TW Global – A Lesson In Finance
By Tshepo Magagane
Here is one bad thing that could happen. A company raises money by issuing bonds. It wants to sell, say, $1 billon of bonds. In the bond offering, it tells investors that it has earnings of $300 million per year. Investors read the prospectus and think “ah, this company makes plenty of money to pay back these bonds,” and they agree to buy the bonds at, say, a 6% interest rate. In fact the prospectus is wrong and the company actually earns $0 per year. The first interest payment on the bonds comes due and the company says “whoops, no money.” It defaults on the bonds, it goes into bankruptcy, and the bondholders get back $0 of their $1 billion. I think it is self-evident why this is bad.
Here is another bad thing that could happen. A company raises $1 billion of bonds at 6% by telling investors that it has earnings of $300 million per year. In fact the prospectus is wrong and the company actually earns $100 million per year. The first interest payment on the bonds comes due, and the company pays it. In fact, it makes all of the interest payments when due — $100 million is much less than $300 million, but it is enough to pay $60 million of interest — and at maturity it repays the full $1 billion. The bondholders get back their $1 billion, plus the promised interest.
Is this bad? I mean, you could make an argument that it’s fine. Like:
- The bondholders bought the bonds because the company promised to repay them their principal with an agreed interest rate, and it did, so that’s fine. No bondholder lost any money: They invested $1 billion and got $1 billion back with interest.
- The bondholders agreed to the fairly low 6% interest rate because they concluded that the company was relatively safe, that it would be able to repay the principal and interest without too much trouble. In drawing that conclusion, perhaps the bondholders considered the (incorrect) disclosure that the company earns $300 million per year; who can say really. That disclosure was wrong, but the conclusion was right: Ex post, the company really was safe, and it really was able to repay the principal and interest. The company’s realized credit risk was low, and therefore its 6% interest rate was fine.
These arguments seem bad? You can probably spot the flaws. Here are a few, though you can doubtless add others:
- Most risky bonds do not default, so “this bond got paid back and therefore its realized credit risk was low” is not a real argument.
- The ex ante probability of default was higher than the market thought — the company had less cushion to pay its debts than investors thought — which is the bad thing.
- If, a year after issuing the bonds, the company had said “whoops actually we make $100 million per year,” the market price of the bonds would have gone down. (Their expected yield would have gone up.) Bondholders would have lost money, on a mark-to-market basis. Of course if they held to maturity they’d get their principal back, but that is not the only relevant measure.
- If, before issuing the bonds, the company had accurately disclosed its earnings, bondholders would have charged a higher interest rate. Therefore they did lose money, measured against the correct baseline: Had they known the true facts, they would have gotten paid more interest.
- In fact there are cases of companies getting in trouble for this sort of thing: If you make incorrect financial disclosures to bondholders, that’s arguably securities fraud, even if you pay the bonds back on schedule.
Here is another thing that could happen. An insurance company raises $1 billion of annuity money. That is, it goes out to 1,000 investors and says to each of them, “if you give me $1 million today, I will pay you a steady income for the rest of your life.”
[3] That is like a bond; the company is raising cash today by promising payments over time. You could imagine the investors evaluating it like a bond: “This company has plenty of capacity to make the promised payments,” the investors might think, “and therefore I will accept an expected annual return of about 6% to reflect the safety of this investment.” But that’s not a real thing. I mean, that’s how the bond market works,
[4] but it is not a reasonable thing to expect of retail annuity buyers. People looking to buy annuities do not, generally, scrutinize the financial statements of insurance companies and choose between buying an annuity from a safe company at 6% and buying one from a risky company at 8%. Evaluating the financial strength of an insurance company is a complex and specialized business, and even figuring out the implied yield of an annuity — figuring out what sort of credit spread is embedded in the annuity product — isn’t always easy.
[5] You can’t say “this company brings in $300 million a year so I’m happy to get a 6% yield on my annuity,” because you can’t figure out how much the company brings in or what yield you’re getting on your annuity.
Instead, there is a somewhat more binary system in which state insurance regulators decide which insurance companies are safe. Safe companies can sell annuities to raise money; unsafe companies cannot. Evaluating the financial strength of an insurance company is a complex and specialized business, so it is done by state insurance regulators using a risk-based capital framework. If you have $X of capital, you can raise up to $Y of annuity money, etc. Insurance customers do not have to evaluate an issuer’s financial strength, because regulators do.
This is exaggerated — some customers and their advisers surely do consider the financial strength of insurance companies, and safer companies probably have a lower cost of capital than bare-regulatory-minimum companies — but it is a useful approximation.
So one bad thing that could happen is: An insurance company wants to raise $1 billion of annuity money, it tells its regulators “we earn $300 million a year so we can easily cover those annuity payments,”
[6] the regulators are like “you sure can, no problem here,” the insurance company sells $1 billion of annuities at market rates, but in fact the insurance company makes $0 per year and can’t make any payments on the annuities. It defaults, it becomes insolvent, it is seized by regulators, and a state guarantee fund pays out some but not all of the money owed to customers. Self-evident badness!
And then another bad thing that could happen is: Raise $1 billion of annuity money, say “we make $300 million a year,” regulators say “sure,” but it turns out you actually earn $100 million per year. But it’s fine, and you make all the required payments on the annuities. The annuities were, ex ante, riskier than the regulator thought. Had the regulator known the true state of affairs, it wouldn’t have let you sell all the annuities; it would have required you to have more capital against your asset base. Ex post, everything was fine. But the regulation is risk-based, and if the regulator doesn’t have accurate disclosures then policyholders and state guarantee funds are taking more risk than they want.
The point here is that it is not the customers who were misled by the wrong disclosures; the customers didn’t read the disclosures. The regulator was misled. And, similarly, when the disclosures are corrected, what happens is not that the market price of the annuities drops; the annuities don’t trade or have a market price. What happens instead is that the regulator demands more capital, to reflect the higher-than-expected risk.
I’m just using the simplest possible bad thing here, the company saying that it has more money than it actually does. In the real world, there are subtler — and less bad — forms of badness. The company could say “we hold $2 billion of investment-grade corporate debt to back our insurance obligations,” but actually some of that debt was downgraded, or the ratings agency had incomplete data or conflicts of interest when it assigned those investment-grade ratings. Or regulators might have questioned those investment-grade ratings if they had known that actually the corporate debt was issued by affiliates of the insurance companies. That’s all stuff that makes the insurance riskier ex ante, but in a diffuse, hard to measure way. If the company had disclosed everything to everyone perfectly, it probably would have been required to have more capital to back its insurance obligations. But it’s probably fine! The insurance will probably get paid!
TWG Global, the holding company at the heart of Mark Walter’s empire, hit back against what it called “multipronged attacks” on its business as US prosecutors continue to probe the firm.
The company is working with both the US Department of Justice and the Securities and Exchange Commission to resolve their inquiries, according to a statement Wednesday. Its insurance business has also submitted plans to its regulators to try to eliminate any concerns they have, the company said.
“Despite what has been reported, there has been no fraud,” TWG said. “There is no victim here. No one has been harmed, and no one has claimed they were harmed.”
We talked a bit about the TWG situation yesterday: TWG’s insurance companies “ disclosed more than $20 billion of loans that should have been labeled as affiliated transactions, but weren’t,” which probably means they should have had more regulatory capital than they did; they are now working with regulators to fix the problem. From the statement:
As it relates to Group 1001 [TWG’s insurance group], at its core this is a regulatory matter with a straightforward plan that has been submitted to its regulator to promptly eliminate all of the affiliate exposure at the Group 1001 insurance companies.
There is no victim here. No one has been harmed, and no one has claimed they were harmed. …
Affiliated transactions are commonplace in the insurance industry, widely permitted subject to applicable regulatory requirements, and a part of the insurance industry’s normal course of business.
Affiliated transactions should be properly disclosed, but to state that they “generally” have the potential to “loot” the insurer is untrue.
The reality is that Group 1001 has invested in real assets that are performing well; the insurance companies have recognized significant income from the investments and no policyholders have lost money because of these transactions.
As part of the plan, TWG is proposing to purchase the affiliated assets from the insurance companies, reflecting its confidence in the quality and performance of those assets.
It’s probably fine!
