Anschutz as Icarus: Flying too Close to the Sun

The variable prepaid forward contract, without question one of the most popular transactions on corporate and high net worth derivatives desks on Wall Street. Every firm has their own brand name for it, but the bottom line is always the same: helping a company or a wealthy individual protect the value of a concentrated stock position and generate liquidity from the position without paying taxes currently. In essence, getting all the benefits of a sale without the costs associated with a sale. An article in today's Wall Street Journal highlighted the structure and provided an example of its being pushed to the limit, so much so that the favorable tax treatment generally associated with the strategy is being challenged by the IRS. These strategies in other forms have not drawn the IRS's ire, but why?

First some historical perspective. In a perfect world, derivatives professionals and their clients would like to figure out how to sell an appreciated asset and not pay taxes - ever. Historically there has only been one foolproof way to accomplish this feat - by dying (with your heirs getting a stepped-up basis in the appreciated stock to fair market value at the time of death, enabling a sale without ever paying capital gains taxes on the position). Most clients and their advisers prefer a somewhat less draconian vehicle for accomplishing this, and the easy answer used to be the "short-against-the-box" trade. This involved simply borrowing stock against an appreciated stock position and selling it, posting the sale proceeds as collateral against the short position and perfectly hedging the value of the appreciated shares. This deal worked for a long time, until the IRS determined that if a transaction looked like a sale and smelled like a sale then it probably was a sale, and eliminated the tax deferral associated with the strategy. So smart derivatives practitioners then asked themselves the question - if a "short-against-the-box" transaction eliminated too much risk to warrant a tax deferral, then exactly how much risk needed to be taken in order to secure the more favorable treatment?

Financial engineering then gave us the variable prepaid forward and its variants (collectively 'VPF"). Essentially, you can think of a VPF as a kind of private mandatory convertible, similar to the instruments sold to raise capital for banks and corporations. Put another way, a client using a VPF to hedge a stock position is:

• Selling their stock forward (agreeing to sell at a future date for a pre-agreed upon price, generally 3 to 7 years foward);
• Buying a call option struck at the current stock price; and
• Selling a call option (or in some structures .833 of a call option) at 120% or more of the current stock price.

And once the hedge is put in place, the client can receive the present value of the future cash flows upfront, which is generally in the range of 80-85% of the current fair market value of the hedged position.The net effect of all this is to give the client significant liquidity, protect the full downside of the hedged position at the current stock price and to defer payment of capital gains taxes until the expiration of the hedge.

• Question: why does the IRS deem this not to be a constructive sale for tax purposes while the short-against-the-box is treated as a sale?
• Answer: because of the variability of future outcomes associated with the hedged position, the measure of which is the spread between the call option bought and the call option sold (in the above example a 100% call bought and a 120% call sold for a 20% spread) as well as the length of the hedge.

What are two ways to make the above hedge more "sale-like" and therefore blowing the tax deferral in the eyes of the IRS?

1. Make the call strikes closer, e.g., a 100% bought call and a 110% sold call; or
2. Make the maturity longer, e.g., 10 or more years.

The best measure of "stock-likeness" is embodied by the concept of delta. Per Wikipedia:

The delta measures the sensitivity to changes in the price of the underlying asset. The Δ of an instrument is the mathematical derivative of the option value V with respect to the underlyer's price.

Think of it this way: owning stock has a delta of +1. Selling stock has a delta of -1.  The hedge is the synthetic selling of stock. So if the delta of the hedge is too high (meaning the call spread is too tight or the maturity is too long), there won't be enough retained risk or variability of potential outcomes to cause the IRS to allow tax deferral. And while Congress hasn't enacted concrete rules that govern these strategies, the IRS has issued "private letter rulings" to law firms and banks on the topic that pretty much support what I've written above (or at least they did when I was in the business). But what was always an issue, a niggling little issue that sometimes found its way into certain of these hedging contracts, concerned the issue of stock borrow. And this is where the wealthy and generally fortunate Mr. Anschutz might be in a bit of trouble.

In order to execute one of these VPF deals, stock needs to be borrowed and sold to establish the short position. The Wall Street bank is the one who does this. But in the hedging contract, it has to be stated who bears the risk of a stock borrow being "called in" (meaning you've got to give the shares back to the stock lender and the transaction gets unwound). While there are lots of shades of gray (e.g., the stock can go "on special" and the borrow simply gets more expensive but doesn't go away, but someone has to incur the higher borrowing costs), someone is taking the borrow risk. So far we're ok as far as the IRS is concerned.

But where it used to be fuzzy prior to 2006 (but now is not) was when the Wall Street firm had the ability to borrow the shares held by the client in the event of a short squeeze or if there was not sufficient borrow available to get the hedge off in the first place. I looked at this feature many, many times and spent countless hours with counsel trying to get comfortable with this but never could. In the late 1990s/early 2000s during the Internet bubble, it was often very difficult to source enough borrow to execute a big hedge on a recently IPO-ed stock, and borrowing the client's shares would have been the ticket to millions in fees. But sadly, a prudent man's view of the facts and circumstances left these deals to be done by others or none at all. Don't shed too many tears, however: there were plenty of liquid stocks to hedge where this issue never came up, but in some cases it did and some decided to roll the dice.

Enter Mr. Anschutz. Now, according to the WSJ article, these transactions were entered into during 2000 and 2001. But they provided the counterparty, DLJ, with the ability to borrow the shares held by Mr. Anschutz. So think about this. Mr. A has shares. He posts them as collateral to DFJ for the hedging transaction. They sell those exact same shares as part of the hedge. Seems like a sale, right? This is the IRS position. The IRS formally shut the door on this type of deal back in 2006, a full 5-6 years after Mr. Anschutz put his hedges in place. Clearly his counsel will argue that such transactions should be grandfathered as they were entered into before the rules were clarified. But some of us saw these deals during the same time period and concluded that they were simply too dangerous. The benefit of an 8-year tax deferral like the one contemplated by Mr. Anschutz's hedges are very valuable. But the terms of his particular agreements are yet another example of something we see on Wall Street time and time again: flying too close to the sun.

 

Bank Holding Company Stockholders: Even Greater Dilution Awaits

During my years as a derivatives and capital structuring professional, I spent a lot of time working with my teams to develop versions of the "holy grail" - tax-deductible equity. In short, when corporations are seeking to raise funds, the goal is to receive equity credit from the rating agencies while incurring a financing cost more akin to debt. And this is nowhere more important than with regulated financial institutions, which have mandated minimum capital ratios which are heavily scrutinized by both regulators and the analyst community. Bank holding companies have been on the leading edge of so-called "hybrid" equity issuance, and have historically been among the largest issuers of such paper.

Without question, hybrid paper has created a form of both regulatory and economic arbitrage, where "equity" can be issued at debt rates. This has been courtesy of bank regulators, ratings agencies and the IRS, from whom opinions are sought to ensure the amount of equity credit received and the tax-deductibility of the structure. It could only be that such an arbitrage opportunity could exist when three different bodies are involved in the treatment of such instruments.

There is a limit to this nirvana, however: only so much of this paper can count as equity before the regulators and ratings agencies call bullshit. And if you believe the story line in a recent Wall Street Journal article - and I do - then this breaking point has pretty much been reached:

U.S. banks and brokers trying to raise capital with hybrid securities have turned to issuing the instruments so frequently they risk losing the securities' capital-raising benefits.

If the banks decide to sell more of these securities, which are a blend of equity and debt, they may not be considered capital by rating firms. That in turn could limit financial firms looking to raise more funds to bolster battered balance sheets.

The companies are then likely to tap other avenues that pose their own disadvantages, such as selling common stock -- which current shareholders wouldn't welcome.

The real issue here isn't that the banks are opportunistically trying to raise cheap capital and get equity credit, though this has been the "sale" from Wall Street firms to the banks during calmer times, but that banks need to raise equity, real equity - and fast. Damaged balance sheets face banks of all sizes across the U.S. the UK, and they either need to massively shrink their assets and de-lever (which causes a flood of paper to further depress asset prices), raise real equity capital or both. And it appears that the equity issuance side of the equation will become more costly, and greater numbers of these sales will be in the form of expensive and dilutive common stock. This is clearly not good for existing common stockholders, who will bear the brunt of this change in issuance strategy. Whether it is through public market issuance or via private sales akin to Washington Mutual's deal with TPG or the announced Bradford & Bingley transaction in the UK, common stockholders will be hurt - badly.

It brings me back to my early days at Citibank when Prince Al-Waleed spent a cool $590 million to buy up what turned out to be one of the best investments of all time (even in light of current problems). We have only witnessed the tip of the iceberg.

 

Yes Ben, the Dollar Does Matter

The weak dollar has been a source of much consternation, at least for me, over the past year. There are those who say "Who cares; a weak dollar helps exports," and "You need to keep pushing down interest rates until the economy recovers and we work through this crisis." My position has been pretty clear: a weak dollar is bad, not in and of itself, but because of the knock-on effects of such a policy. Why? Consider just a few reasons:

• The U.S. is a debtor nation. We rely on foreign governments to finance our deficits. If the value of those dollar-denominated holdings keep falling, at some point they will either stop buying or demand an increasingly high interest rate to offset currency losses;

• The U.S. financial system is in a badly weakened state. We need both onshore and offshore sources of capital to bolster bank balance sheets burdened with busted ABS and retained LBO loans. If foreign investors lack confidence in the dollar, this erects an extremely high barrier for investment.

• The U.S. imports a lot of stuff. Paying for this stuff with depreciated dollars means only one thing - rising prices. A weak dollar is fundamentally inflationary and something that could bring us back to a time we'd all rather forget - the 1970s.

But for most of the time I've been writing about my frustration with Fed policy, Mr. Bernanke has been turning a deaf ear to my pleas. But now it appears that we've reached a tipping point in Ben's mind, a point that has prompted him to sing a somewhat different song; here are his comments during yesterday's speech at the International Monetary Conference in Barcelona:

In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.  The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation.  We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.  Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.

Price stability? Maximum sustainable employment? Flexible markets? Hmm, not sure we've done such a good job on these fronts. Productivity, yes - so far. Mr. Bernanke is focused on the right goals to be sure. It's just that it has taken him a while to get there. And now he has to follow through with actions to back up the words. Clearly in his calculus he viewed the need to push down rates regardless of the impact on the dollar as critical in order to help repair the broken U.S. credit markets. It is hard to fault him for his intentions, though one can argue that pain taken quickly and sharply is, in the long run, a better policy than death by a thousand cuts. And given that the impact of Fed policy has a lag associated with it, are inflationary forces already unleashed in the system too far advanced for tighter monetary policy to tame them? Are we destined to suffer higher prices and higher interest rates due to the Fed's slowness in reining in liquidity to stem a plunging dollar? This is the $64,000 question. And given the way things are looking, I'm not sure I want to know the answer.