The Privatisation of Royal Mail: how hedge funds cleaned up

OLIVER WRIGHT  , JIM ARMITAGE , MARK LEFTLY

 The Independent

Tuesday 29 April 2014

The Royal Mail flotation scandal has deepened after officials finally admitted that hedge funds were among the “priority investors” sold hundreds of millions of pounds of shares.

The Business Secretary, Vince Cable, has repeatedly insisted that the handful of key investors offered Royal Mail shares on preferential terms were long-term institutional investors. This was to ensure the new company started with “a core of high-quality investors” who “would be there in good times and bad”. He promised to marginalise “spivs and speculators”.

But sources in the Department for Business have confirmed to The Independent that around 20 per cent of the shares it had allocated to 16 preferred investors had gone to hedge funds and other short-term investors. This would equate to around £150m of Royal Mail shares – 13 per cent of the entire stock sold by the Government. The companies bought in at the float price of 330p a share. The shares shot up within seconds of trading, eventually peaking within weeks at more than 600p, allowing the hedge funds to bank vast profits at the taxpayers’ expense.

Mr Cable is now under mounting pressure to name the priority investors given preferential deals in the form of extra-large share allocations, which his department has so far withheld citing commercial confidentiality. Unions have called for his resignation over the “botched” handling of the sale.

A recent National Audit Office report revealed that of the 16 priority investors, half had sold their shares within weeks of the flotation.

Vince Cable refuses to apologise over the losses, and says Royal Mail remains fragile (Getty)
Sources close to Mr Cable told The Independent that hedge fund involvement had been necessary to give the new stock “liquidity” and that the practice was entirely normal in share offerings. They added that they made up a small minority of the total share allocated to institutional investors.

But the revelation contrasts with Mr Cable’s previous statements on the sale. He has said institutional demand was so strong that the Government would be able to allocate shares to “responsible long-term institutional investors” rather than speculators.

An analysis of Royal Mail’s share register shows that Och-Ziff, an aggressive US-based hedge fund, had a holding of 10 million shares on 15 October, the day the company’s shares started trading. A week later it had reduced its holding to 3.5 million shares. It is not known if Och-Ziff was allocated shares or bought its holding from other institutional shareholders who sold out as soon as shares started trading.

Lansdowne, another hedge fund which is known for its close links to the Conservative Party, also appears to have received an allocation of around 18 million shares, at a cost of just under £60m. Lansdowne said the owners of the shares are Lansdowne’s clients not Lansdowne. It is understood that Lansdowne has not sold any shares.

The revelation that the Government knowingly sold off Royal Mail shares to hedge funds is likely to come under scrutiny today when the Public Accounts Committee questions the Department for Business’s Permanent Secretary and representatives of the investment banks who handled the sale on behalf of the Government.

The PAC will examine what advice was given by investment banks including Goldman Sachs, UBS and Lazard and why the shares were priced so cheaply. It will also demand to know why Lazard has been appointed to run the vast majority of major privatisations under the current Government following previous revelations by The Independent.

Shares in Royal Mail were floated on the London Stock Exchange last October (Getty)

Today in openly hostile exchanges with MPs on the Business Select Committee, Mr Cable refused to apologise over accusations that the Government sold Royal Mail on the cheap. He argued that the 360-year-old postal service remained “a fragile company”, despite becoming a City favourite since shares debuted in October.

Conservative committee member Brian Binley said that government advisers had underpriced the shares out of the “fear” of being unable sell them at a higher but more accurate valuation. “I don’t understand why you are being so obstinate about getting this right when you so palpably got this wrong,” Mr Binley admonished William Rucker, the chief executive at lead adviser Lazard.

Business minister Michael Fallon insisted that the Government had sold the shares “at the best price we possibly could have got at that particular time”. Committee chairman Adrian Bailey mocked this claim as “absolutely Alice in Wonderland”.

Mr Fallon also indicated postmen and women were partly to blame for the suppressed price of the sale, because the unions had “no interest in lifting the threat of industrial action”.

However, the Business Secretary conceded that he would have to take a close look at whether selling shares in the markets was the best way of privatising public assets.

He also promised to “reflect” on whether the full list of the 16 major institutional investors should be revealed. Mr Cable has agreed to privately hand the list to Mr Bailey.

Then and now: What Cable said

“We are in a position to ensure we do get the right type of investor community – pension funds, insurance companies that hold the savings of millions of people. That’s the type of community we want.”

Vince Cable to MPs in  October 2013. (At the same hearing he said the Government would be able to block shares from going to “spivs and speculators” in favour of “responsible long-term institutional investors”.)

“We wanted to make sure that the company started its new life with a core of high-quality investors who would be there in good times and bad, interested in  Royal Mail and the universal service it provides for  consumers over the long term. We were told if we sought a higher price, these investors would have walked away, leaving the company exposed to short-term  hedge funds with different objectives.”

Mr Cable in an interview in December 2013

“Having a long-term investor base remains a basic objective, and we  have achieved that fundamental objective.”

Mr Cable in the Commons on 1 April 2014

We need a fair system for restructuring sovereign debt

If the debt vultures have their way, there will never be a fresh start for indebted countries - and no one will agree to restructuring

• 
• • Joseph Stiglitz
  • theguardian.com, Wednesday 4 September 2013 17.48 BST

If the debt vultures have their way, there will never be a fresh start for indebted countries - and no one will agree to restructuring. Photograph: Joe Petersburger/Getty Images/National Geographic Creative

A recent decision by a United States appeals court threatens to upend global sovereign debt markets. It may even lead to the US no longer being viewed as a good place to issue sovereign debt. At the very least, it renders non-viable all debt restructurings under the standard debt contracts. In the process, a basic principle of modern capitalism – that when debtors cannot pay back creditors, a fresh start is needed – has been overturned.

The trouble began a dozen years ago, when Argentina had no choice but to devalue its currency and default on its debt. Under the existing regime, the country had been on a rapid downward spiral of the kind that has now become familiar in Greece and elsewhere in Europe. Unemployment was soaring, and austerity, rather than restoring fiscal balance, simply exacerbated the economic downturn.

Devaluation and debt restructuring worked. In subsequent years, until the global financial crisis erupted in 2008, Argentina's annual GDP growth was 8% or higher, one of the fastest rates in the world.

Even former creditors benefited from this rebound. In a highly innovative move, Argentina exchanged old debt for new debt – at about 30 cents on the dollar or a little more – plus a GDP-indexed bond. The more Argentina grew, the more it paid to its former creditors.

Argentina's interests and those of its creditors were thus aligned: both wanted growth. It was the equivalent of a "Chapter 11" restructuring of American corporate debt, in which debt is swapped for equity, with bondholders becoming new shareholders.

Debt restructurings often entail conflicts among different claimants. That is why, for domestic debt disputes, countries have bankruptcy laws and courts. But there is no such mechanism to adjudicate international debt disputes.

Once upon a time, such contracts were enforced by armed intervention, as Mexico, Venezuela, Egypt, and a host of other countries learned at great cost in the nineteenth and early twentieth centuries. After the Argentine crisis, President George W. Bush's administration vetoed proposals to create a mechanism for sovereign-debt restructuring. As a result, there is not even the pretence of attempting fair and efficient restructurings.

Poor countries are typically at a huge disadvantage in bargaining with big multinational lenders, which are usually backed by powerful home-country governments. Often, debtor countries are squeezed so hard for payment that they are bankrupt again after a few years.

Economists applauded Argentina's attempt to avoid this outcome through a deep restructuring accompanied by the GDP-linked bonds. But a few "vulture" funds – most notoriously the hedge fund Elliott Management, headed by the billionaire Paul E. Singer – saw Argentina's travails as an opportunity to make huge profits at the expense of the Argentine people. They bought the old bonds at a fraction of their face value, and then used litigation to try to force Argentina to pay 100 cents on the dollar.

Americans have seen how financial firms put their own interests ahead of those of the country – and the world. The vulture funds have raised greed to a new level.

Their litigation strategy took advantage of a standard contractual clause (called pari passu) intended to ensure that all claimants are treated equally. Incredibly, the US Court of Appeals for the Second Circuit in New York decided that this meant that if Argentina paid in full what it owed those who had accepted debt restructuring, it had to pay in full what it owed to the vultures.

If this principle prevails, no one would ever accept debt restructuring. There would never be a fresh start – with all of the unpleasant consequences that this implies.

In debt crises, blame tends to fall on the debtors. They borrowed too much. But the creditors are equally to blame – they lent too much and imprudently. Indeed, lenders are supposed to be experts on risk management and assessment, and in that sense, the onus should be on them. The risk of default or debt restructuring induces creditors to be more careful in their lending decisions.

The repercussions of this miscarriage of justice may be felt for a long time. After all, what developing country with its citizens' long-term interests in mind will be prepared to issue bonds through the US financial system, when America's courts – as so many other parts of its political system – seem to allow financial interests to trump the public interest?

Countries would be well advised not to include pari passu clauses in future debt contracts, at least without specifying more fully what is intended. Such contracts should also include collective-action clauses, which make it impossible for vulture funds to hold up debt restructuring. When a sufficient proportion of creditors agree to a restructuring plan (in the case of Argentina, the holders of more than 90% of the country's debt did), the others can be forced to go along.

The fact that the International Monetary Fund, the US Department of Justice, and anti-poverty NGOs all joined in opposing the vulture funds is revealing. But so, too, is the court's decision, which evidently assigned little weight to their arguments.

For those in developing and emerging-market countries who harbor grievances against the advanced countries, there is now one more reason for discontent with a brand of globalization that has been managed to serve rich countries' interests (especially their financial sectors' interests).

In the aftermath of the global financial crisis, the United Nations Commission of Experts on Reforms of the International Monetary and Financial System urged that we design an efficient and fair system for the restructuring of sovereign debt. The US court's tendentious, economically dangerous ruling shows why we need such a system now.

The Herbalife saga is practically a made-for-Hollywood script

Herbalife is a diet company that excels at drama. It has Wall Street titans sparring, KPMG resigning and investors confused

• 
• • Heidi Moore
  • guardian.co.uk, Tuesday 9 April 2013 20.45 BST

Bill Ackman (right) traded insults with fellow hedge funder Carl Icahn on television over Herbalife. Photograph: Reuters

There is something about diet company Herbalife that makes very rich men act very strangely. The weight-loss company should be relatively unremarkable. Instead it's been in the center of a dramatic story that should have Hollywood calling.

It has everything – intense, dashing hedge-fund titans embroiled in a public war, allegations of pyramid schemes, billions of dollars riding on on the outcome and now, as of today, a rogue auditor who risked his entire career by allegedly squirreling away inside information to make himself a profit. The Herbalife scandal even features Carl Icahn, one of the 1980s corporate raiders who reportedly inspired the timeless capitalist character of Gordon Gekko. If Wall Street wars got Oscars, Herbalife would be a top contender.

With so much heady money and power surrounding Herbalife, it's no surprise that the wafting scent of greed would envelop one of the people whose virtue should have been above reproach: the company's auditor, the prestigious accounting firm KPMG.

Auditors are not glamorous people. If investment bankers are the popular, fratty jocks of the financial world, and traders are the kids who love to hang out with their Camaros, auditors are more like the bespectacled stars of the math team. They are accountants – precise and cautious by nature – and, as a result, they have all the usual attendant social insecurities that nerds do: they're so happy just to be invited to the party that they may not judge too carefully the underage drinking and drugs that are going on. When auditors get into trouble – as they did with companies like Enron and WorldCom – it's usually because they were too eager to please their clients that they kept quiet when they saw something wrong. They didn't want to lose their place at the party.

So the "rogue auditor" is a rare character to cast. Auditors are often guilty of neglect, or looking the other way; rarely do they do something really bold and reckless like trade on inside information. Yet, apparently prompted by the drama around Herbalife, this is what a partner with the company's auditor, KPMG, did, according to Herbalife.

KPMG fired the rogue auditor on 5 April and told Herbalife about the whole debacle yesterday. This morning, Herbalife's stock was halted for an unusually long time – two hours – as the company tried to decide how to tell investors.

During that time, traders and journalists took to Twitter to speculate on what could possibly be so horrible that it would require the company to completely stop trading its stock for most of the morning.

The answer, it turns out, was pretty bad.

The partner at KPMG was entrusted with combing Herbalife's financial statements for errors. Unfortunately, according to Herbalife's version of the story, he also shared the company's confidential information with someone else, presumably so they could make a profit of their own. That would give him an incentive to mess with the company's results to help his own financial interests. As a result, KPMG's entire opinion on the company is reduced to worthless chaos; the auditor said it had to withdraw its reports on Herbalife for the last three fiscal years.

Herbalife, already embroiled in months of wars between its investors, hastened to assure everyone that the company was still sound. It stressed that KPMG had resigned as its auditor purely because of the possible insider trading and "not for any reason related to Herbalife's financial statements, its accounting practices, the integrity of Herbalife's management or for any other reason".

Herbalife managed to contain the damage: by halting the stock for two hours, it had raised expectations that the news would be far worse. The stock fell only 1% on the news when it finally came out. However, there was still evidence of chaos. In the same statement, Herbalife said that KPMG had said the three years of financial statements could both be "continued to be relied upon" and "should no longer be relied upon".

So that clears things up.

This only adds another twist for the Herbalife saga that's been playing out on the larger Wall Street stage. It was only three months ago that the distinguished Carl Icahn was publicly trading insults on television with Bill Ackman, the silver-haired, baby-faced boy wonder of investing. Ackman has argued that Herbalife is a pyramid scheme and has bet against the company; Icahn took the other side of the bet. Daniel Loeb, who was previously a friend of Ackman's, shocked the investing world by switching allegiances and taking Icahn's side.

There's a lot more information that has yet to come out about the problem with KPMG and Herbalife. That's good if you're in Hollywood. It means there's enough time to run through the casting. What do you think of Alan Alda, Elliott Gould, or Frank Langella to play Carl Icahn? John Slattery to play Bill Ackman? Michael Sheen as Dan Loeb? Philip Seymour Hoffman as the rogue auditor?

Now who's going to call John Grisham and tell him about all this?

Hedge funds betting millions against Britain's high street

Hedge funds are betting there will be blood on the high-street this Christmas as Britain’s retail stocks dominate a list of big short positions that has been published for the first time.

The secretive financiers have bet millions of pounds that companies including WH Smith, Home Retail Group, Ocado, Sainsbury, Tesco and Dixons will fall in value, according to a list published under new rules by the Financial Services Authority (FSA).

Lansdowne Partners, one of London’s best known hedge funds, has short sold 0.63pc of the value of Tesco - a £163m bet that the supermarket’s shares will fall. The Mayfair-based group has a 2.51pc short position in WM Morrisons, worth £159.8m.

GMT Capital, an American group, has built up a 3.56pc short position in Carpetright - which is worth just £16.3m but is the third biggest position of the list relative to the size of the company.

Barrington Wilshire, another US fund, has a bet against Mothercare worth £8.24m or 3.18pc of the company’s market value. Two hedge funds have revealed big short positions in Marks & Spencer, whose shares rose 1.18pc yesterday despite revealing a 10pc slide in profits.

Jim Chanos, the famed US short-seller who runs Kynikos Associates, has a 2.52pc short position in Asos, the online fashion retailer. 

The biggest short position by percentage of market value is Greenlight Capital’s bet against Daily Mail & General Trust. The fund manager David Einhorn has built up a short position of 4.4pc of the company worth £80.7m.

But in terms of monetary value, Glencore has attracted among the biggest bearish bets. Och Ziff has a 0.82pc short stake worth £202m in the mining giant which is trying to merge with Xstrata. Elliot Management has a 0.71pc short stake in Glencore worth £175m.

The list, which is the most comprehensive view of bearish bets ever seen, follows the introduction of European rules that came into force on November 1. Under the regulations, all short positions worth more than 0.2pc of a company’s market capitalisation have to be revealed to the regulator. Positions of more than 0.5pc of the market value have to be published.

Hedge fund managers, who prove their worth by making money in markets that go down as well as up, are concerned that the disclosures could hamper their efforts.

Experts in London, where more than 80pc of Europe’s hedge funds are based, argue that short selling improves efficiencies in the markets. But European politicians have held the opaque trading practises responsible for volatility in the markets.

On Tuesday, fund managers said the rules unfairly penalise independent funds while allowing the big investment houses to keep their short positions secret.

Tim Steer, a fund manager at Artemis, said: “Under the rules, managers have to disclose a net short position so big asset management groups can hide their short positions because somewhere they will have a fund that has long-only positions which cancel them out. Pure hedge funds are being penalised because their short positions could antagonise companies.” Investment houses that have hedge funds as well as long-only funds are absent from the list, including Blackrock, JP Morgan Cazenove and Jupiter Asset Management.

The mathematical equation that caused the banks to crash

 Ian Stewart in The Observer 21-02-12

It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments, blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of the financial markets became the Black Hole equation, sucking money out of the universe in an unending stream.

Anyone who has followed the crisis will understand that the real economy of businesses and commodities is being upstaged by complicated financial instruments known as derivatives. These are not money or goods. They are investments in investments, bets about bets. Derivatives created a booming global economy, but they also led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump. And it was the Black-Scholes equation that opened up the world of derivatives.

The equation itself wasn't the real problem. It was useful, it was precise, and its limitations were clearly stated. It provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be traded before they matured. The formula was fine if you used it sensibly and abandoned it when market conditions weren't appropriate. The trouble was its potential for abuse. It allowed derivatives to become commodities that could be traded in their own right. The financial sector called it the Midas Formula and saw it as a recipe for making everything turn to gold. But the markets forgot how the story of King Midas ended.

Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world's manufacturing industries over the last century. The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.

Black and Scholes invented their equation in 1973; Robert Merton supplied extra justification soon after. It applies to the simplest and oldest derivatives: options. There are two main kinds. A put option gives its buyer the right to sell a commodity at a specified time for an agreed price. A call option is similar, but it confers the right to buy instead of sell. The equation provides a systematic way to calculate the value of an option before it matures. Then the option can be sold at any time. The equation was so effective that it won Merton and Scholes the 1997 Nobel prize in economics. (Black had died by then, so he was ineligible.)

If everyone knows the correct value of a derivative and they all agree, how can anyone make money? The formula requires the user to estimate several numerical quantities. But the main way to make money on derivatives is to win your bet – to buy a derivative that can later be sold at a higher price, or matures with a higher value than predicted. The winners get their profit from the losers. In any given year, between 75% and 90% of all options traders lose money. The world's banks lost hundreds of billions when the sub-prime mortgage bubble burst. In the ensuing panic, taxpayers were forced to pick up the bill, but that was politics, not mathematical economics.

The Black-Scholes equation relates the recommended price of the option to four other quantities. Three can be measured directly: time, the price of the asset upon which the option is secured and the risk-free interest rate. This is the theoretical interest that could be earned by an investment with zero risk, such as government bonds. The fourth quantity is the volatility of the asset. This is a measure of how erratically its market value changes. The equation assumes that the asset's volatility remains the same for the lifetime of the option, which need not be correct. Volatility can be estimated by statistical analysis of price movements but it can't be measured in a precise, foolproof way, and estimates may not match reality.

The idea behind many financial models goes back to Louis Bachelier in 1900, who suggested that fluctuations of the stock market can be modelled by a random process known as Brownian motion. At each instant, the price of a stock either increases or decreases, and the model assumes fixed probabilities for these events. They may be equally likely, or one may be more probable than the other. It's like someone standing on a street and repeatedly tossing a coin to decide whether to move a small step forwards or backwards, so they zigzag back and forth erratically. Their position corresponds to the price of the stock, moving up or down at random. The most important statistical features of Brownian motion are its mean and its standard deviation. The mean is the short-term average price, which typically drifts in a specific direction, up or down depending on where the market thinks the stock is going. The standard deviation can be thought of as the average amount by which the price differs from the mean, calculated using a standard statistical formula. For stock prices this is called volatility, and it measures how erratically the price fluctuates. On a graph of price against time, volatility corresponds to how jagged the zigzag movements look.

Black-Scholes implements Bachelier's vision. It does not give the value of the option (the price at which it should be sold or bought) directly. It is what mathematicians call a partial differential equation, expressing the rate of change of the price in terms of the rates at which various other quantities are changing. Fortunately, the equation can be solved to provide a specific formula for the value of a put option, with a similar formula for call options.

The early success of Black-Scholes encouraged the financial sector to develop a host of related equations aimed at different financial instruments. Conventional banks could use these equations to justify loans and trades and assess the likely profits, always keeping an eye open for potential trouble. But less conventional businesses weren't so cautious. Soon, the banks followed them into increasingly speculative ventures.

Any mathematical model of reality relies on simplifications and assumptions. The Black-Scholes equation was based on arbitrage pricing theory, in which both drift and volatility are constant. This assumption is common in financial theory, but it is often false for real markets. The equation also assumes that there are no transaction costs, no limits on short-selling and that money can always be lent and borrowed at a known, fixed, risk-free interest rate. Again, reality is often very different.
When these assumptions are valid, risk is usually low, because large stock market fluctuations should be extremely rare. But on 19 October 1987, Black Monday, the world's stock markets lost more than 20% of their value within a few hours. An event this extreme is virtually impossible under the model's assumptions. In his bestseller The Black Swan, Nassim Nicholas Taleb, an expert in mathematical finance, calls extreme events of this kind black swans. In ancient times, all known swans were white and "black swan" was widely used in the same way we now refer to a flying pig. But in 1697, the Dutch explorer Willem de Vlamingh found masses of black swans on what became known as the Swan River in Australia. So the phrase now refers to an assumption that appears to be grounded in fact, but might at any moment turn out to be wildly mistaken.

Large fluctuations in the stock market are far more common than Brownian motion predicts. The reason is unrealistic assumptions – ignoring potential black swans. But usually the model performed very well, so as time passed and confidence grew, many bankers and traders forgot the model had limitations. They used the equation as a kind of talisman, a bit of mathematical magic to protect them against criticism if anything went wrong.

Banks, hedge funds, and other speculators were soon trading complicated derivatives such as credit default swaps – likened to insuring your neighbour's house against fire – in eye-watering quantities. They were priced and considered to be assets in their own right. That meant they could be used as security for other purchases. As everything got more complicated, the models used to assess value and risk deviated ever further from reality. Somewhere underneath it all was real property, and the markets assumed that property values would keep rising for ever, making these investments risk-free.
The Black-Scholes equation has its roots in mathematical physics, where quantities are infinitely divisible, time flows continuously and variables change smoothly. Such models may not be appropriate to the world of finance. Traditional mathematical economics doesn't always match reality, either, and when it fails, it fails badly. Physicists, mathematicians and economists are therefore looking for better models.

At the forefront of these efforts is complexity science, a new branch of mathematics that models the market as a collection of individuals interacting according to specified rules. These models reveal the damaging effects of the herd instinct: market traders copy other market traders. Virtually every financial crisis in the last century has been pushed over the edge by the herd instinct. It makes everything go belly-up at the same time. If engineers took that attitude, and one bridge in the world fell down, so would all the others.

By studying ecological systems, it can be shown that instability is common in economic models, mainly because of the poor design of the financial system. The facility to transfer billions at the click of a mouse may allow ever-quicker profits, but it also makes shocks propagate faster.

Was an equation to blame for the financial crash, then? Yes and no. Black-Scholes may have contributed to the crash, but only because it was abused. In any case, the equation was just one ingredient in a rich stew of financial irresponsibility, political ineptitude, perverse incentives and lax regulation.

Despite its supposed expertise, the financial sector performs no better than random guesswork. The stock market has spent 20 years going nowhere. The system is too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don't represent reality adequately. The entire system is poorly understood and dangerously unstable. The world economy desperately needs a radical overhaul and that requires more mathematics, not less. It may be rocket science, but magic it's not.
Ian Stewart is emeritus professor of mathematics at the University of Warwick.