Wednesday, 18 December 2019

Updates: Fiat-Chrysler and PSA Peugeot Merge; Boeing Halts 737-Max Production; and the Latest British Review of the Audit Sector Makes New Proposals

A number of developments regarding stories that we have been covering for quite a while here in Financial Regulation Matters have taken place recently, so in this post we will look at some updates on each one to see how the issues are developing.

Fiat-Chrysler Finally Merge with PSA Peugeot

We last looked at developments within the automotive industry in September with the credit downgrade of Ford, but one of the underlying sentiments within the industry has been that companies may, or will need to merge in order to survive their environment. Tougher regulations, increased costs, potentially saturated marketplaces, the need to keep up with technological advancement, and inconsistent and unpredictable economic and social arenas are making the job of manufacturing and selling cars much harder. The three largest automotive players are Toyota, Volkswagen, and the Renault-Nissan alliance. Now, the fourth largest is this new PSA-Fiat Chrysler merged partnership which, according to the Independent, will produce nearly 9 million cars a year and generate €170 billion in sales a year. The new entity will be led by PSA’s Chief Carlos Tavares, who has gained a reputation for being an incredibly efficient ‘cost-cutter’ – it is therefore not a surprise that Tavares has been tasked with leading the entity, as it must cut $4 billion (although it has not been declared where and how these costs will be cut). This has led to some concern from British groups in particular, as the Vauxhall plants in Ellesmere Port and Luton teeter on the brink; there have been discussions in the past whereby Tavares has made clear that the plants must remain profitable or else he will move the production elsewhere. Union figures have suggested that ‘the fact remains, merger or not, if PSA wants to use a great British brand like Vauxhall to sell cars and vans in the UK, then it has to make them here in the UK’. This, of course, is not true at all, but demonstrates the importance of the merger to the lives of many. Ultimately, the deal should take around 15 months to complete and will, in all likelihood, precipitate more mergers in this marketplace as companies seek to protect themselves from the harsh environment that is surrounding them.

Boeing Halts Production of the 737-Max

We have looked at the 737-Max crisis for Boeing before (here), which has developed since the two planes came down killing nearly 350 people. Boeing had been confident that the FAA would clear the plane to fly before the end of the year, suggesting that the ever-growing cost of this crisis – which has been estimated to be at $9 billion and rising – would secede. However, the FAA have declared that ‘the aircraft will return to service only after the FAA determines it is safe’. With the FAA facing pressure over allowing the first batch of planes to fly with the malfunctioning safety system, it is clear that they do not want to be seen as presenting a light-touch regulatory solution to this important issue. Also, if cleared to fly but then another plane falls, the blowback on the FAA would be extreme. It is for this reason that there are fears within Boeing that the ban will not be lifted until the Summer of 2020, perhaps even later. The cost for missing the peak-season for the company could be massive. So, for that reason, the company has decided to stop its reduced-rate of production that was in place during the suspension. Boeing declared that ‘we have decided to prioritise the delivery of stored aircraft and temporarily suspend production on the 737 programme beginning next month’. In response, the company has moved staff on that production line to other lines, and investors will be waiting with baited breath to find out the financial impact, with the next set of financial declarations due at the end of January. What is clear is that there is plenty more pain left in the tank for Boeing.

British Enquiry into Auditing Issues Argues for New Qualifications

The audit sector has been the focus of a large proportion of the posts here in Financial Regulation Matters (here, here, and here as just a few examples). Now, in the latest review commissioned by the May government in the aftermath of the Carillion crisis, Sir Donald Brydon – former Chairman of the London Stock Exchange – has led a review that assessed the quality and effectiveness of audit. The review’s report, lasting 135 pages, covers a number of issues like the relationship between the firm and its shareholders, engaging shareholders more generally, the auditing process, and the regulation of the field. However, one point has stood out above all the rest. In making the fair and accurate point that ‘it’s not the auditors that cause companies to go bankrupt. It’s the directors who are responsible for bankrupting a company’, Sir Brydon used this basis to suggest that what is needed is a separation between auditing and accounting, with the former becoming a new profession complete with its own qualifications, regulations, rules, and penalties. This suggestion has been based on that, for Sir Brydon, ‘it was quite a startling discovery to me that there was not an audit profession as a standalone entity’. This is a reasonable and valid observation because, as he continues, ‘the qualities you need to be an auditor are quite different to those you need to be an accountant’. Quite. The Competition and Markets Authority’s Chairman Andrew Tyrie said that the ‘robust proposals are a big step forward’, but it is this concept of competition that would be the major issue if these reforms were enacted.

For example, if they were, where would the newly-developed auditing companies come from? They would be spin-offs from the established Big Four (and probably Big Six). It is no wonder that the deputy CEO of Deloitte said that the report added ‘much needed clarity’; in one foul swoop the accusations levelled towards the Big Four of needing to be more involved in spotting aspects like fraud would be removed, and an entirely new revenue stream would be opened up to them. However, this would cause issues. There would need to be efficient ‘walls’ between the new entities and their accounting brethren, and we know full well the so-called ‘Chinese walls’ that are usually erected have not always been fit for purpose. Would the two companies be able to insulate the information about which company has utilised their services so that the corresponding entity would not factor that into the final decision? Hypothetically, a new auditing entity spun-off from PwC may be more inclined to pass of an audit for a company who had been using PwC for its accounting needs – with the forced separation and the development of a new ‘industry’, can regulators provide efficiency insulation between the two? Do they have the resources to get ahead of this issue? Only time will tell. However, this solution looks like a particularly palatable one to all involved. Governments can say they have acted and imposed now qualifying standards. The Big Four (or Six) can say they have obliged with the demands. Regulators can attempt to develop strategies and mechanisms to allow for the two stand-alone industries to operate. Whether or not this reduces the likelihood of a company collapsing just days after being given a clean bill of health is another issue altogether, however. If one was cynically minded, it could be advanced that the proposed system would limit the exposure to penalties of the established Big Four (or Six) to that of the spun-off entity, which would be massively beneficial for these global behemoths.

Keywords – cars, automotive, planes, Boeing, 737-Max, audit, accounting, reform, @finregmatters

Tuesday, 17 December 2019

Experts Warn of the Continued Divergence between Credit Rating Agencies

Today’s post looks at a recent article produced by credit rating experts Marc Joffe and Joe Pimbley. In the article entitled ‘Mall Shooting Highlights Folly of Single Asset CMBS Ratings’, Joffe and Pimbley discuss how recent events at the Destiny USA Mall in Syracuse have highlighted underlying and, arguably, fundamental issues within the credit rating arena in relation to CMBS – Commercial Mortgage-Backed Securities. In this review of their article, we will examine this issue more closely, along with the points made by the article in question.

First, some context. On the most recent ‘Black Friday’, the Destiny USA Mall in Syracuse (New York) fell victim to a shooting attack, within which a victim received wounds in the leg. Then, only the very next day, ‘at least one person was stabbed during a fight at Apex Entertainment inside Destiny USA’. Here in Financial Regulation Matters we have, admittedly from a majoritively British perspective, analysed the diminishing health of the bricks-and-mortar retail industry, and the US is no different. According to data compiled and analysed by Credit Suisse, between 20 and 25% of all American malls will close by 2022. Although the authors do not suggest that these factors mean that any securities offered by Malls may not be creditworthy as a result, they do suggest that the large amount of factors affecting Malls in the US, on top of any negative press that may hasten the demise of a Mall, means that instances such as S&P and Kroll’s AAA-rating of $215 million (of a total securitised package of $430 million) are worth analysing further.

As part of the structured package put together by Destiny USA, the structure dictates that ‘a credit event that forces a write-down of the underlying mortgages by more than 50% will trigger losses on the AAA (senior) notes’. The authors correctly argue that, whilst this event may be unlikely, it is certainly not unimaginable – the large amount of factors affecting the retail marketplace mean that assigning the top-rated ratings to a structured product put forward by such entities is potentially hazardous. The scholars put it much better when they state that, for S&P for example, the agency ‘expects AAA bonds to have a default probability of 0.15% over any 5-year period’. The scholars then go on to ask just how an agency can ascribe such a definitively positive label to a single property, even when that contains multiple businesses, where the potential for a 50% loss is arguably much greater than 0.15% (on the proviso that senior notes will become negatively affected if the entire securitisation suffers more than a 50% loss). The article continues by discussing how Moody’s and Fitch Ratings have assigned ratings to similar bonds (supported by Mall revenues) as Ba2 (speculative grade) and BBB respectively.

Joffe, in 2015, discussed how the CMBS marketplace, whilst not similar in size or stature to the Residential Mortgage-backed Securities (RMBS) marketplace that decimated the global economy in 2007/8, did similarly contain inherent issues from a rating agency perspective; namely, ratings shopping. In the RMBS era, the shopping took place between the top 2 or top 3 agencies, but for the CMBS marketplace the shopping is spread across the top 6 agencies. It has been argued, therefore, that previous issues affecting S&P with regards to their CMBS rating provision – S&P were suspended from rating conduit/fusion CMBS in 2011 - have affected their approach to the marketplace. Joffe, in 2015, declared that the SEC’s enforcement actions ‘cemented S&P’s also-ran status’, and that now ‘we don’t know when the next financial storm will occur or what it might look like, but overrated commercial mortgages are clearly a vulnerability’. In addition, Joffe discussed in 2015 that the SEC’s enforcement action had led to Kroll capturing S&P’s share of the CMBS market and that the behaviour that led to the settlement – ‘distorting a Great Depression data set to justify lower AAA credit enhancements’ – was likely motivated by the fear of losing out to a competitor in what is a particularly lucrative marketplace, or at least an attempt to recapture its former status held before the suspension in 2011. Nevertheless, the SEC labelled this behaviour as ‘race-to-the-bottom’ and that it is something the SEC would not tolerate. That is all well and good, but it is one of the fundamental issues within the rating arena; the rating oligopoly does not function optimally with increased competition enforced upon it, which is something legislators and regulators have been trying to do for the past decade, at least.

Ultimately, Joffe and Pimbley are absolutely correct in their identification of an issue on the horizon. They are correct in their analyses regarding the relative size of the CMBS market in relation to the RMBS market, but their understanding is accurate that an issue within the CMBS market could be massively impactful. The connectedness of the modern marketplace means that a tremor in one sector must be felt in another; the question then becomes how many other sectors may be affected, and how strong was the initial impact in the original sector. This is perhaps a perfect demonstration of why the continued critical analysis of the agencies is tremendously important, because of their centrality to that interconnectedness. Joffe and Pimbley conclude with the warning that rating agencies should take a harder, more sceptical look at collateralised deals before the clouds start gathering (which is true), but perhaps that same message needs to extrapolated further in that regulators need to take a harder, more sceptical look at the agencies and their role in the system before clouds start gathering, systemically. This is, of course, a common request of regulators, but it does not detract from its accuracy – the agencies will be involved in another financial scandal because, quite simply, the financial system and the agencies’ connection to it determines that they will be central to a future failure in the marketplace. Perhaps that could be the starting point to a regulatory strategy, or perhaps it is just not optimal to do that in terms of allowing the growth of particular markets?

Keywords – credit rating agencies, CMBS, Mall, @finregmatters

Wednesday, 4 December 2019

Large Investment Players Seek to Change the Investment Landscape

Earlier this year we looked at the concept of large investors starting to take a stand with regards to the actions of those they invest in. In recent news, this trend is potentially continuing, with some of the world’s largest players now focusing on issues such as climate change and short-selling. In this short post we will review these stories and continue analysing the trend as it develops.

We have looked at the concept of ESG many times, and the first story we shall assess focuses on the ‘E’ component. Yesterday the Independent ran with the story that Sir Christopher Hohn, the founder of TCI Fund Management, said that he will begin taking purposeful and potentially impactful action against firms he is invested in who do not take the issue of climate change seriously – his firm has more than £21 billion in assets under management. He has decided to focus on the issue of disclosure, stating that the firm would move to ‘vote against all directors of companies which do not publicly disclose all of their emissions and do not have a credible plan for their reduction’. In order to push for this increased rate of disclosure, and to have it standardised, Hohn will be pushing for the companies it invests in to report their total carbon emissions via CDP – an independent environmental consultancy. He goes on to make the valid point that ‘investing in a company that doesn’t disclose its pollution is like investing in a company that doesn’t disclose its balance sheet. If governments won’t force disclosure, then investors can force it themselves’. Bloomberg recently called Hohn the Hedge Fund Industry’s ‘own Greta Thunberg’, and Hohn lives up to this billing as we see that he has accused the world’s largest asset manager – BlackRock – of ‘greenwash’. Other firms that he has identified as needing to improve Airbus, Moody’s, and Charter Communications. Hohn is quoted as saying that ‘investors have the power, and they have to use it’, which is a welcome notion because it has been identified that, for a number of reasons, institutional investors have been reluctant to take on this role. The question is, however, whether Hohn’s sentiment will be found to be lip-service, or whether investors are genuinely starting to take a greater role in the governance and progression of the companies they invest in.

In terms of a wider lens, the role of investors upon the shaping of the marketplace is another factor that needs to be considered. In the second story we will be assessing, Japan’s largest – and the world’s largest – governmental pension fund will no longer be allowing overseas shares to be lent out from its $733 billion global equity portfolio. What does this mean in simple terms? It means that ‘short-sellers’ will be potentially impacted negatively, which has drawn an immediate and positive response from Elon Musk who declared that it is ‘the right thing to do! Short selling should be illegal’. Short-selling, in essence, is a trading strategy that speculates on the decline of a stock or security, rather than its success. Investopedia discusses how the strategy may be employed by speculators, or by investment managers to hedge against risks elsewhere in their portfolios, but the sentiment from Japan is that the move by Mr Mizuno – the fund’s Chief Financial Officer – essentially brands the practice of short-selling as ‘non-ESG’ because the process of short-selling, which is based upon the short-seller first borrowing the shares, means they cannot then vote on internal governance issues as associated with that share’s voting rights (because they do not own the share themselves). However, a number of onlookers have pointed out that mechanisms exist to cover for this issue. For example, asset owners can require that their shares are returned for voting purposes. It has also been argued that securities lending is ‘critical to properly functioning markets’, which is why Mizuno’s recent move has been labelled as divisive and has encountered many internal objections. Whether or not other institutions like the Government Pension Investment Fund follow suit and, effectively, brand the process of short-selling remains to be seen. However, and despite the objections raised and the arguments of ineffectiveness, Mizuno’s move is just the latest in a growing line of instances whereby investors are starting to impact on how ESG, as a principle, is being adhered to by companies. Perhaps that in itself is the biggest positive from this story.

The role of investors in aspects such as maintaining good governance within companies has been researched from within a number of fields. Perhaps the new field to analyse is how ESG, as a concept, is being monitored and enforced by investors. We have seen elements relating to disclosure and business model being focused on by investors, with business practices changing as a result. Yet, the question remains as to how such initiatives are to be coordinated and developed from an investor-standpoint, because it is taking certain characters and organisations to take the lead – who is to say that they will continue doing so? If the wave of sentiment changes, who will be leading that? That question is, then, how does society utilise the position and subsequent power of institutional investors to its advantage? Is it even possible to do so? One would likely be forgiven for arguing that it is not and that, in effect, wider society is a slave to the marketplace. Yet, there may be things that can be done, like an elevation in the research and media scrutiny on concepts and developments such as ESG and the associated fervour that is accompanying its implementation. The focus on ESG is societally-positive, so the more it can be championed the more that entities such as institutional investors will feel more obliged to contribute – particularly if it is demonstrated, economically, that it is beneficial (which research has suggested that it is). The hope is that ESG does what ‘ethical investing’ never managed, and becomes mainstream. If it does, it may be the case that ESG-related considerations become a norm, which is the ultimate goal.

Keywords – ESG, Investment, Short-selling, institutional investors, @finregmatters