were worth on their balance sheets. In effect, the quality of banks balance sheets were now under suspicion. This fear and uncertainty further exacerbating the pull back in lending as investors refused to lend money to banks or to buy debt securities.

Impact to the real economy:
This cutback in the amount of loans extended made it hard for businesses to finance trade, inventory and working capital needs. The climate of fear about the true value of debt and asset-backed securities also made it difficult for companies to issue corporate bonds and short term commercial paper to finance working capital needs. (Investors simply stopped buying bonds, and refused to put money into money market funds which invested in short term commercial paper)

Economically, the bad lending decisions resulted in a misallocation of resources as people built houses and assets which society didn't really need and people couldn't really pay for. The subsequent fear and pull back in lending then threatened to cripple healthy companies who relied on credit, as many companies do, for day to day operations. This effectively put the economy in cardiac arrest, as credit, the oxygen carrying blood of economic activity, ceased to flow. Companies began to reduce their production and overall economic activity declined.

The decline in home prices also made people feel less wealthy. Combined with rising unemployment caused by the drop in economic activity, people reduced their consumption and lowered their standard of living. This further exacerbated the economic contraction, as people consumed less goods and services than what the global economy was geared to produce.

Government intervention to support the economy:
The government then intervened on two fronts: on the fiscal front, the government started spending through a series of stimulus packages, to kick-start economic activity. On the monetary front, the government started propping up banks and credit instruments in order to open up the flow of credit to healthy businesses. This monetary intervention had various side effects on the good banks, and their shareholders:
  1. TARP forced equity investments. Through the TARP program, the government forced a wide swathe of banks to take the government on as an investor, by issuing preferred shares to the government that came with a 5% dividend payment. This allowed all banks to "raise capital", whether or not they needed it. The result was that:

    - prudent banks, who didn't need the capital, got saddled with high cost equity capital. This lowered their operating profits and reduced their ability to pay dividends to ordinary shareholders.

    - unsound banks continued operating and continue competing with the prudent banks.

    The prudent banks should have been able to grab market share during as their weaker competitors floundered, by being able to raise funds at a lower cost and taking on loans which the weak banks didn't have the funds to. Instead the TARP program allowed weaker banks to carry on operating, and negated the competitive advantage that prudent banks would otherwise have had.

  2. Low cost loans through the TAF program. The Federal Reserve started making extremely low cost loans (below the discount rate) to banks in exchange for almost any type of collateral. The wide range of collateral accepted essentially opened up the loan facility to all banks, irrespective of the quality of their assets. This allowed weak banks to fund their daily operations, and kept them alive and able to continue competing with the stronger banks. (It is likely that this program didn't increase the amount of loans made, since it merely monetized a bank's illiquid assets. It does nothing to fundamentally improve a bank's capital adequacy ratio.)

  3. Implicit government support for bank bondholders. When a bank got into trouble, it appeared that the government would keep the bank afloat by injecting funds and wiping out shareholders, while keeping bondholders untouched. This meant that troubled banks and financial companies could likely have issued bonds and raised funds at lower rates than healthy banks, whose bondholders didn't have that implict government support (at least for the moment). The result was that troubled companies and banks had access to cheaper funds than prudent, healthy banks.

  4. Commerical paper guarantees through the FDIC's TLGP. The FDIC started its Temporary Liquidity Guarantee Program, which guaranteed the interest and principal repayment on all commercial paper issued by eligible depository institutions and financial companies. As a result, almost all banks and finance companies were suddenly able to issue commercial paper at the same low rates, since they were all effectively backed by the U.S. government. Prudent banks lost their lower cost funding competitive advantage.
Impact on shareholders:
The government intervention effectively eliminated a significant cost advantage that prudent, healthy banks enjoyed. Unless they have found a way to attract customers on factors other than price (not easy in a commodity-like business like banking) they are potentially going to lose market share if the government subsidyof troubled banks drags on. (I'm not saying the state subsidy is wrong - considering the dire stituation we are in, there is a real need to stimulate overall credit and lending to keep the economy working)

It was also possible that governments may have cajoled stronger banks to take over weaker banks in order to stabilize the banking system. For example, there is a possibility that the UK government encouraged Lloyds TSB to take over HBOS in order to prevent HBOS from collapsing. While this helped to stabilize the UK banking system, it saddled Lloyds TSB with HBOS' loan book which was of dubious credit quality. Lloyds TSB, which had one of the best banking franchises in the UK, is now in danger of needing to raise lots of additional funds (likely by issuing shares to the government) in order to manage the losses from HBOS. The merger has been bad for Lloyds shareholders.

The Lesson for Investors:
Always consider the probability of Eminent Domain intervention

So if you are considering investing in a company in one of these critical industries, then it is essential that you factor in the probability of such "eminent domain" type government intervention occurring:
  1. You need to consider the probability of events which can cause your essential service to become unaffordable; for example, massive unemployment, or a spike in raw material prices.

  2. You also need to consider the probability of systemic industry failure which would lead to the government changing the rules overnight.

  3. If you are a passive investor, then you'll also need to consider the probability of the company management messing up, since you don't exercise discretionary control over management.

  4. You need to analyze the political framework in the regulatory domain, to see how susceptible the political environment is to popular public pressure.

Risk #2 : Badly designed regulation that creates hidden dangers to the viability of your business

You've also got to check if the regulatory framework is well designed; some regulatory frameworks simply aren't designed well. (This is not a knock on the regulators - it's not easy to design a framework to balance the needs of society and the needs of private investors)

A good example is the California Electricity Crisis in 2000-2001, when several electric utilities went bankrupt and almost caused major disruptions to California's electricity supply. This was caused by faulty regulation which (1) imposed price controls on electric utilities who owned the distribution to retail customers, which reduced their incentive to invest in power generation, whilst (2) requiring them to purchase electricity on the spot market from electricity generation companies when their own generation was insufficient. Because wholesale electricity from generators was traded, and because electricity is not storable, it led to probable speculation (and possible manipulation) by energy traders and generators which caused the wholesale price of electricity to rise beyond the price at which the electricity distribution utilities were able to charge their customers. As a result the distribution companies went bankrupt, and the state government had to intervene to buy electricity on the spot market for the electricity distribution companies.

While there is no foolproof way of analyzing regulatory frameworks for such dangers, there are some general rules-of-thumb which you can use:
  1. Any regulation that imposes any form of price ceiling is dangerous.

  2. A regulatory regime that allows for a return on capital is better; but watch how this allowed return is calculated. For example, a return based on a WACC calculation might use the prevailing share price to calculate the cost of capital. This could dramatically reduce the allowed earnings if the share price drops over the years. This reduced earnings would in turn further lower the share price (unless the market is willing to pay a higher PE), leading to a downward spiral.

  3. Any industry practice or regulatory regime requiring a "take or pay" arrangement warrants careful study. These are common in arrangements between companies using oil and gas pipelines. Typically, pipeline or downstream companies who receive gas from a pipeline are required to enter into a "take-or-pay" arrangement with the pipeline owner or the gas producer that is pumping gas into the pipeline. This to give the gas producer predictable demand, so that it can build the infrastructure to produce the gas. But this places a risk on the downsteam company.

Industries that may be subject to regulation in future

Based on the current political climate and zeitgeist, I think there is a possibility that a couple of presently unregulated industries may be regulated in the not too distant future:

1. Food industry. Possible regulation to discourage the consumption of food deemed to be unhealthy. For example, a tax on foods containing sugar would affect candy, soft drink and snack food manufacturers.

2. Tobacco industry. Possible regulation to further discourage the consumption of tobacco products.