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Besides these explicit restrictions on how certain industry types may or
may not invest, a variety of other formal and informal restrictions affect both
investors and issuers on a day-to-day basis, without the benefit of an act of
Congress. One informal restriction relates to the use of a particular cash flow
type(s) such as derivatives. More formal restrictions can take the form of
actual or anticipated reactions of the rating agencies, of peers and colleagues,
or even of the financial press. Reputation can count for a great deal when
it comes to the business of managing other people™s money, and fund man-
agers generally want to guard against adverse exposure whenever possible.
In at least one very real sense, the rating agencies themselves can be
thought of as having a regulatory kind of influence on companies.
Specifically, if one or more of the rating agencies were to frown on a par-
ticular use of capital, and if it were communicated that such usage could
place the offending company in a position of being downgraded, this would
most certainly weigh on a company™s decision-making process. For exam-
ple, when TruPs (or trust preferred securities) first came to market a few
years ago as a hybrid of preferred stock and debt, rating agencies were quick



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TABLE 6.7 Underwriter™s Exemption Eligibility under ERISA
Aset Category Eligible Ineligible*

Residential home LTV up to 125%; LTV over 125% or
equity senior only; and rated rated below BBB“ or
AA“ or better or LTV over 100% but not
LTV up to 100%; senior or over 125%; and (i)
subordinate; and rated BBB“ rated below AA“ or (ii)
or better subordinate

Commercial or multi- LTV up to 100%; senior or LTV over 100% or
family (real estate subordinate; and rated BBB“ rated below BBB“
secured), motor or better
vehicles and
manufactured housing

Commercial or multi- LTV up to 100%; senior only; LTV over 100% or
family (not real and rated A“ or better rated below A“ or
estate secured) and subordinate
and equipment

Home equity None All
(revolving), credit cards,
motor vehicles (leases/
revolving), student loans
and equipment (leases)
* Subordinate equity interests that satisfy Eligible LTV constraints are also eligible
for purchase by insurance company general accounts under Department of Labor
Class Exemption 95-60, regardless of their rating, as long as senior equity interests
backed by the same asset pool are also eligible.

Pension funds
Pension funds restricted from
investing in unsecured obligations
(ERISA)
Credit
Banks Credit union
Restrictions on equity Limits on types of
purchases(Comptroller qualifying CMOs (FFIEC)
Bonds
of the currency) Equitiies Cash flow
Products


Currencies


Insurance
Limits on purchases of non-dollar assets (NAIC)
Products

FIGURE 6.1 Restrictions on cash flow, credit, and products by type of investing entity.



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to respond with opinions about where they were best ranked relative to the
issuer™s capital structure. At the same time, they also issued explicit guide-
lines regarding how much of this product type they felt a given entity should
issue.
Table 6.8, reprinted with permission from the Bank of International
Settlements, summarizes various credit-related statutes as practiced within
the United States.
In closing, investment rules and regulations”both those that are vol-
untarily imposed and those that are mandated by formal decree”will
always be a key consideration for investors.


CHAPTER SUMMARY
The very existence of various market rules and regulations (inclusive of taxes)
may serve to create pockets of price dislocation in the marketplace. From a
pure classical economic viewpoint, this not very surprising. When economic
agents act more in response to how someone else wants them to behave than
to how they themselves might want to behave, distortions can well arise.
When such distortions are a necessary side-effect of commonly accepted prin-
ciples of sound behavior (as with protecting the risks that banks or insur-
ance companies might take to the detriment of consumers who rely on their
sound business practices), such rules and regulations typically are embraced
as necessary and reasonable. What particular rules, regulations, and tax poli-
cies are helpful or not, and how best to create and enforce them, is a topic
of considerable debate and review as long as there are markets.
Figure 6.2 offers a three-dimensional viewpoint to help reinforce the inter-
relationships presented in this chapter. Again, readers should think about how
other product types might be placed here, not just as an academic exercise,
but as a practical matter of how portfolios are constructed and managed.
With reference to the above mapping process, investors can view a vari-
ety of investment choices in the context of legal, regulatory, and tax envi-
ronments, then make strategic choices according to their preferences and
outlook regarding each category of potential risk and reward.
To bridge the first four chapters, Table 6.9 links products, cash flows,
credit, and legal and regulatory matters.
While they are often thought of as a rather unexciting aspect of finan-
cial markets, tax, legal, and regulatory considerations are quite important,
fluid, and deserving of very careful consideration.




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TABLE 6.8 Partial List of Investor-Related Regulation in the United States




[Table not available in this electronic edition.]




265

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[Table not available in this electronic edition.]




266

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267
Market Environment



Tax
Treated as an equity
A mapping process¦ for tax purposes,
price changes in this
security may be
subject to either
Cumulative preferred
short- or long-term
convertible stock
capital gains




Legal
Regulatory
The usual legal protections
Regulatory restrictions prohibit
are enhanced with special
bank purchases of convertible
language pertaining to
preferreds, and this affects supply
missed dividend payments
and demand fundamentals as
and how the firm would be
would any similar restriction
expected to respond to
prespecified events

FIGURE 6.2 Mapping process for cumulative preferred convertible stock in the con-
text of tax and legal and regulatory considerations.




TABLE 6.9 Credit-Enhancing Strategies by Product, Cash Flow, and
Legal/Regulatory/Tax

Product Cash Flow Legal/Regulatory/Tax


Shorten maturity
Change position in

capital structure

Collateralize

Guarantees

Covenants

Wraps




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CONCLUSION
As a brief summary of the text, and as another conceptual way of thinking
about market interrelationships, consider Figure 6.3.
Most continuums are presented as a horizontal line, with one main
idea at one end and a contradicting idea at the opposite extreme. Yet in
Figure 6.3 we present a continuum in the shape of a semicircle. The purpose
for presenting bonds and equities in this circular context is to suggest that
while bonds and equities are different product types, they are also closely
related”at least more closely related than would be implied by placing them
at opposite points of a horizontal continuum. Indeed, as has been referenced
earlier in the text, the Achilles™ heel of equities is the right conveyed to share-
holders to vote on matters pertaining to the company, and the Achilles™ heel
of bonds is the presence of a maturity date.
In sum, while it remains popular in financial circles today to emphasize
how different bonds are from equities, and how different these are from cur-
rencies, and so on, it is this author™s view that financial products of all stripes
have much more in common than not; there is much more to be gained ped-
agogically by emphasizing commonality as opposed to rifts. When an
investor considers any financial product, there ought to be at least some cur-
sory consideration of market risk, credit risk, and regulatory and tax issues,



Second preferred stock Mezzanine debt




First
Junior debt
preferred
stock




Common stock Senior debt


Common stock (CS) “ Voting rights = Preferred stock (PS)
PS + Maturity date = Mezzanine debt (MD)
MD “ Equity allocation + Maturity date (optional) = Junior debt (JD)
JD + Secured status + Maturity date = Senior debt

FIGURE 6.3 The debt/equity continuum as semicircular.




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