One of our regular (and valued) commenters asks
Are there any constraints under which you would accept that discounting of long-term liabilities at more than risk-free could be societally justifiable?
It depends on circumstances.
Here are some possibilities.
- The excess return is genuinely risk free. Which implies a continuum of risk free rates from the one on government bonds to the one on the asset with excess returns. But then I question the existence of such an asset or set of returns, as I did earlier. You object that the wait for the excess return may be long, and short term investors will have no patience. I reply that it is easy to unlock long term returns, even zero coupon returns, over a shorter time frame that would satisfy less patient investors. Or give me an example where this is impossible.
- The firm wants to create equity by discounting liabilities at more than risk free, then paying a dividend. I don’t see how this would be justifiable in any sense, let alone ‘societally justifiable’. The firm is simply creating money out of nothing, then siphoning it off to enrich some fat cats.
- The firm is not paying dividends, but wants to bolster its balance sheet by creating equity, so that its owners can sell the firm on to not-so-savvy investors. A regulatory kite mark of approval always helps. I reply: while it’s generally accepted that the buyer should beware, most buyers do not understand the intricate mechanism of the matching adjustment. Nor do they understand that there is a similar mechanism used in the valuation of the statutory accounts. I have spoken to a number of equity analysts who do not realise this. Do prospective share holders understand that by buying at the MA book value of the firm, they are unlikely to participate in the promised excess returns? I doubt it. One of the backstops is a strong audit function, which can provide assurance to not-so-savvy investors that management are not cheating them. Are auditors providing such assurance? I wonder. At some point the truth will become clear, but then trust in the equity markets will evaporate, and society needs equity markets as the primary shock absorbers of the financial system. Societal benefit and all that.
- The firm is not paying dividends, and is not putting itself on the market, but needs to avoid technical or regulatory insolvency. Then I ask exactly why the regulatory insolvency exists. If it will be all right in the long term, why is the regulator basing its capital requirement using data from the short term? Makes no sense. If short term market volatility is really artificial, then so is the capital requirement. Why fool investors by creating artificial equity to meet an artificial capital requirement. Did anyone ask whether that made sense? Thought not. If on the other hand the market volatility indicates a real risk of insolvency, and thus a risk to policyholders, widows and orphans, then I question the societal benefit.
- The firm needs to avoid actual (as opposed to technical or regulatory) insolvency. Actual insolvency is where the firm cannot meet obligations which are due and payable. Are we really saying it is societally justified to borrow at risk free from pensioners, invest enough of it in a pile of junk to meet the pension liabilities at excess return, and pay the rest of it to some creditor banging at the window? OK, thought not.
- There is no limited company at all, but rather the obligations are to a staff pension scheme of a private company, or a public organisation, or some other entity. That’s a separate case which I will not discuss for now, though I will point out that it did not end well in this case.