Tag Archives: Credit default swaps

Life Insurance Shenanigans

What are shenanigans? The Merriam-Webster dictionary defines them as “tricky or questionable practices or conduct.”

A prime example of such a shenanigan is an employee benefit that was recently proposed for the teachers of the Pasco County, Florida public school system. A small group of private investors offered to create an organization that would provide free life insurance to the teachers, as well as an equally free death benefit for the school district.

Why would these private investors offer free life insurance to the teachers and the school district of Pasco County? By basing the insurance company in Bermuda and passing death benefits through an off-shore trust in the Cayman Islands, the investors planned to avoid all federal, state, and local income taxes in the United States. In addition, by basing the company and trust in a pair of off shore regulatory and tax havens, the group planned to avoid many governmental oversight functions as well.

But the most important factor involved the youthful ages of most of the 9,769 teachers. Because the investors were forecasting that only thirteen teachers would die annually during the early years of the insurance program, they were free to dedicate the lion’s share of any early tax free profits to other purposes. The investors could, for instance, use the funds to pay dividends to themselves, or to allow the profits to accumulate in their tax-free off shore investment accounts.

Last week, when questions arose about the personal and professional backgrounds of the investors, the school district walked away from the plan. Nevertheless, for a time, they did actively consider entrusting their employees’ life insurance benefits to a “tricky or questionable” proposal that promised free coverage for all.

Insurance companies, of course, have been engaging in “tricky or questionable” practices for years. In 1991, for instance, Executive Life of California and Mutual Benefit Life of New Jersey both went bankrupt because of excessively risky investments in junk bonds and other securities. For the first time, policy holders with Guaranteed Investment Contracts (GICs) learned that there was nothing “guaranteed” about the GICs that were issued by their life insurers.

And more recently, in 2008/09, the government of the United States bailed out AIG because of concerns that its failure would destroy the global economy. Although AIG did indeed sell insurance policies, its insolvency was attributable to its transactions involving the creation of credit default swaps on collateralized debt obligations. Such transactions, by and large, fell outside of the regulatory umbrellas of the federal authorities and state insurance commissioners.

Thus, we should give the school district of Pasco County full credit for learning from these prior experiences and declining the offer of free life insurance. When insurers propose risk-free returns at little or no cost, the only prudent response is “thanks, but no thanks.” After all, any such proposal is most likely a shenanigan.

Libor Manipulation: Calculating Damages

Last week, in our blog posting entitled Libor and the Public Interest, we discussed what National Public Radio has called the biggest scandal in the world. Of course, NPR was referring to the Libor manipulation scandal, a scheme that dwarfs the other controversies that are now roiling the financial services industry.

And we don’t use the word “dwarfs” lightly. After all, within the past week, we learned that traders at JP Morgan Chase may have hidden losses from CEO Jamie Dimon that are now expected to exceed $7 billion. We also discovered that HSBC laundered several billion dollars for Mexican drug cartels. And we were told that the bankrupt Peregrine Financial Group misappropriated over $200 million in client investments.

Nevertheless, what of the news that over a dozen global banks have been manipulating the Libor rate that continues to be used around the world to establish interest charges on variable loans? It affects every citizen who holds a variable mortgage, credit card, line of credit, or small business loan. It also affects billions of dollars of corporate debt instruments, issued by global corporations, that utilize the Libor rate to calculate interest charges.

Extent of the Profits

By how much did the banks profit during this scandal? Well, a single bank with a $10 billion debt position (or portfolio) that successfully moves the daily interest rate 0.1% in a favorable direction could earn an incremental $10 million that day. If ten of the sixteen banks that define Libor earn similar profits on that day, the colluding group could earn a collective $100 million.

And what if the same group repeats the tactic one hundred times in a year? The annual collective profit of the group would equal $10 billion. And the counter parties on the “flip sides” of those transactions, i.e. individuals and organizations that are unfavorably influenced by such moves in the daily interest rate, would thus lose $10 billion per year.

As a point of comparison, the entire Centers for Disease Control and Prevention of the United States — the government entity that protects the American public against maladies from HIV / AIDS to influenza epidemics — received $10.6 billion in total funding last year (i.e. in fiscal 2011). It’s no wonder that Time Magazine has suggested that the Libor scandal may be considered the crime of the century because of its immense scale.

Proving Damages

With profits that are so significant, and with commensurate losses incurred by others, one would think that it should be easy for aggrieved parties to sue the banks and collect damages. Surprisingly, though, plaintiffs would be advised to proceed cautiously before filing lawsuits.

After all, the Libor mechanism serves to summarize the interest rates that each global bank estimates it would pay if it borrows funds from other banks in the City of London. Yes, Libor focuses on estimates that each bank would pay as opposed to the precise rate that each actually pays, and the hypothetical interest percentage if each bank chooses to borrow, as opposed to the real amount when each bank actually borrows.

In other words, each bank’s daily Libor quotation represents an educated guess, as opposed to an actual report. In order for a plaintiff to estimate damages, though, he would need to calculate the interest rate that each bank would have quoted if it had no incentive to manipulate the rate. But if the Libor quotations only represent rough estimates and educated guesses, how can any plaintiff establish what an unbiased “actual” rate would have been for a particular bank on a certain day?

The Trouble With Proxies

There are always “proxies” available for any statistic, including (perhaps) credit default swaps for unbiased Libor rate quotations. According to a Connecticut government report, “a CDS is a privately negotiated derivative through which a “buyer” pays an agreed-upon amount to a “seller” and, in return, receives a payment if a certain event occurs … the buyer does not need to own the underlying security and does not have to suffer a loss from the event in order to receive payment …”

When independent investors believe that a global bank is more likely to default on its borrowings, they bid up the market price of the CDS that is designed to pay off in the event of a bank default. And because such a bank might expect to pay a higher risk-adjusted interest rate on its borrowings, some commentators believe that plaintiff attorneys can use fluctuations in CDS values as proxies for appropriate Libor estimates.

What is worrisome about this belief? Simply put, the CDS market itself is prone to manipulation by wealthy investors. A single large investor can drive up the value of a single CDS, at least temporarily, by making a large strategically timed purchase. So by using CDS values as proxies for Libor values, a plaintiff’s attorney would simply be substituting one manipulable statistic for another.

Clearly, it will not be easy for plaintiff attorneys to calculate damages. And without such calculations, it will be difficult for courts to require banks to pay awards.

Delta Airlines: Welcome to the Oil Business!

At first blush, it appeared to be an April Fool’s Day prank. A satirical, mock corporate announcement, one that couldn’t possibly be true.

What was the announcement? It was a statement, supposedly issued by “people familiar with the matter” at Delta Airlines, that the firm was “seriously thinking” about an opportunity to enter the oil business by purchasing a 185,000 barrel per day oil refinery from Conoco Phillips. Although the facility has been idle since October 2011, the mysterious statement asserted that Delta believes it can somehow succeed where Conoco Phillips has failed.

But the announcement was no prank. Shortly after the initial rumor hit the press, both Reuters and CNBC confirmed that Delta was, in fact, considering the acquisition. Financial analysts across the globe weren’t impressed; they reacted with skepticism, with criticism, and even with ridicule.

At first blush, of course, most of us would agree that it makes no sense for an airline to diversify into the oil business. But if we take a moment to reflect on Delta’s competitive position, we may start to understand why the airline believes the gambit may be worthwhile. The acquisition strategy, though unconventional in nature, is actually more reflective of the state of the commodity markets than of the state of the airline industry itself.

Method To The Madness

In order to understand Delta’s strategy, it is necessary to appreciate the impact that is wielded by fuel prices on the profitability of the airline industry. Generally speaking, the industry operates on very thin profit margins, with fuel alone representing almost one third of all operating expenses. Over the years, entire airlines have gone bankrupt because of aging fleets of airplanes that consume huge amounts of fuel, rendering flights unprofitable at virtually any level of passenger fares.

The challenge of high fuel prices is worsened by the impact of extreme price volatility. When American automobile drivers wince at double digit percentage increases in the retail prices of gasoline fuel, airline executives experience similar inflationary wallops and wince as well. In fact, such increases inflict far more damage on airlines than on automobile drivers, given that airlines must sign fuel purchase contracts well in advance, long before they know how many passengers will actually purchase tickets to board the scheduled flights.

If the fuel commodity markets were patronized exclusively by producers and users of gasoline, any such price swings would be determined by the economic market forces of supply and demand. But the commodity markets are also open to speculators who buy and sell huge quantities of the commodity, thereby causing wild swings in prices that can wreak havoc on the bottom lines of the low profit margin airlines.

So Delta has decided that it may be worthwhile to find a way to avoid the extreme volatility caused by speculator driven commodity markets. In essence, Delta is willing to bet that the cost burden of operating an unprofitable refinery — one that may nevertheless provide airplanes with fuel at prices equal to or below the cost of production — may be less onerous than the cost burden of purchasing energy from a wildly volatile global market. In other words, even though Delta’s strategy may appear to be madness, there is indeed a rational method to its underlying logic.

The $100 Million Man

Ironically, if Delta does proceed with the acquisition, the extent of its success will likely be determined by the conditions of the fuel markets that it intends to avoid. If those markets are relatively calm and rational, the airline will likely regret its assumption of the burdens of operating an oil refinery. But if those markets are relatively volatile and unpredictable, Delta will likely celebrate its decision to produce its own fuel.

In Delta’s defense, every week appears to produce a new story about the volatility of the global investment markets. Last week, for instance, a bizarre story about a “London Whale” spread throughout the financial press. The story involved a mysterious trader, working for JP Morgan, who was affecting market values around the world by investing heavily in derivative products called credit default swaps.

The trader, Bruno Iksil, reportedly earns $100 million per year by placing massive bets on the future movements of corporate bond prices. But because the placements of such large bets can themselves affect market prices, the very presence of traders like Mr. Iksil can affect what firms like Delta Airlines must pay to borrow money, to raise equity capital, and to purchase commodities for use in running their operations.

In other words, although our global debt, equity, and commodity markets were originally formed to help firms like Delta operate their businesses, they are now serving as vehicles for the highly speculative short term trading strategies of firms like JP Morgan. Apparently, Delta must now decide whether it would prefer to purchase fuel from a market that it doesn’t trust, or whether it would prefer to operate a refinery in a business it doesn’t understand.