coggan 4

Shares


It is easy to get confused by financial jargon, and the stock market is no exception. Although people use the terms ‘stocks and shares’ as synonyms, there used to be a distinction, with stocks referring only to fixed interest instruments.
Shares are quite distinct from loans and bonds. Whereas someone who lends money to a company or buys its bonds is a creditor of a company, a shareholder is the owner of the company. A share, or equity, represents a share in the assets and profits that the company produces.
Unlike loans or bonds, a shareholder is unlikely ever to be repaid by the company itself. If a shareholder wants to realize his money, he must sell the shares in the open market. Furthermore, the return available to lenders or bondholders is normally fixed in advance; the return to shareholders is infinitely variable. Once a business’s costs (including interest payments) have been met, all the excess belongs to the shareholders. However, if the business goes bust, the shareholders are at the back of the queue for repayment.
Shares and shareholders are unique to the capitalist system. Under a communist system, bonds are issued but never shares, since ownership of virtually all commerce is in the hands of the State. It is not exaggerating the case, therefore, to say that shares are at the heart of capitalism. They have traditionally been the investment most likely to get people rich quickly and also to reduce them to poverty (remember the Great Crash of 1929).
OWNERSHIP AND CONTROL


Shares also provide the means through which ownership of industry can be divorced from control. Death and taxes have gradually weakened the grip of the founders of old family-run businesses. Few individuals now have the capital to finance a firm’s expansion. Modern industrial giants are run by boards of directors, who in turn appoint salaried managers to administer the day-to-day business of the company. Some managers sit on the board and have shares of their own but, except in a few special cases, managers rarely own a significant proportion of the company’s equity.
An attempt has been made in the last twenty-five years to reverse this trend by giving managers share options, which allow them to buy shares at a set price. The theory is that this will ensure that the interests of investors and managers are aligned, since both will benefit from a rising share price.
In practice, the system has certainly made many managers rich. But it was something of a one-way bet while the stock market was rising for much of the 1980s and 1990s; managers were able to earn huge sums just for being reasonably competent.
The richest managers of all were those who took part in leveraged buyouts (see Chapter 9), in which the executives, aided by some private equity groups, made takeover bids for companies and removed them from the stock market. These deals tend to leave the managers with a big proportion of the equity but land the company with a big burden of debt; if things went well, the managers would earn a fortune but if things went badly, the company would go bust.
The Rights of Shareholders


What rights do shares confer? The most common form of share is the ordinary share: it gives the owner the right to vote (although there are non-voting ordinary shares), the right to appoint and remove directors and, most importantly, the right to receive dividends, if and when declared. Remember that the dividend is to the shareholder what the coupon is to the bondholder (i.e. an opportunity to receive income rather than capital appreciation).
Most companies pay a dividend every six months although some (particularly the multinational groups) now pay out every quarter. The first appears with the half-yearly results and is known as the interim dividend and the end year dividend is known as the final.
Because shareholders stand at the end of the creditors’ queue if a company fails, shares are on the riskiest end of the risk–reward scale and can therefore attract the highest return. Like bonds, shares can increase in price but the potential for share price increases vastly exceeds that for bonds. Although dividends add to the attractiveness of shares, it is this chance of a sharp rise in price that makes shares such an exciting investment. An investor who placed £1,000 in Polly Peck shares at the start of the 1980s would have seen his sum grow to £1.28 million by the end of July 1989. But a year later, the shares were effectively worthless.
Just as individual companies can go bust, the whole market can experience sharp declines. The 23 per cent fall in the Dow Jones Industrial Average on 19 October 1987 was only one illustration of how quickly and dramatically share prices can take a turn for the worse. Between Janaury 2000 and March 2003, the FTSE 100 index more than halved. History is littered with stock market crashes and with companies that have gone bust. The ordinary shareholders are usually the losers from such failures.
Other Types of Share


In order to attract investors who are wary of the risks of ordinary share ownership, companies have devised other forms of shares which are slightly less risky. Preference shares are different from ordinary shares in that they give the holder a first claim on dividends and on the company’s assets, if and when it is liquidated. The amount of dividend attached to a preference share is fixed. If it is not paid, it is a sign that the company is in severe financial trouble. The lesser risk attached to holding preference shares means that the return in good years is less than that of ordinary shares. In addition, the voting rights of preference shareholders are normally restricted.
Cumulative preference shares entitle the holder to be paid in arrears if the dividend is not paid one year. Since they are slightly less risky than ordinary preference shares, the yield on cumulative preference shares is marginally lower. Redeemable preference shares will be repaid at a future date; they closely resemble bonds and must offer a similar return to be attractive to investors. Participating preference shares offer a lower basic rate of return but allow for a bonus rate if the ordinary dividend is high. Convertible preference shares can be converted into ordinary shares at a certain price – they closely resemble convertible bonds (see Chapter 11). Again, the investor is compensated for the lower initial rate of return by the chance of future gains.
As a group, preference shares resemble fixed-rate bonds; indeed, the yield from such shares tends to be compared by investors with the yield on long-dated gilts. However, unlike bonds, companies which issue preference shares cannot offset the dividend against tax. This made them increasingly unpopular in the bull market when it was cheaper to issue ordinary shares to a seemingly insatiable investing public.
Options


Options differ from other types of equity investment because they are not issued by the companies concerned. Instead, they are instruments traded on stock exchanges designed to give investors greater leverage and to act as hedging vehicles for those investors worried about future share price movements.
Options grant the buyer the right to buy (a call option) or to sell (a put option) a set number of shares at a fixed price. The option buyer is not obliged to buy or sell at that price if it is not advantageous to do so. In return for granting the option, the option seller receives a non-returnable premium.
An example will help explain the principles involved. Suppose an investor has bought British Telecom (BT) shares at £1.50. Their price moves to £1.70 each. The investor wants to make sure that he retains some of his gain, but does not want to miss out on the chance of seeing the price rise still further. So he buys a put option at £1.70 – giving him the right to sell his shares at £1.70 if he so wishes. In return, he pays a premium of five pence a share. If the share price falls to £1.50, the investor exercises the option and sells the shares at £1.70. Taking away the cost of the premium, he has retained a profit of fifteen pence. If the share price rises to £2.00 the investor simply lets the option lapse. He has paid five pence a share but has a profit of forty-five pence a share over his original purchase.
More speculative investors may try to use options for their leverage potential. Suppose an investor has no shares in British Telecom at all but merely believes their price will rise. In the above situation (BT shares at £1.70), he could buy a £1.70 call option for a premium of five pence a share (on 100 shares, that would cost him £5). If the price rises to £2.00, then the option will be worth at least thirty pence on the traded market, because he could buy his shares at £1.70 through the option and then sell them at £2.00 at the Stock Exchange. Rather than exercise his option, the investor would sell the option and receive £30, or a 500 per cent profit on his original investment. An ordinary shareholder, buying at £1.70 and selling at £2.00, would have made a profit of only 17.65 per cent.
Another way for investors to speculate on share price movements is via contracts for difference. These are agreements between two parties that one will pay the other the difference between the current price of a share and its value at some future date. To go back to the BT example, an enthusiast for the company might agreee on a CFD based on the £1.70 price. If the price then moves to £2.00, the enthusiasts will earn 30p per share; if it falls to £1.50, he will have to hand over 20p per share.
The attraction in CFDs for speculators is that shares can be bought on margin, that is without putting up a lot of capital. This margin can vary widely but let us assume it is 10 per cent. To buy 10,000 BT shares in our example, the investor would have to pay £17,000; with a 10 per cent margin, he only has to hand over £1,700. The risk, of course, is that only a small market movement can wipe out a large part of his capital. In addition, in the UK, buyers of CFDs are exempt from the 0.5 per cent stamp duty charge. As a result, CFDs are often used by hedge funds as a way of getting exposure to a share; a process that can also protect the privacy of the hedge fund trying to build up a position.
A related way of speculating on shares is spread betting. Readers may be familiar with the concept from sport, where gamblers bet on such statistics as the number of wides in the cricket World Cup or the time of the first goal in the FA Cup final. A spread bet requires the gambler to bet that a given number will be higher or lower than the specified range; it does not really matter to the bookmaker what the subject of the gamble is. If the range is 100–105, it could be the number of rainy days in the year or the number of goals scored by Manchester United in a season.
How does it work for shares? Let us go back to our BT example and say the spread is 168–173p. Someone who believed that BT shares would rise would go high and bet, say, £100 a point. In other words, for very penny that BT traded above 173p, he would make £100. If the share price reached 200p, he would gain £2,700. However, the converse is also true. For every penny below 173p, the gamble will lose £100. So a fall to £1.50 would cost £2,300. This is a much riskier gamble than a fiver on the Grand National.
Spread bets have a defined period but the bet can be closed before that date by making an equal gamble in the opposite direction. Indeed, the bookmaker may force the gambler to take his losses (or put up extra money) if the gamble goes sufficiently wrong. The good news is that any profits are not subject to capital gains tax; the bad news is that the Treasury does not charge CGT because it reckons there will be more losers than winners. (Provided the bookmaker can run a matched book, the spread should be pure profit.)
NEW ISSUES


New issues are one of the most exciting parts of the stock market. Not only do they allow investors to spot the successes of the future at a relatively early stage, they are also a direct means of providing capital for industry. Obviously, the daily buying and selling of shares – known as the secondary market – is extremely important. Without the knowledge that their shares could easily be sold, investors would not subscribe for new issues. But it is new issues – and the subsequent capital-raising exercises for expansions and acquisitions – which provide the main economic argument for the Stock Exchange’s existence.
Companies have a choice as to which market they can list on these days. The main market of the London Stock Exchange is designed for well-established companies; the Alternative Investment Market (AIM) is designed for younger companies and has fewer rules for qualification. Nowadays, it is quite possible for UK companies to list on overseas markets as well as, or instead of, London and indeed many overseas companies choose to list here rather than in their own country.
AIM is the successor to the unlisted securities market, an earlier attempt designed to attract young and growing companies. The rules for floating on AIM are much less stringent than for the main market, and depend heavily on the advisers, or sponsors, who bring the company to the market. After some early disasters, a review of sponsors led to some leaving the market.
The name of the sponsoring house may be very important in ensuring investors’ confidence in the issue. The sponsor will also advise on the timing and the terms of the issue. After Black Monday in 1987, for example, several companies withdrew their issues, on advice from their banks or brokers, until the stock market was more settled. When they returned, they were able to raise less money than they had originally planned.
There are a variety of methods by which a company can join the market. If the company is particularly large – like British Telecom or Eurotunnel – it will make an offer for sale. This is the most expensive method of making a new issue since it requires a large amount of publicity and also the underwriting of the offer by investment banks and institutions.
Once the underwriting is arranged, a company will issue a prospectus setting out in very detailed form its structure, trading record and prospects. Investors are then invited to apply for shares by a certain day. On the day that applications close, the sponsor counts up all the offers and then announces whether the issue is over-or undersubscribed. If oversubscribed, this means that investors have applied for more shares than there are on offer; either their applications will be scaled down or there will be a ballot, in which only a few will get shares. If the issue is undersubscribed, the underwriters will have to buy the shares at the offer price.
In a conventional offer, investors are told the share price in advance; in a tender offer, they pick the price themselves (although a minimum price is usually set). When all the tenders are in, the highest will be awarded shares, then the next highest and so on down until all the shares are allocated.
Tenders are unpopular with institutional investors, since they reduce the chance of an increase in price (premium) when the shares start trading. Private investors also are not inclined to apply for tender offers. As a result, tenders are comparatively rare and only tend to be used when an issue looks certain to be popular.
A placing is by far the most common, and also the most prosaic, means by which a company joins the stock market. The sponsoring bank or broker contacts key investment institutions and asks them to take some shares; individual investors are unlikely to be approached. The placing method is cheaper than an offer for sale and tends to ensure that the shares are held in the hands of a few, supportive institutions.
The success of all these new issue methods depends on setting the right price for the shares. The higher the price, the more money flows into the company. But the sponsor will not want to set the price too high, for fear that it will fall when dealings commence. The ideal is a modest price rise on the first day. That reflects well on the company and pleases the shareholders – in the long run that will be better for the company than squeezing the last penny out of the issue price. The sponsor’s problems in setting the price will be exacerbated by the presence of stock market investors called stags, who are eager to make a profit out of new listings when the price is set too low.
Stags are one species of the financial menagerie which commentators use to describe different types of investor. Essentially, stags are speculators who believe that a new issue has been priced too low, and who therefore attempt to purchase as many shares as possible. If they have correctly assessed that the issue is underpriced, the shares will immediately rise in value when the issue is made. The stags can then resell the shares and make a quick profit.
Stags only really emerge for offers for sale; placings and tenders give them little chance for profit. Another mechansim has made the life of a stag more difficult; the so-called grey market for shares. This market, often supervised by the spread betting companies, allows investors to speculate on the likely issue price (or first trading price) of flotations. But it also allows the sponsors of the deal to assess the likely market reaction to an issue. As a result, they may move up their expected offer price. This happened during the dotcom boom with the travel company Lastminute.com. When this happens, stags find their opportunity for profit has been sharply curtailed.
RIGHTS ISSUES


A new issue normally takes place in the early years of a company’s existence. As companies attempt to expand, however, they need more funds than were provided by the original sources. There are many avenues open to raise funds in the form of debt. However, too much debt makes a company unbalanced. At some point, the company will need further equity capital.
The traditional means of raising new equity is a rights issue. Shares are offered to existing shareholders in proportion to their holdings – a typical offer might be one share for every four owned. The shareholder may then take up the rights and pay for the new shares or sell his rights to do so to another investor.
Rights issues are a fairly expensive way of raising new money. They have to be underwritten and the shares usually have to be offered at a substantial discount to the market price. Such are the costs that some companies have tried to find alternatives to the rights offer. But the institutions have stood firm in defence of their rights. It is a general principle of UK companies’ legislation that existing shareholders should have a pre-emptive right to subscribe to any new shares on offer. Without that right, the original shareholders’ stake in the company would be eroded. So except for quite small issues, UK companies can still only place shares with new investors if the existing shareholders agree.
Some companies make so many acquisitions, using shares as their means of payment, that constant rights issues are out of the question. A compromise method is called a ‘vendor placing with clawback’. It works like this. Company A wants to buy Company B and would rather pay in shares than in cash. But Company B’s shareholders want cash rather than shares. So Company A issues shares to Company B and then immediately arranges for the shares to be placed with outside investors, thereby getting Company B its cash. To protect the rights of Company A’s shareholders, they are given the entitlement to apply (to ‘claw back’) any or all of the placed shares.
When considering a rights issue, the main questions facing the company and the bank or broker advising it are when to make the issue and at what price. The shares will normally have to be offered at a discount to the market price for the company’s existing shares, otherwise those shareholders who want more shares will simply buy existing ones on the market. The bigger the proportion of new shares on offer (say, one to four), the heavier the discount will have to be, in order to attract the amount of funds needed.
The company will also have to allow a grace period, usually five to seven weeks, to allow shareholders time to decide whether or not to take up their rights. This is a weakness in the process since it leaves the company vulnerable to bad news, or a change in the fortunes of the stock market. If the price of the existing shares falls too far during that period, it can ruin the prospects of the issue; the discount offered may have to be substantial in order to avoid that risk. Sometimes the discount is not enough. In 2008 Bradford & Bingley decided to reprice its rights issue, following a profits warning; the decision saved the banks that underwrote its issue many millions of pounds. In the end, the bank had to be rescued by the government.
Timing the issue is very important – if the stock market is strong, then a company can raise a lot of money by issuing fewer new shares. However, shareholders may be unwilling to take up new shares which are highly priced. If the share market is weak and a company’s share price is low, then a rights issue to raise a large amount will involve issuing a large number of shares. This can dilute the control of its shareholders.
The proportion of a company’s total profits, dividends and assets held by existing shareholders is unaffected by the price at which new shares are issued under a rights issue or the number of shares issued – it is the proportion of equity raised which is important. A one-for-four issue will create 25 per cent more shares, in other words there will be five shares in issue for every four that existed before. If existing shareholders do not take up their rights, they will own four-fifths of the enlarged company, regardless of whether the shares were issued at 50 pence or £2 each. The important question for existing shareholders to decide is whether to exercise their rights to the issue or whether to sell them to a more willing buyer. That decision may depend on whether or not they have the cash available to pay for the new shares, whether they have an interest in controlling the company and what they see as its future prospects.
How much would their rights be worth? Assume that the company offered one million shares at £2 each and that its 4 million existing shares were trading at £2.50 (a one-for-four issue). The theoretical value of the rights can be calculated as follows:

4 million existing shares at 250 pence   £10 million
1 million new shares at 200 pence         £2 million
5 million shares in total                      £12 million


Dividing the total value of the company by the number of shares, £12 million ÷ 5 million = £2.40. Subtracting the rights issue price of £2.00 gives a theoretical price for the rights of 40 pence. In fact, this theoretical value is rarely attained exactly but it is a rough guide for investors.
BONUS ISSUES


Capitalization issues, sometimes known as scrip or bonus issues, create more shares but without a resulting cash flow to the company. Each shareholder is given extra shares in proportion to his or her current holdings. These issues are essentially accounting operations, transforming retained earnings into shareholders’ capital. Sometimes, they are undertaken to reduce the price of shares since it is usually believed that high-priced shares are unpopular with individual investors.
Although the price of a company’s shares should theoretically fall in proportion to the size of the capitalization issue (since the number of shares has increased while the nominal value of the company has remained constant) this does not always happen. Capitalization issues normally take place during periods of high company profits, and shareholders may be encouraged by news of such an issue to improve their view of the company’s prospects and thus bid up its share price. This effect is likely to be only temporary, however, if investors are rational. Just because a pizza is sliced into eight pieces rather than four doesn’t mean that any more food is on offer.
SHARE BUY-BACKS


As well as using the stock market to raise new capital, companies can also return cash to shareholders. In the past, companies tended to hang on to spare cash, on the ‘rainy day’ principle. But financial theory suggests they should not do so. If companies have no profitable projects in which to invest, they should give the money back to shareholders so they can make use of it.
Under a share buy-back, a company simply goes into the market and buys its own shares. Not only will this help boost the share price, it will enhance one measure of a company’s performance called the earnings per share.
Provided the company is earning a decent return on its business, then profits should not be dented much by the cost of share buy-back. But the number of shares in issue will fall, so the profits per shareholder, or earnings per share, will rise.
It may even pay for companies to borrow money to buy back shares since corporate finance theory shows that debt financing, which is tax-deductible, is cheaper than equity. Share prices may also be preferred to dividends by some shareholders if the tax rate on capital gains (when they sell their shares) is lower than the tax on income. But buy backs can make companies look very silly. Banks, in particular, bought back shares in 2006 and 2007 and then had to issue more shares, at much lower prices, in 2008. They bought high and sold low.
THE STOCK EXCHANGE


The London Stock Exchange is the traditional arena where existing securities are traded. It has long been seen as one of the symbols of both the City and the British economy. The daily fluctuations in its index are seen as reflections of the nation’s economic health.
An exchange has two main functions. First, it is a place for companies to list and to raise new capital. It therefore needs a set of rules. Companies are required to have a history of public accounts, to announce all major developments promptly, to treat shareholders fairly and so on. Second, it is a place for shares to be traded. You can’t have the first without the second; who would want to buy shares without knowing that they could be sold? But the main economic rationale for an exchange is that it is a place where industry can raise the long-term finance it needs.
The Exchange’s origins lay in the seventeenth century, when merchants clubbed together to form joint-stock companies, like the East India Company, to conduct foreign trade. After a time, some merchants sold their holdings to others, and in the process there developed a secondary market for shares in the joint-stock companies. At first, the shares were traded in the coffee houses which were then fashionable, but in 1773 the different sites for trading were centralized for the first time. By 1801, the Stock Exchange was established in roughly its modern form.
Exchange members built up some of the country’s most colourful traditions. Legend has it that if a member spotted an outsider on the Exchange floor, he would shout, ‘Fourteen hundred!’ (for a time, there were 1,399 members), and the offending individual would be ejected into the street, minus his trousers. Another tradition which has vanished is that of ‘hammering’, the term used to describe the financial failure of a member firm. The term arose because in the old days failure would be announced after an official had interrupted proceedings by hammering on a rostrum.
Times change, and the old gentlemanly agreements have given way to the age of the computer. The Big Bang, back in 1986, saw the end of the old trading floor. Instead of being marked up by hand, prices were displayed on electronic screens, via the Topic system. Traders then contacted each other by telephone to do the deal. This allowed traders a fair degree of leeway; on 19 October 1987 when US shares fell 23 per cent, those who called the leading traders in the hope of dealing found the phones were never answered.
As prices went electronic, so did company announcements which were broadcast through the Topic news service. And electronics led to the slow demise of the share certificate, now largely confined to private investors. Details of share ownership are now held electronically and many investors hold their shares in nominee form, with a stockbroker standing between them and the company. The result has been a bit of a disconnect between companies and private shareholders, who may no longer receive annual reports from the business they hold or attend annual meetings.
In the 1990s and 2000s, the system gradually changed again. Rather than conduct deals by phone, it became possible to do deals electronically, simply by pushing the right button or clicking on the right area of the screen. Large hedge funds and so-called quantitative investors often used computers to search the market for pricing anomalies and do deals automatically when they found them.
Investors sought ways of conducting trades without moving market prices against them. (If other people know you have a big position to sell, they will cut their buying prices.) Techniques called algorithmic trading and smart order routing emerged that were designed to trade as efficiently as possible. Some of these traders aimed to do deals in fractions of a second.
THE INTERNATIONAL CHALLENGE


In this new world, the whole idea of national stock exchanges seems a bit anachronistic. Some of the biggest companies on the London stock market have their origins in other countries – BHP Billiton or Anglo-American, for example. Others like BP may have British origins but are clearly global businesses with only a tenuous link to the UK economy.
Investors who want an exposure to the oil sector are as likely to choose ExxonMobil in the US or Petrobras in Brazil as BP. And they probably do not care whether they buy those stocks in London, New York or Frankfurt – tax and costs are the main consideration.
Indeed, why do they want to buy the shares on an exchange at all? For regulatory reasons, exchanges like to publish the details of their transactions, so a false market is not created. But if you are a big investor with 20 million shares in BP, you probably do not want other investors to know you are selling part of your stake. They may anticipate the sale of the rest of your stake and drive the price down against you.
So there are rivals to the established exchanges. One format is crossing networks, where sellers and buyers are matched to save costs. The seller of BP shares simply waits until a buyer is found. Another format is dark pools; here both buyers and sellers are anonymous. The aim is to prevent deals from having an impact on market pricing.
In a sense, the existence of these networks reveals the conflict between the aims of transparency and liquidity. It is nice to know what everybody in the market is doing but not so nice for those who are participating. It is a bit like having your poker hand revealed.
With investors going global and competition emerging from new kinds of network, the London Stock Exchange can no longer rely on its national monopoly. Indeed, it is possible to imagine one day that all shares will be traded on a global electronic exchange. At the very least, there might be just one exchange for Europe, to go alongside New York and Tokyo.
For a long time the London market was the biggest in Europe, but the others have been catching up. The LSE recognized the problem by agreeing terms for a merger with the Frankfurt Exchange in the late 1990s, but the deal fell through. That was when London was operating from a position of strength. But as European exchanges merged, London seemed to be left behind. A particularly strong competitor was Euronext, the exchange created by the merger of the Amsterdam, Brussels and Paris markets. The shift in power was neatly illustrated in 2002 when Euronext bought LIFFE, London’s futures market, from under the London Stock Exchange’s nose. Euronext merged with the New York Stock Exchange in late 2006.
In 2004, London was on the receiving end of a bid from the Frankfurt exchange, with the implication that London would be the junior partner. That bid was only defeated by the actions of shareholders in the Deutsche Börse. Such a bid was only possible because the London Stock Exchange demutualized, after a vote of members in 2000, and became a public company. It floated on itself in 2001.
The long-term future of the London Stock Exchange is still open to question. NASDAQ, the US electronic exchange, made a bid in 2006 but eventually lost interest. The LSE’s own imperial ambitions have been limited to a merger with Borsa Italiana, the Italian exchange in 2007 but further consolidation seems likely.
The LSE has not stood idly by. It has used the more flexible rules of AIM to attract foreign companies to list (the number of overseas groups rose from 4 in 1998 to 220 in 2005). This attracted some criticism that its rules were too lax but it did allow the market to steal a march on its US rivals.
HOW INVESTORS VALUE COMPANIES


Why do share prices move up and down? What makes some companies into poor investments and others into the equivalent of pools winners? In the end, the price of a share should be equal to the value of all future cashflows that the investors will receive, discounted to allow for the time value of money. But it is very difficult to agree on the right discount rate and even more difficult to estimate all the future cashflows. So investors have to find some short cuts.
One obvious step is to look at profits. But what is profit? It is not quite as simple as deducting a company’s costs from its revenues. A charge must also be made for the gradual fall in the value of a company’s fixed assets. This charge is known as depreciation. It is a useful concept, since it prevents accounting blips (such as a sudden drop in profits because a firm needs a new boiler). Allowances for depreciation make it easier to judge the trends in a company’s profits performance.
Since tax rates can vary substantially because of the proportion of profits made overseas and because of accumulated losses in the past, it is the pre-tax profit figure which is most often chosen for analysis. If a newspaper headline talks of a company’s profits being up 25 per cent, then it will be the pre-tax figure that is being referred to.
But profits cannot be the only measure of corporate performance. It is easy for companies to improve their profits by buying their competition in return for shares. Shareholders will not necessarily benefit – they could end up with 5 per cent of a company earning £20 million instead of 20 per cent of a company earning £10 million. So an important way of valuing a company is to look at its earnings per share (i.e. the base profits of a group divided by the number of shares in issue). That calculation is made after tax has been deducted.
Calculating earnings per share is one step on the road towards the comparison of different companies. The next step is to divide the share price by the earnings per share; the result is the price/earnings (P/E) ratio, perhaps the most popular way of valuing shares. It gives an immediate rough guide to the time needed for the investor’s initial stake to be paid back in full. If the P/E ratio is 15, then it will take fifteen years (on current earnings) to pay back the shareholder’s investment. If the P/E ratio is 2, then it should take only two years. Of course, for the P/E ratio to be a perfect guide to the payback period, the firm would have to keep its profits constant and distribute all of them in the form of dividends. Both events are extremely unlikely, but the P/E ratio is still an important measure of a group’s worth.
One might assume that the lower a company’s P/E ratio (and therefore the shorter the payback period), the better the shares are as an investment. This is far from being the case. Since all investors would prefer to have their stake repaid in two years rather than in fifteen, if they thought that the prospect was feasible they would flock to buy the shares of the company with the P/E ratio of 2. As a result, the price of that company’s shares would rise, and so consequently would its P/E ratio. Other investors would sell the shares of companies with high P/E ratios and those companies would see their share price (and therefore their P/E ratio) fall.
The P/E ratio thus reflects investors’ expectations of a company’s earnings power. If the ratio is low, it indicates that investors expect the company’s earnings to fall or stagnate. If the ratio is high, it normally means that investors expect the company’s earnings to rise extremely quickly.
Another frequently consulted index of a company’s performance is the yield, calculated by dividing the dividend by the prevailing share price. This calculation differs from the P/E because not all of a company’s post-tax profits are paid out to shareholders. Sometimes the dividend can be a tiny fraction of the profits. The rest of the company’s earnings will be retained by the company to finance its investment.
Yield figures and P/E ratios are given in the Financial Times every day for most of the shares traded on the Stock Exchange. An important point to note is that share prices fall just before the company issues its dividend and the shares are sold ‘ex-dividend’. The person selling the shares will receive the dividend rather than the person receiving them and the fall in price will reflect the likely dividend payment. Shares become cum-dividend shortly afterwards and for a few days it is possible to choose whether to buy shares ex- or cum-dividend.
There are other valuation methods. One is to calculate the value of the company’s assets and then, after deducting the value of its debts, calculate a net asset value per share. If the company’s share price is lower than its net asset value per share, then, in theory, it would be possible to buy the company, sell off all the assets and make a profit.
Asset value is a quite useful valuation method for some companies but in modern industry, when many businesses are service companies with very few tangible assets, it has a limited application.
In the late 1990s, investors started to use other valuation measures to assess shares. In some cases, these were designed to overcome the problem of companies that had no profits or dividends, mainly in the internet sector. In other cases, the aim was to produce something more sophisticated than earnings per share, a figure that can be easily manipulated. The most popular new measure was EBITDA (earnings before interest, tax, depreciation and amortization), a figure which aimed to show the cashflow of the company. Another measure was free cashflow, the cash left over after the company had paid its working costs and any necessary capital expenditure.
TAKEOVERS


Although corporate profitability is very important to share prices – and a sudden move into losses or extra-high profits can have a dramatic impact on a particular share – it is the prospect of a takeover that really gets investors excited.
Takeovers have been the basis for many scandals in the City, and they can also arouse much passion as the managers and the workers in the target company unite to fight off the unwanted predator. The concept is quite simple – one company buys up the majority of the share capital of another. Usually, for tax and other reasons, the predator will buy all the share capital but it is not inevitable. A simple majority will give the owner control but 75 per cent may be needed to force through key decisions about a company’s future. More than 90 per cent is needed if the predator wants to eliminate all minority shareholders; beyond that level, the buyer has the right to compulsorily acquire the remaining shares.
Occasionally, takeovers are dignified by the name mergers and the talk is of a partnership between equals. There may even be co-chairmen and the lead management positions are shared out between the two sets of executives. However, in the vast majority of cases, one party has the upper hand. Genuine mergers are quite rare.
What motivates the company making a takeover? Normally, it is the belief that it can run the target company better than the existing management. This might be because the incumbent management is particularly incompetent; it might be because combining two businesses can bring cost savings; it might be because the target company has moved into industrial sectors which it does not understand. In some cases, predators may simply believe that the shares in the target company are cheap. It may be possible, once the target has been acquired, to sell off the various parts of the company for more than the whole – a process which used to be known as ‘asset-stripping’.
Most takeovers involve private companies (i.e. those not quoted on the stock market). Normally private companies are owned by one individual, or a group of individuals and the predator cannot gain control without their agreement. Why do companies agree to be taken over? There are lots of potential reasons. If you own 80 per cent of a thriving private company, you are in theory wealthy but your money is locked up. Only by selling your shares can you get hold of the capital to buy your dream house, luxury yacht, or whatever. Since your shares are not quoted on the Stock Exchange, few people will want to buy them. In most instances, the only practical way to realize your cash is to agree to a takeover. Another reason for a private company agreeing to be taken over is to obtain funds for expansion. A big, publicly quoted company finds it easier to pay for a new factory or set of computers.
When a predator wants to take over a quoted company, a whole set of complex rules and customs have to be followed. The Takeover Code is voluntary but, in practice, City firms have to follow its rules if they want to keep their reputation. (Or at least, they have to avoid being caught breaking the rules.)
It is a general principle that all shareholders must be treated equally, and many of the rules are designed to ensure this happens. For example, it is obviously in the interests of the predator to ensure that his intentions are kept as secret as possible. As soon as news of a bid leaks out, the share price of the target company will rise substantially. Thus the greater the secrecy, the more shares the bidder can acquire at lower prices. However, the proportion of shares that a predator can acquire without revealing its stake is just 3 per cent. Once that level is reached, a buyer must reveal the amount of shares he owns and any further purchases. Otherwise, other shareholders might sell their stakes at ‘artificially low’ prices, only to see the price rise when the bid is announced. Another rule is that a bidder cannot buy more than 30 per cent of a company, without offering to buy the rest of the equity. Again the principle of equal treatment applies. If the rule did not exist, a bidder could buy just 50.1 per cent of the equity at a high price; the owners of the other 49.9 per cent would then miss out.
So what happens when a bid is launched? Usually, a predator will try to win the consent of the board of the target company. That board has a duty to recommend the bid, if it thinks it is in the best interest of shareholders. Sometimes, the price offered is so high or the advantages of combining the businesses are so obvious that the board will agree to the offer. In such instances, bids are nearly always successful.
It is when a bid is rejected, that the fun starts. Each side will hire one, and sometimes two, banks to advise them on tactics; each will have a public relations firm putting its case to the press. On the day the predator launches its offer, it will outline the logic of combining the two businesses and describe its offer as extremely generous. The target will come back quickly with a statement proclaiming its desire for independence and dismissing the offer as ‘derisory’ and ‘opportunistic’.
The whole process takes up to eighty-one days. It is up to the predator to convince shareholders in the target company that the price offered is fair and the logic of a combination sound. If the predator is offering its own shares in exchange for those in the target, it will have to show that there is a prospect of long-term growth in its own profits.
The process is kept to a short timetable. After announcing its intention of making a bid, the predator has twenty-one days to send an offer document to shareholders in the target company. Then the predator has sixty days in which to win the argument; if it has failed to get the majority of shares by then, it must give up the bid.
Normally, companies are only bid for if their profits record has been disappointing. So, they are in the difficult position of arguing, ‘We’ve been bad before, but we’ll be good in the future.’ Target companies will usually put some flesh on the bones of their promises with a profits forecast. They will also attack the record of their opponent. If such tactics appear to be having little success, they may be forced to call on a ‘white knight’– a third company which will outbid the unwanted predator. The target company will have lost its independence but it will at least have deprived the enemy of total success.
Most shareholders wait until the last minute before deciding, in case a higher bid is put on the table. The final count can be agonizingly close – bids have been disallowed because the vital acceptances were delivered just a few minutes after the final deadline. These days hedge funds may often be involved. Some may follow a strategy known as merger arbitrage in which they buy the shares of the target and sell short (bet on a decline in) the shares of the predator. Others may be activist funds that buy stakes and try to force a company’s managers to increase the share price by seeking a bid.
Takeovers tend to be terribly acrimonious, although the kind of high-profile advertising that characterized the takeover battles of the early 1980s has been discouraged. They are also very lucrative for the banks, lawyers, accountants and public relations advisers involved. The costs of a substantial bid, successful or not, will run into many millions of pounds.
It is unsurprising, in the circumstances, that banks are eager to get work as bid advisers. Some of the big commercial banks have tried to make inroads in the market by financing, as well as advising on, the bid. This can leave the banks rather exposed if things go wrong.
There is plenty of controversy over whether takeovers are actually good for industry. Academic studies have been written arguing that the larger businesses created are rarely more efficient than the old. Some believe that the fear of a takeover restricts the managers of companies – they tend to worry about short-term results rather than investing for the long-term good of the firm. It is certainly true that some companies are more famous for their takeovers than for actually running the businesses they own. The stock market history books are littered with the names of whizz-kids who built up vast empires through a series of acquisitions, only to see the whole edifice crumble in disaster.
But it is hard to see how shareholders would ever rid themselves of incompetent managements without the prospect of a takeover. It is possible that if taking companies over was made more difficult, control of industry might be seized by less open means – boardroom coups, for example. At least, under the current system, the arguments are made public.
Takeovers and Fraud


Since so many of the City’s scandals are tied up with takeover battles, it is worth explaining the practices that incur such disgust. The first is insider dealing. This is not an offence confined to takeovers, although bids offer most of the best opportunities. All it involves is someone – the chairman’s brother, the stockbroker, the lawyer – buying or selling shares in advance of some piece of important corporate news. Say that Acme Inc. is about to bid for Dullsville. Acme employs the First National Bank of Wigan as its adviser. A young broker at the First National learns of the bid and buys a large slug of Dullsville shares just before the bid is announced. He makes a substantial profit but he is an insider dealer.
Not everyone thinks that insider dealing is wrong. Some think that it makes the markets more efficient, since it is a way of ensuring that all the information about a company is in its share price. It is, such people say, a victimless crime. And insider dealing is very hard to define as an offence. There have been some scandals which involved people learning of the shares that newspapers were about to tip in their columns and then buying accordingly. But you could argue that the only people to suffer were those foolish enough to buy on the back of a newspaper tip. Then there is the question of how you obtain the information. Supposing you overhear two men in a bar saying that they think ICI is about to be taken over. The chances are very high that the two men do not know what they are talking about. If you buy ICI shares, you may actually lose money. But if, by chance, the men were right, does that make you a criminal?
The second sort of scandal involves the tactics used in the bid. Since many offers are made using the shares of the predator company as payment for those in the target company, it is obvious that the higher the price of the predator’s shares, the better the chances of the bid. Thus, there is an incentive for the predator to try to manipulate its share price, perhaps by bribing others to buy its shares. Such schemes are now against the law, but they can be difficult to prove. Similarly, if a few shareholders have large stakes in the target company, the predator may try to bribe them to accept its offer, perhaps in return for some commercial deal after the bid is successful. Again such arrangements can be difficult to prove.
THE FTSE INDEX


Every day, on the television news, some reference will be made to the performance of the FTSE Index – the so-called barometer of industry’s health. If the FTSE Index goes up, that in itself is regarded as ‘good’ news. If it goes down and keeps falling, talk of a national crisis begins.
There are several indices in use, but the one most commonly referred to is the FTSE 100, which stands for the Financial Times Stock Exchange 100 Index. The hundred firms involved are some of the biggest in the country – the so-called ‘blue chips’.
The idea is to select companies of such size and range that they reflect both the industrial diversity of Britain and the shares involved in the market. Every time a company is taken over or falls on bad times, the index must be changed.
In earlier times, the main index that was followed was the FT-30, which as its name suggests covers just 30 companies. But that index is now felt to be too narrow a base since a large move in the price of just one firm can affect the whole index. An even wider index than the FTSE 100 is the FTSE All-Share Index. The latter, despite its name, does not include all the shares traded on the Stock Exchange but it does include all those (around 700) in which there is a significant market. Indices have also been developed to cover medium- and small-sized companies. There are equivalent indices in other markets. The US uses the Dow Jones Industrial Average and the S&P 500 index, Tokyo the Nikkei 225 average and Frankfurt, the DAX.
Does it really matter if the FTSE Index falls or rises? The answer is not clear-cut. Day-to-day shifts are of little importance. They may result from a chance remark of a government minister, from an unexpected set of economic statistics or because investors expect any or all of these things to be good or bad. What actually happens to the economy or to the government is usually not as important as the expectations of investors about what might happen.
Remember that the vast majority of shares are held by investing institutions. They must not only judge the prospects of individual companies but also the prospects of the share market as a whole. If they think that, say, interest rates are about to fall, they might shift their portfolios into bond investments because the prices of bonds will rise as rates fall. However, they might feel that a drop in rates will reduce the costs of industrial companies and cause share prices to rise. Either line of reasoning would have logic behind it. The net result will be that some investors will sell shares and some will buy, moving the index up or down depending on where the balance lies.
Such day-to-day shifts are what statisticians call noise and have little effect on the performance of business, although they may be costly for shareholders who buy or sell at the wrong time. Obviously a disastrous day like 19 October 1987 (‘Black Monday’), when the Dow Jones Industrial Average fell 508 points, has an enormous impact. But such earth-shattering days are fortunately few in number. It is long-term shifts in the index which are important.
There is little doubt, for example, that the Wall Street Crash of 1929 contributed to the depths of the 1930s depression. In the UK, share prices bounced back in the late 1970s from their lows of January 1975 as the economy recovered from the three-day week, the miners’ strike and hyper-inflation. Some thought at the time that Black Monday signalled a repeat of the 1930s. Although the 1990s recession was bad, it did not plumb the depths of that earlier era.
Through the auspices of the London International Financial Futures Exchange (see Chapter 13), it is possible to buy futures based on the FTSE 100 index. If the index rises, the price of the future will also rise. Under the system through which futures are traded, a rise in the futures price benefits futures buyers and a fall benefits the sellers. That allows institutional investors to sell futures to protect their shareholdings against a general fall in prices by selling index futures. For those who do not fancy the intricacies of the futures market, several bookmakers offer simple bets on whether the index will fall or rise.
Bulls are investors who believe that share prices are about to rise, and rise substantially. They may even borrow money to invest in shares, in order to get the maximum possible benefit from any increase. Bears, in contrast, believe that share prices are set to fall. They will try to sell now and buy back later at a lower price. As we saw in the chapter on hedge funds, they may even sell shares they do not own, a practice known as going short, to try to exploit the price fall. In accordance with the risk/reward rules, aggressive bulls and bears take great risks, in the hope of making their fortunes. Anyone who went bearish before the crash of 1987 could have made a lot of money from that otherwise disastrous event.

The International Bond Market


The growth of the international capital markets is probably the single most important development in the international financial markets since the Second World War, because it has created a market in which borrowers and lenders can borrow and invest funds, virtually untouched by the wishes of nation states.
For many years, this international market was known as the Euro-market after so-called ‘Eurodollars’– dollars that were held outside the United States. Other currencies held outside their country of origin were known as Eurocurrencies.
Some people believe that this market had its origin in the unwillingness of the Soviet Union to hold dollars in New York for fear that the US government might freeze its deposits at times of political tension. However, the Russians still needed dollars to be able to conduct international trade, and they began to borrow in Europe through a Russian-owned bank, Banque Commerciale pour l’Europe du Nord, whose telex code was Eurobank.
Where did the dollars that the Russians borrowed come from? From the late 1950s onwards there were plenty of dollars around outside the United States because of the current-account deficits run up by the Americans. If a country has a current-account deficit, it pays out more of its own currency than it receives in foreign currency. Dollars were therefore flowing out of the country into the hands of foreign exporters. At the same time the US Treasury imposed Regulation Q, which set upper limits on the level of interest rates that US banks could offer to domestic and foreign investors. Those people who held dollars outside the United States and wanted to invest them found that non-US banks were able to offer more attractive rates than their US counterparts. Thus the Eurodollar market was born.
As more currencies became convertible (readily exchangeable) following the dismantling of post-war controls, the market grew. There was a range of major convertible currencies by the late 1950s. Investors were able to put their money into Eurodollar deposits in the knowledge that they would be able to convert their holdings into their domestic currencies if they wished.
A liquid market for these deposits quickly developed, and banks began to quote interest rates for dollar loans up to a year. After a short while London became the centre of the market, restoring to the City a position which it had begun to lose to New York. This was an immensely important development: the City’s financial pre-eminence, formerly a concomitant of sterling’s role in world trade, had been eroded by the UK’s economic problems. By comparison with its rivals, London had a distinct advantage – its position in the middle of the time zones between Tokyo and New York, which allowed London-based dealers to talk to those in other centres in the course of the working day.
Those American banks which had been precluded by Regulation Q from attracting foreign investors’ deposits began to set up branches in London, enabling them to compete with the European banks in the Eurodollar market. In addition to its time-zone position, London had the extra advantage of speaking the same language as the Americans, thus making it easier for bankers to live and work in Britain.
The market has a great importance in the world economy, since it provides a mechanism by which funds can flow quickly between one currency and another. As the market is largely outside governmental control, it can prove a potent weapon for destabilizing a currency.
SYNDICATED LOANS


Having begun with short-term deposits, the Euromarket was quickly adapted to serve the needs of longer-term borrowers by the development of the syndicated loan. This is merely a large, long-term bank loan which a syndicate of banks club together to provide because no one bank wants to commit that much capital to any one borrower. Usually, these loans carry interest rates at a margin relating to LIBOR or EURIBOR, the equivalent measure for the Eurozone. Companies, countries or institutions with a good credit rating can sometimes borrow below LIBOR or even the London Interbank Bid Rate (LIBID), but borrowers whose financial position is not so healthy can expect to pay a considerable margin over LIBOR.
The syndicated loan market gives borrowers access to large sources of long-term funds (loans can extend to billions of dollars) in a short space of time. Another advantage for borrowers is that, having got the loan commitment, they do not need to borrow it all. The overall limit on the loan may be $1 billion, but borrowers pay interest only on the amount outstanding at any time. (This compares favourably with a bond issue, interest on the full amount of which must be paid until the bond is repaid.) Syndicated loans have been particularly attractive to nation states which wish to raise large amounts of money in a single borrowing. The advantage to banks of such loans is that they can lend long-term at rates above their normal costs of funds without committing too much capital to any one borrower.
In the early 1980s the syndicated loan market was badly hit by the number of government loans which were rescheduled or deferred by the international debt crisis. The banks were faced with bad debts which cut their profits and reduced their credit ratings. Banks became unwilling to tie up their money in syndicated loans and started to lend money in more liquid forms or even to act as arrangers rather than providers of borrowings.
However, corporations and supranational institutions continued to borrow in syndicated loan form and the market continued, if not quite in the lavish style of the 1970s.
LEVERAGED LOANS


The international loan market has been transformed in recent years by the growth of leveraged loans. These are loans used by private equity groups (see Chapter 9) to finance their takeovers of companies.
The term leveraged is used because the companies concerned take on a lot more debt than would normally be considered prudent. As a result, leveraged loans pay much higher interest rates than conventional syndicated loans. But this makes them attractive to a certain type of investor, particularly hedge funds who are aiming to achieve outsize returns.
The hope is that the private equity groups will be skilful enough to cut the costs and improve the cashflow of the companies they buy, so that it is easy for them to pay the interest on the loans and, in relatively short order, repay the debt. But the danger is that if such companies hit recessionary conditions, the burden of repaying the debt will prove insuperable. Some investors diversify their risk in the leveraged loan market by putting their money into portfolios of loans known as collateralized loan obligations, or CLOs. But the CLO market dried up in the wake of the credit crunch.
THE EUROBOND MARKET


In parallel with the growth of the syndicated loan market in the 1960s and 1970s, borrowers issued long-term tradeable instruments – Eurobonds. A bond, as seen in the Introduction, is merely a piece of paper which promises, in return for an immediate loan, to pay the holder interest until the loan is repaid. Since the original purchaser can (and usually does) sell the bond, repayment will be made to whoever ends up holding the bond (the bearer) on maturity. Attached to each Eurobond are coupons which the bearer can tear off in order to claim the interest payment. Normally the maturity of the bond will be at least two years; the maximum maturity is around thirty years, although some bonds have been issued on the express condition that they will never be repaid.
The borrower can arrange to pay back the debt by setting aside a certain amount each year during the life of the bond through a sinking fund or by waiting until the end (a so-called ‘bullet maturity’). Bonds can be repaid early if a borrower buys back the debt in the traded market or if it incorporates a call option at the time of the issue, allowing it to repay a certain amount of bonds each year. The effect of all these strategies is to minimize the impact of repayment on the borrower’s cash flow.
There are bond markets in most parts of the world. Traditionally borrowers raised money only in their domestic bond markets. Formerly issues in foreign markets were the exception rather than the rule. As a consequence a bond issued by a foreign institution became known as a bulldog in the UK, a Yankee bond in the US, a samurai bond in Japan and so on (these terms are rarely used these days).
As we saw in Chapter 7, in the sterling market the main issuer of bonds (in the form of gilts) is the government. In the Eurobond market a whole range of borrowers issue bonds, such as corporations, banks, governments and supranational institutions like the World Bank.
Some companies, governments and banks have borrowing requirements which are so large that their domestic market cannot accommodate them. It is possible for them to borrow at a much better rate abroad. Domestic investors may have already bought large numbers of their bonds and no longer wish to buy the bonds of that institution unless they are guaranteed a high rate of interest. Foreign bond issues give borrowers access to other countries’ investors: Eurobond issues grant access to international investors.
How did the Eurobond market develop? In 1963 the USA imposed an Interest Equalization Tax (IET) to discourage foreign borrowers from raising capital in the US market. President Kennedy was worried about continuing US current-account deficits; he considered that these were encouraged by US investment overseas. The IET was imposed, at a rate ranging from 2.75 per cent to 15 per cent, on the purchase value of foreign bonds bought by US citizens, thus making it considerably more expensive for foreign institutions to borrow money in the US (since they had to offer higher yields to compensate investors for the tax disadvantages). Non-US borrowers were still keen to borrow dollars, however, and therefore began to look for investors outside the US who had dollars to lend.
Although this is the subject of debate, some people regard the first Eurobond as a $15 million issue of Autostrade, the Italian motorway company. As we have seen, a Eurodollar is merely a dollar held outside the US: a Eurobond is a bond sold outside the country of the denominating currency. The vast majority of the early Eurobond issues were denominated in dollars – a reflection of the dominant role played by the dollar in international trade.
European bankers, especially those based in London, realized that the IET had created an opportunity which they could exploit. Traditionally dollar-denominated bonds were managed by US banks, which pocketed the substantial fees involved (0.5 per cent was then standard, and on a $50 million issue that would mean $250,000). The US banks also acted as underwriters for the issues – that is, they agreed to buy any bonds which failed to be sold to outside investors. The fee for underwriting was often as much as 1 per cent. European bankers seized a portion of this lucrative business and created a London-based market to bring together international borrowers and investors.
To whom did the banks sell Eurobonds? In the markets the legend was that the typical Eurobond buyer was the Belgian dentist, the middle-class professional attempting to avoid the stringent tax laws of the Benelux countries. Indeed, an important reason for the success of the Eurobond market was the fact that bonds are denominated in bearer form, allowing the investor almost complete anonymity. Whoever presents the coupon to the bank for interest, or the bond itself for repayment, will receive payment. There is no register of owners; accordingly, they cannot be traced by regulatory authorities. As a result investors who hold bonds outside their own countries are normally able to escape tax. Anyone who enjoyed the thriller Die Hard will recall that the aim of Alan Rickman’s group of terrorists was to rob the office building of a vast sum in bearer bonds. In fact Eurobond investors include banks, investment management firms, pension funds and insurance companies all over the world as well as wealthy individuals like the Belgian dentists.
Nowadays, the term Eurobond market is falling out of use because the market is so international in scope, with debt issued by US manufacturers being bought by Chinese banks, an unimaginable concept in the 1970s. Bonds are issued in a wide range of currencies, including sterling, Canadian dollars, Japanese yen and even the Kuwaiti dinar. Borrowers are not limited to issues denominated in their domestic currency. With the help of swaps (see Chapter 13), they can issue in one currency and end up with cheap funding in another.
The arranging bank must set the bond’s yield at a level that will be attractive to investors but will be the lowest rate possible for the borrower. At one time, the banks were paid their fees in the form of a discount to the issue price, which led to losses if the bond was mispriced. That changed from 1990 onwards, when the fixed price re-offer system started to be used. Under this system, the banks involved agree to sell the bonds at a fixed price for a set period; their fees (usually between 0.25 and 0.3 per cent) are paid quite separately.
GROWTH IN THE MARKET


The advantages of the international bond market – the degree to which it is unfettered by regulation and the size of the investor base – have resulted in its truly phenomenal growth since that first Eurobond issue in 1963. In that year the volume of Eurobond issues was just over $100 million. In 2007, issuance was over $3.1 trillion, according to figures compiled by Dealogic.
Once a bond has been issued, it moves into the secondary market. A primary market is one in which bonds are sold for the first time; a secondary market is one in which existing bonds are traded. Traders sit in vast dealing rooms, surrounded by electronic screens displaying the current prices of bond issues, the latest moves in interest rates and the trends in the economy. They look for bond yields which have moved out of line with the rest of the market and can therefore be bought or sold for profit. They also try to anticipate whether interest rates will fall (and bond prices will rise) or rise (and bond prices will fall). If they make the right decision, they can earn their companies a lot of money; in consequence, they are some of the most highly paid men and women in the country.
Trading is now incredibly sophisticated. Investors will be looking to bet on whether issues of one particular maturity (say, ten years) will outperform those of shorter or longer duration. They will bet on whether riskier bonds will outperform safe bonds. They will separate the interest payments of bonds from the capital. They will speculate that one type of debt issued by a company will deliver higher returns than another (because, for example, that class of debt has better rights in case of bankruptcy). They will separate the interest rate risk of the bond from the prospects of default.
London is the centre of this market. The Americans have tried, without much success, to switch the market to New York by setting up international banking facilities, which allow banks to treat some of their New York offices as being off the US mainland. The UK government has also managed to see off the idea of a European withholding tax, which would deduct tax at source for bond payments. Since one key appeal of the market is the fact that payments were made gross (leaving it up to the investor whether to declare the income to the tax authorities), such a tax might drive the market to, say, Switzerland.
The location of the market may still be London, but it is the American rather than the British banks who now have the lion’s share of the business of Eurobond arranging. The early lead of the European bankers evaporated when US banks set up London-based subsidiaries to recapture their hold over the dollar bond market. And the market is now highly sophisticated, with debt being issued in a wide variety of forms.
Floating-Rate Notes


Most people are aware of the concept of floating-rate debt. After all, nearly all mortgages are a form of floating-rate debt: a building society can (and does) frequently change the interest rate to be paid on the amount borrowed. The same is true for most people’s savings. The interest paid to a lender is subject to change, largely at the whim of the deposit-taking institution.
Floating-rate bonds (more often called floating-rate notes or FRNs) have been a major part of the market only since 1970. One reason was that traditionally many UK borrowers, particularly companies, preferred the idea of fixed-rate debt because they could calculate their costs in advance. (Floating-rate debt was more common in the USA.)
When interest rates are high, borrowers become reluctant to borrow long-term at fixed rates because they would then find themselves saddled with a very expensive debt obligation should interest rates subsequently fall. The interest payments on an FRN, however, rise and fall with the level of rates in the market. This is particularly attractive to banks. Most of the money they invest (lend) is lent at floating rates, so borrowing through FRNs allows them to be sure of a constant relationship between the return on their investments and the cost of their funds.
Investors tend to be especially interested in buying FRNs at times when the yield curve is inverted – that is, when short-term interest rates are above long-term rates. Since the return on FRNs is linked to a short-term rate, they provide a higher income than equivalent fixed-rate bonds at such times. Booms in FRN issues have therefore taken place when high interest rates (which make borrowers want to issue FRNs) have occurred simultaneously with an inverted yield curve (which makes investors want to buy FRNs). Such conditions existed in 1970, 1974 and again in 1984–5.
Typically, FRNs are linked to six-month LIBOR (the rate which banks charge other major banks for six-month loans) and are reset every six months. Most borrowers pay a margin over LIBOR that is related to their creditworthiness. The first issue was made by the Italian public utility Enel, which paid a margin of 0.75 per cent over the mean between LIBOR and LIBID, the rate which banks are prepared to pay in order to borrow.
What about the secondary market in FRNs? As we saw in Chapter 2, the level of interest rates has a major effect on the market price of fixed-rate bonds. Because they are closely linked to the prevailing level of interest rates, one might expect FRNs to stick fairly close to their issuing price. However, this does not always happen. Although the interest rate on FRNs changes, it does so only once every six months. In the intervening period the general level of interest rates can rise and fall, affecting the price of FRNs.
If interest rates rise, investors will receive a return on the FRNs which, because it is set by an out-of-date benchmark rate, is unattractive. They will sell their FRNs, causing their prices to fall, until the yields come back into line. If rates fall, FRNs will be offering a higher return than the market rate and their prices will rise. However, because the FRN rate is changed every six months, these fluctuations are nowhere near as substantial as those on fixed-rate bonds: most FRNs trade in a range of 96–104 per cent of their issuing price.
‘BELLS AND WHISTLES’


Banks have developed other variations on bonds, so-called ‘bells and whistles’, which are designed to attract investors and thereby help the issuer to achieve a lower interest rate than would be possible with a conventional issue.
One of the most prominent ‘variations’ is the zero-coupon bond, which, as its name suggests, pays no interest at all. Instead it is issued at a discount to its face value. Say it is issued with a face value of £100; its selling price may then be £50. When the bond matures in five years’ time, the borrower will repay the full £100. The investor has effectively received all the interest in a lump, rather than spread out over the years. This can be particularly attractive to investors in countries which have tax regimes that differentiate between income and capital gains. The difference between the prices at which the bond is bought and sold is treated by some tax systems as a capital gain; capital gains taxes are normally below the highest rates of income tax. If the investor is going to pay less tax on a zero-coupon bond, he will be willing to accept an interest rate effectively rather lower than that on a straight bond. Both investor and borrower thus benefit.
It is possible to calculate the ‘interest’ on a zero-coupon bond, though this sounds an odd concept. Assume that the bond has a one-year maturity and a face value of £100, and that it is sold for £80. An investor who buys the bond on issue will make a £20 gain if he holds it until maturity. A profit of £20 on an investment of £80 is a return of 25 per cent per annum. If the bond had a two-year maturity, an issue price of £64 would achieve the same return (25 per cent of £64 is £16, which, added on to £64, makes £80).
Another variation is the partly paid bond. This allows investors to pay only a proportion of the bond’s face when the bond is issued and to pay the rest later on. This gives them an opportunity for ‘leverage’. Suppose a bond is issued at a yield of 10 per cent and the investor is asked to pay only £50 on a bond with a face value of £100. If, because of a change in the market level of interest rates, the price of 10 per cent bonds rises from £100 to £110, then the price of the partly paid bond will rise to £60. The partly paid investor will make a gain of 20 per cent on his initial stake, whereas a conventional bond in the same conditions would have earned him only 10 per cent. Of course, had conventional bonds fallen from £100 to £90, partly paid bonds would have fallen from £50 to £40, a drop of 25 per cent as against 10 per cent (the risk/reward trade-off again).
A further potential advantage to buyers of partly paid bonds is the scope for currency speculation. Investors can buy a partly paid bond in another currency, believing that the foreign currency will fall against their own. If it does, they will have to pay less for the second part of the bond.
The problem of currency risk affects all investors who buy bonds denominated in foreign currencies. A US investor who buys an issue denominated in sterling will want sterling to appreciate against the dollar during the lifetime of the bond. Suppose the bond is worth £1 million when it is bought and the exchange rate is $1 =£1. If, when the investor redeems the bond, the sterling exchange rate has risen to $2 =£1, then the investor will receive $2 million (double the original investment). However, if the pound has fallen against the dollar, the investor will receive less than his original investment.
Dual-currency bonds fix the exchange rate at which the investor is paid. The investor pays for the bond in one currency but will be repaid in another at a pre-arranged exchange rate. The borrower will protect this rate through the forward foreign-exchange markets (see Chapter 14).
Just as exchange-rate movements can adversely affect the investor, so can changes in the level of interest rates. Bonds have been devised to combat this risk with fixed and floating characteristics. Among the special features on offer from issuers have been the warrant and capped and collared floaters.
The warrant. This is similar in principle to an option. Warrants are normally sold separately from the original issue and give the investor the right to purchase a new bond, bearing a fixed rate of interest. The borrower gets additional and immediate cash from the sale of the warrants but incurs the risk of being forced to issue extra debt at above-market rates. The investor enjoys the prospect of profiting if interest rates fall but faces the risk that the warrants will be worthless when they expire because interest rates have stayed above the level available for the warrants.
Capped and collared floaters. These are FRNs where the rate can fluctuate but cannot rise above a certain level –‘the cap’, – or fall below a different level –‘the collar’.
One of the problems with the bells and whistles described above is that they can be briefly fashionable, then go out of favour with the market. That can be bad news for investors who bought the bonds when they were first issued. However, one type of bond which has been a constant feature of the markets has been the equity convertible.
CONVERTIBLE BONDS


Convertible bonds, as their name suggests, are bond issues which can be converted into shares of the issuing company. The company issues a (normally fixed-rate) bond. The investor may exchange each bond into a given number of shares, which becomes advantageous when the shares reach a price on the stock market which is usually 20–25 per cent above their current value. The investor has two ways of profiting from a convertible issue: through the interest rate and possible capital appreciation of the bond, and through conversion into shares, which permits him or her to earn dividends and a possible further increase in the share price. The borrower will be able to offer a reduced coupon on the original bond issue because of the potential benefits to the investor of conversion. If the investor converts, the company will increase its equity base but will dilute the value of its shares.
Another means of achieving a similar effect is to issue a bond with equity warrants attached which grant the investor the right to buy the company’s shares at a set price. The difference between the two methods is that with a straight convertible the borrower gets the benefit of a reduced cost of borrowing because of the lower coupon and with a warrant the borrower receives the benefit in the form of additional cash from the sale of the warrant.
One problem with equity convertibles occurs when the share price of the issuing company falls sharply. This is bad news for bondholders, since they will be left with a low-yielding bond in a company with diminished prospects. It is also bad news for the issuer. Instead of acquiring a new bunch of shareholders on conversion, they will have to find the money to repay the bond on maturity.
This was a particular problem in the late 1980s. Companies issued convertible bonds in the bull market of 1987 when share prices were rising rapidly; after the Crash, it became clear in 1988 and 1989 that the bonds would never be converted into shares.
GETTING A BOND RATING


It is almost impossible for investors around the world to be aware of the strengths and weaknesses of the multitude of borrowers who issue bonds. Largely for this reason, rating agencies have assumed an important and unusual place in the financial hierarchy. The market is dominated by three agencies – Standard and Poor’s, Moody’s and Fitch IBCA. Before most bond issues, the borrowing institution will pay one of the rating agencies to rate the issue. Standard and Poor’s ratings range from AAA (the ability to repay principal is very strong indeed) to D (the bond is in default and payment of interest or repayment of principal is in arrears). Only bonds rated BBB or above are regarded as being of investment grade and eligible for investment by the more cautious institutions.
The criteria which Standard and Poor’s use for rating issue made by governments are quite interesting and give an insight into the minds of international investors. The first is political risk. The agency makes an assessment of the country’s underlying political and social stability: it sees the most important factors as ‘the degree of political participation, the orderliness of successions in government, the extent of governmental control and the general flexibility and responsiveness of the system’. Standard and Poor’s add: ‘Signals of high political risk include such events as periodic social disorder and rioting, military coups or radical ideological shifts within the government.’
Among the social factors that the agency examines are the rate of population growth, its location and its ethnic mix. The more fast-growing, concentrated and racially diverse the population, the greater the social risk. Further factors are the degree of the country’s integration into the Western political system and the extent of its participation in international organizations. The more the country is enmeshed in the Western system, so the reasoning runs, the less likely it is to repudiate its debt and therefore the better its credit rating.
An economic analysis of a country’s prospects is undertaken by comparing the total of the country’s debts with its foreign-exchange reserves and its balance-of-payments position. This last factor is seen by the agency as one of the most important of the economic criteria, since most debt defaults have occurred when countries have incurred persistent trade deficits. However, the standard of living of the inhabitants is also considered – the higher it is, the more able a government will be to cut down demand if it is faced with a trade deficit. A good economic growth rate also helps: the agency feels that ‘A high rate of growth in total output and especially exports suggests a better ability to meet future debt obligations.’
Rating governments can occasionally get the agencies into trouble if a political administration dislikes the result. The agencies can also have problems rating companies. If they assign too low a grade, the companies may complain; a reputation for being too strict may send issuers elsewhere. This is important because it is the issuer, not the investor, that pays the agency their fee. But if the agency is seen as too lax, then investors will complain. The collapses of Enron and Worldcom in 2002 brought criticism that the agencies only acted after a company’s finances had deteriorated, not before.
But the greatest flak came with the boom in structured products, the repackaged asset-backed loans (particularly linked to subprime mortgages) that were described in Chapter 3. The growth of this market caused a huge boom in the profits of the agencies and led to criticism that the lure of fees was warping their judgement. When the market collapsed, the agencies did admit to a few mistakes.
One problem was that the new products were so complicated that it was harder to predict their behaviour; another was that the agencies based their ratings on the likelihood of default, not on the risk of sharp price falls. But investors were understandably taken aback when AAA-rated debt, the safest in the market, fell to 90 per cent of face value or below. That would not happen with a conventional issue, unless the bonds had been downgraded. The net result was that the reputation of the agencies undoubtedly suffered; perhaps they should have been more cautious in handing out their highest mark of approval.
JUNK BONDS


Bonds are generally seen as a conservative investment. They offer more security than equities, but a lower return. For much of the 1980s, however, a US phenomenon made the bond market seem positively exciting (in financial terms, at least); this was the enthusiasm for junk bonds.
The term initially referred to bonds which had collapsed in price, normally because the company which issued them had become mired in financial difficulties. The market marked down the price of the bond because it feared the company would be unable to repay the capital, or even maintain the interest payments. In the language of the rating agencies (referred to above), the bonds would be ‘below investment grade’ with a rating below BBB.
A smart trader called Michael Milken, who worked for a US banking group called Drexel Burnham Lambert, saw the opportunity for profit in junk bonds. Say a bond was issued with a coupon of 10 per cent, but the company gets into difficulty and its price falls to 50 (compared with a face value of 100). If the company just pays the interest, the investor will earn a running yield of 20 per cent (10/50). And if the company repays the bond in full, the investor will double his capital.
Obviously, there is a strong chance that the company will go bust. But Milken worked out that if the investor bought a large enough portfolio of these bonds, enough of them would earn high returns to wipe out the effect of those which went wrong. His early clients who followed his advice made large amounts of money.
Later on, Milken played a key role in the takeover boom of the 1980s, financing predators with newly created ‘junk bonds’. These would trade at, or near, face value, but would offer much higher yields than other bonds in the market (to reflect the higher risk). The term junk bonds extended to cover all high-yielding bonds of this type.
Milken fell from grace and was eventually jailed, and many investors who bought junk bonds at the peak of the market lost money. As with other financial theories, by attempting to exploit it so heavily, Milken and his followers altered the rules. If there was any merit to the junk bond theory, it was because few people bothered to follow the market and it was therefore possible to find bargains. Once everyone started to get interested, the bargains disappeared and investors started to forget the heavy risks involved.
LOAN FACILITIES


Companies may not want to raise money via a bond issue, on which they have to pay interest throughout its life. In the 1980s, it was quite common for companies to borrow via loan facilities, which allowed them to draw down money when they wanted it. In return, they would pay a commitment fee to a panel of banks, for agreeing to lend the money at any time.
These facilities were known by a variety of acronyms, such as RUFs and NIFS. In the late 1980s, the most common was the MOF or Multi-Option Facility which allowed the borrower to borrow money in a variety of forms, such as in different currencies or over different periods.
The 1990s recession caused so many bad debt problems that banks began to regret having committed themselves to so many facilities, often at very low spreads. Many overseas banks decided to withdraw from the UK lending market. This caused immense problems for companies trying to renegotiate their facilities; they had to deal with a large number of banks, some of whom were unwilling lenders.
The early 1990s saw a shift to so-called ‘bilateral lending’, as companies decided to opt for a series of loans from individual banks, rather than group all the banks together in a complex facility.

Insurance


Almost everyone in the country has insurance of one form or another whether it is for their house, their car or their life. Most have insured all three and more besides. Companies need insurance as much as individuals – for damage to factory buildings or equipment and even against claims for damages from aggrieved customers. The result is a multi-billion-dollar industry represented by insurance institutions which, as we saw in Chapter 8, play a vital part in the financial system and in the economy, because of their role as investors in industry.
The insurance sector has, since the Second World War, been one of the country’s biggest foreign-exchange earners. It plays a vital role in assuming part of the risk involved in industry. Without insurance, a severe fire, for example, might render a department store bankrupt. With insurance, the company can concentrate on the commercial risks it faces (i.e. whether it can attract enough customers). In return for assuming an insurance risk, insurers charge a premium. They hope that their premium income will exceed the money they have to pay to those with legitimate insurance claims. If an insurance company feels that the risks it runs are too great, it can pass some of them on to a second company, the process known as reinsurance.
Financial institutions, by providing this service, oil the wheels of the economy just as they do by giving savers a home for their funds and by lending the proceeds to industry for investment. And providing protection against the risk of fire or theft is little different in theory from protecting against a rise in interest rates or a fall in sterling. It is just a question of calculating the risks and setting the premiums accordingly.
But the business is a highly volatile one. The UK consumer market can be highly competitive as new companies move into the business, driving down premium rates. The last ten years has seen the emergence of direct insurers, who sell policies over the telephone and internet rather than via branches or door-to-door agents. These groups, such as Direct Line, have captured large portions of the market; they have also concentrated on the better risks, leaving the older companies to insure the less attractive areas of the market.
At the same time, the international market was affected in the 1990s by a series of disasters, such as Hurricane Andrew and the San Francisco earthquake, which brought heavy losses for insurance groups. Even those catastrophes pale into insignificance beside the potential losses if say, a hurricane were to hit a major US city directly.
The insurance industry has responded with a series of mergers, both in the high-risk end of reinsurance and in the consumer sector, where savings can be made in the back office. The number of UK insurers is likely to shrink significantly in coming years.
LLOYD’S


The changes in the insurance market have had a particular impact on London’s most famous insurance market, Lloyd’s. A series of scandals and financial problems have significantly reduced the market’s importance and prompted substantial changes in the way the market operates.
Lloyd’s of London developed from a coffee house opened by one Edward Lloyd just before 1687. Gentlemen from the City used to meet there and discuss insurance over their beverages. By the middle of the eighteenth century they decided that they might as well make it their main place of business.
From the beginning, the speciality of Lloyd’s was marine insurance, helped by the fact that England has traditionally been a great naval power. Like underwriters in the other financial fields we have looked at (bonds and shares), Lloyd’s underwriters accept a payment (in this case called a premium) in return for providing against an unfortunate eventuality. In the case of underwriters of financial instruments, they guarantee to buy the bonds if no one else will, in return for a premium. Early Lloyd’s underwriters agreed to pay shipowners for the damage to, or loss of, their ships and cargo. For a long time, Lloyd’s had the best intelligence on the movements of foreign shipping. Perhaps the most famous occupant of Lloyd’s is the Lutine Bell, which is rung when important news is about to be announced (one ring for bad news, two rings for good).
The Lloyd’s Structure


An elaborate structure was built on the flimsy edifice of a coffee house. First and foremost, there are the clients. Merchant shipping has long since passed its peak and Lloyd’s now provides insurance for a wide variety of customers and products, including film stars’ legs, potential kidnap victims and space satellites. Sometimes the clients may be other insurance companies and markets for whom Lloyd’s provides reinsurance.
The second tier in the structure are the brokers. They link client with underwriter in return for a commission. Their business is rather less risky than the underwriters’, since they are not liable to pay out for any claims. But with Lloyd’s challenged by other insurance markets around the world, Lloyd’s brokers have been forced to travel far and wide to drum up business. Not all of it goes to Lloyd’s; indeed the bulk goes to outside insurance companies. However, Lloyd’s still retains the flexibility that encourages brokers to place with it substantial or unusual risks. Brokers provide a service which goes beyond merely broking: they advise clients on the best kind of insurance protection for their needs and they act for clients by administering their insurance business and by collecting any legitimate claims they may have. The big broking firms have gradually come to dominate the market, in the process buying many underwriting agencies. As we shall see, this has led to many problems.
The next tier up are the managing agents, who run syndicates on behalf of investors in the market. The agents decide whether to underwrite the risk, hence their traditional title of underwriters. In 2008, there were eighty syndicates run by fifty-one managing agents, some of which are in speciality areas such as marine, aviation, professional indemnity and motor.
To bring in the capital to allow the market to work efficiently, Lloyd’s has to attract outsiders. Hence the need to bring in outside investors – private individuals and companies – and members’ agents (to service these investors).
The private individuals were traditionally known as names. Being a name was standard practice for wealthy and upper-class individuals for much of the twentieth century. There were tax advantages, income was steady, and disastrous years were few. That was until the mid-1980s, when losses started to pile up and many names were ruined.
The problem was the principle of unlimited liability which underpinned the market. If you invest money in Marks & Spencer and the company goes bust, you have lost your stake and that is it. Under unlimited liability, the market can come for the rest of your savings or your home in order to meet the losses.
The individuals concerned were horrified when the full extent of their losses became clear. Many claimed they had been misled about the risks; some said they had been defrauded and placed in syndicates which bore the heaviest losses. A sizeable number said they could not, or would not, pay, which led to lengthy court cases and negotiations about a settlement.
The only answer for Lloyd’s was to bring in new capital to strengthen the market. A series of corporate vehicles were established, which had the crucial advantage of limited liability; investors’ losses were limited to the amount of their stake.
This corporate capital quickly came to dominate the market; by mid-2008, there were more than 16,000 corporate members. By contrast, the number of names, which reached 34,000 in the 1980s, dropped to below 1,000 by 2008.
The members’ agents act as a sort of dating agency: they earn a fee in return for introducing private individuals to Lloyd’s and for placing them on profitable syndicates.
In theory, underwriting can be immensely profitable. The capital employed by the underwriter can be invested so that it earns interest. (Or invested in equities. This is the secret of how Warren Buffett made his fortune. He applied his immense skill to investing the capital of an insurance company.) The premium income that results from assuming risk can also be invested; the key is that the premiums are received long before any claims have to be paid out. If premiums exceed claims, there is also a profit. An underwriter’s money is thus working several times over. In addition, Lloyd’s has certain tax privileges. Underwriters can carry forward losses in order to offset them against underwriting profits for tax purposes in future years.
The effect of investment earnings means that underwriters can afford to pay out slightly more in claims than they receive in premiums and still make a profit. However, if the deficit between claims and premiums becomes large, the arithmetic begins to look less healthy.
Regulating Lloyd’s


A series of scandals in the late 1970s cast doubt over Lloyd’s ability to regulate itself and led to the passing of the Lloyd’s Act in 1982. A new committee was appointed on which representatives from outside the market were introduced and a chief executive brought in from the Bank of England.
But the reforms were unsuccessful in assuaging the market’s critics and self-regulation was condemned by a parliamentary committee report in 1995. Eventually, the market itself accepted that the system would have to change and the market is now regulated by the Financial Services Authority (see Chapter 16).
Meanwhile, the shift from names to corporate capital might have helped protect the long-term future of the market but did nothing to deal with the past losses. That problem was dealt with by the creation of a new company called Equitas, which reinsured more than £8 billion of the market’s old liabilities. As part of this process, a settlement was reached with the loss-making names and most (but not all) of the legal cases were dropped.
In 2007, Lloyds managed a profit before tax of £3.8 million, not huge but a great improvement on some of the performances of the 1980s and 1990s.
GENERAL INSURANCE


The insurance companies that most people deal with are not members of Lloyd’s. Some specialize in life insurance and some cover the whole range of policies from life to vehicle insurance. Between them, these companies represent a substantial category of the institutional investor sector, whose characteristics we examined in Chapter 8.
Most of the big companies are proprietary companies (i.e. owned by shareholders in the same way as a normal business). Some, however, are mutual companies which are owned by the policyholders in the same way as building societies are owned by their depositors.
There is quite a difference between life and general insurance businesses. The liabilities of life companies are much easier to assess; they can consult actuarial tables to see, on average, how many people die over a given period. They also have to make payouts to people whose policies mature, but they have plenty of leeway to reduce those payouts (by paying a smaller terminal bonus) if investment conditions are poor.
As general insurance businesses have found, their liabilities are much less predictable. Freak weather can lead to increased claims for storm damage; crime rates continue to rise rapidly; claims can be exaggerated by fraud.
THE PROBLEMS OF INSURERS


Since the Second World War, insurers have been faced with continuing expansion of the scale of risk. The risks of new developments like computers and space travel are very difficult to assess, since there are no track records to follow. The decline in the old heavy industries and their replacement with high technology seems, in fact, to have greatly increased insurers’ risks. As one writer put it, ‘Large-volume, low-unit-value, low-hazard risks have been replaced by small-volume, high-unit-value, high-hazard propositions.’ The litigious nature of US society, and the high awards paid by US courts, have created one set of problems; the gradual development of laws in areas such as pollution and product liability has added another. Insurers have faced claims out of all proportion to what they might have expected when they agreed the business. A further problem is that insurance companies have big investment portfolios. These suffered in the post-2000 decade. Insurers lost money on their holdings in equities and corporate bonds. In some cases, such as AIG, the giant US group, it turned out they had insured some mortgage-based products; the resulting losses caused a huge bailout by the US government.
Even insurance companies need insurance and they turn to the re-insurance market. Big companies like Munich Re and Swiss Re agree, for a premium to take on losses beyond a certain limit. The principle is the same. If the risks are broadly spread, then the reinsurance company should not be wiped out by one massive claim, such as the bill for the 9/11 attacks in the US.
But the reinsurance market has been hit by a number of catastrophe-related claims, particularly hurricanes and flooding. The industry has consolidated, as companies have sought the size required to pay out on large claims without facing ruin. Alternative forms of capital have been found, such as catastrophe bonds, which pay a higher rate of interest but face the risk of capital loss if claims are made.
Life companies faced their own unexpected set of risks in the 1980s, when the sudden appearance of Aids led to the possibility that they might be overwhelmed with claims. In the event, Aids proved less of a killer than had been feared, but the disease opened up a new area of controversy.
Companies started to ask lifestyle questions, designed to find those most at risk of Aids, so that they could be charged higher premiums or even refused cover. While such questions have long been asked of smokers, the prospect of excluding homosexuals from cover raised much protest.
In the 1990s, the issue was broadened to cover genetic details. If insurers knew your genetic background, they would find it much easier to predict your susceptibility to certain diseases, and thus could adjust their premiums accordingly. But there are obviously huge issues of privacy involved.
Modern society could not function without insurance. The fact that individuals and companies know they are covered against disaster makes business and risk taking possible. But the industry is involved in a constant struggle to cope with changing risks and laws and with a highly cyclical business. When times are good, capital floods in and drives down premiums; when times are hard, losses on underwriting can be ruinous.