Carl from Chicago

Business executive interested in history, economics, taxation and energy policy.

Flight 93 Memorial

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I recently visited the Flight 93 National Memorial in Pennsylvania. The park is new and well laid-out and highly recommended. There are signs off the highway to direct you to the park and it seemed very well attended when I was there, on a beautiful Friday afternoon.

There are a series of introductory displays as you enter the park. This display shows the crew and passengers on Flight 93. You can see that there weren’t many of them that day.

There were many parents with their children in hand. I could hear them trying to explain what the park was about, and it was difficult. September 11, 2001 was over ten years ago, and I have several nieces born since then, and other relatives too young to remember what 9/11 as it happened.

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Unsightly Rooftop Debris

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In the city they don’t built out they build up. When you first move into your condo you are amazed at the city view (if you have one). But then, after a while, you start to notice the details.

While buildings may lavish effort on their facades and interiors, often times they forget the roof. After all, who cares what the roof looks like. Your neighbors up above, that’s who. Those in the middle of the photo collage, to give a feeling for all the condos in the mostly beige and white skyscrapers look down onto the smaller (mostly commercial) buildings. In the loop it is businesses looking at businesses while in River North and the Gold Coast it is mainly condos and hotels looking down on commercial buildings.

Upper left – ever wonder how they hang signs and lights off the side of the building? In this case it is a series of planters filled with concrete in a grid. At least they are neat, I guess. Upper right – there has been a puddle with floating debris (including that rope and those boards) up on that roof for SEVEN YEARS. I can’t believe it doesn’t drive the people beneath them crazy with leaking but, rain or shine, in all seasons, there is a big pond on that roof (in the winter it does freeze). Middle left – there is grass growing (it is dead now) in the large puddle on that roof. Middle right – a roof is a great place to store your cinder blocks, un-needed antennas, and the like, apparently. Also been there almost a decade. Lower left – a bunch of boxes and cartons have been strewn about on that roof for a while. Lower right – of all the rooftops this is the most amazing. That is a fully grown tree (in the winter it sheds its leaves) on the roof of the old firehouse. I have no idea how it gets enough purchase to stay on that roof in the high winds but it has been up there for at least seven years, changing with the seasons. Kind of like those trees that live on the rock face in the wilderness.

Dan asked me over at LITGM why I used the word “purchase”… I was using it as a synonym for “grip” which I thought I heard somewhere but maybe I am just confused.

Cross posted at LITGM

Dollar Denominated Debt

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Debt is traditionally thought of as a conservative financial instrument. You buy a bond, it pays you interest (tax exempt or taxable), and then you receive your principal back when the bond matures. The interest you receive depends on the duration (time until you get your money back), riskiness of the borrower (traditionally the US government has been the safest lender with the lowest rates, but it may not be that way forever), and the overall level of interest rates in the economy (either the prime rate or LIBOR).

There are many, many variations on bonds, however, and this view of debt is out-dated. Convertible bonds allow the debt to be converted into shares of the company’s stock at certain price points, which allows the company to offer a lower interest rate on debt (because of this “upside”). Distressed debt is often bought by hedge funds and others as a way to take over companies in distress because post-reorganization the equity holders are generally wiped out and the debt-holders receive the new company’s shares.

A risk with debt and all financial instruments is an implied currency risk. In the US we don’t directly “see” the impact of the falling dollar in our day to day activities, but it is immediately evident if you leave the country and go somewhere with a strong currency, as I found out when I traveled to Norway and spent $20 US to buy a drink and lunch for 2 in a decent cafe was over $100. More subtle signs of the dollar’s decline are the hordes of foreign tourists from countries that have a trade surplus with the US buying everything in sight – Dan and I saw an entire upscale mall full of them in San Francisco.

Along with changes in currencies, there is a general hunger for “yield” meaning income that can be earned with relatively low risk (or at least according to models and rating agencies), meaning that borrowers are rushing to market to take advantage by issuing debt at historically low long term rates. Countries that may have had difficulty borrowing in the past or paid high rates like Mexico are now able to issue at interest rate levels that are very low by historical standards – Mexico is now able to borrow with a 10 year maturity at 5.85% (in local currency). These types of rates are at historical lows.

In addition to governments (with decent credit ratings) going out to market for more debt, companies are also issuing debt to take advantage of these historically low rates. Even if the companies have no immediate use for the cash, they are taking advantage of the rates to build funding if the economy turns, for acquisitions, or even to buy back stock and take advantage of leverage to increase EPS. Per this article in the WSJ:

Their timing could hardly be better. Average corporate bond yields finished Monday at 3.28%, just 0.01 percentage point from the all-time low going back to 1973, according to the Barclays U.S. investment-grade index. Industrial bond yields are even lower, at 3.07%.

For private companies in foreign countries, often local banks provided financing. In the US corporations traditionally don’t rely on banks to the same degree and issue bonds to the general public (many of which are bought by pension funds and insurance companies, as well). As banks pull back around the world, foreign companies are now trying to take advantage of 1) historically low interest rates 2) hunger for yield by tapping into this demand for debt by buyers.

Many of the issuers in other countries are now issuing “dollar denominated” bonds. Dollar denominated debt means that they agree to pay at the rate of the US dollar against their local currency, regardless of what happens to the local currency. This insulates the buyer (probably a foreigner from the US) from currency fluctuations in countries like India, Mexico and Chile – but on the other hand it makes the entire transaction much riskier from the seller’s perspective (assuming they don’t hedge this risk). There aren’t just US dollar denominated bonds – there are Euro denominated bonds, Yen denominated bonds, and likely more Chinese currency denominated bonds in the future.

The interesting part for me is the long term “evolution” of debt from a relatively straight-forward low risk instrument (except for default risk, which supposedly could be “rated”) to a very complex instruments with myriad risks. One OBVIOUS risk on these dollar denominated bonds is – what happens when the country’s currency falls vs. the US dollar and these bonds have to be paid back in US dollars? What do you think happens?

According to this article “Weak Rupee Hits India Bondholders“:

The Indian rupee’s sharp depreciation has added to the woes of Indian companies scrambling to repay foreign currency bonds – and it is increasing the likelihood that foreign investors will be hurt… in 2005-2007… the rupee was strengthening, trading at a record of around 40 rupees to a dollar. The bonds were sold only to foreign investors, and companies used the money to fund their growth plans… Indian companies have to repay nearly $3.4 billion in foreign-currency bonds before the end of 2012.
 
But now, many of these bonds are coming due when the rupee has lost nearly 40% from its high and is trading around all-time low levels.

The article goes on to mention several companies who are having trouble making payments and asking for reprieves from lenders, which typically involves extending terms and / or changing the interest rates. And since these were sold to foreigners, good luck trying to take action within the Indian legal system unlike the US where debt can lead to an implied stake in the post-bankruptcy entity (this wasn’t mentioned in the article and I am not an expert on this so it is only my opinion).

I don’t know how any investor looking for yield and wanting to avoid currency risk just assumed that these risks didn’t exist because they were being borne by the issuer and not them when they received their payment in US dollars. Now these chickens are coming home to roost, and it is pretty obvious in retrospect that these issues were very risky on the currency side and were much closer to a high risk investment than a vanilla boring interest bearing security. The hunger for yield and the fact that these were issued in US dollars made them appear to be much less risky than they apparently turned out to be.

Cross posted at Trust Funds for Kids and LITGM

Britain Revives Central Planning… for Electricity

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This is the second of a series of posts on recent events in the world electricity & energy market. Here is Spain.

Britain’s Energy Policy

Britain has a mostly de-regulated electricity market for generation. One item that must be considered with electricity is plain old geography; Britain is an island and must generate all their electricity locally. Thus they can have costs either significantly higher or lower than those found on mainland Europe, because it is difficult to use arbitrage (in the form of transmission) to resolve price imbalances. Correction – Britain imports 5% of her electricity from France in a cross-channel cable. Thanks to commenter Jim Miller for pointing this out.

Like most of Europe, Britain is in the thrall of the greens, and their favorite tool is to mandate a certain percentage of energy to come from “renewables” (wind and solar, for semi-practical purposes), while hounding coal on environmental grounds and nuclear on whatever grounds they tend to come up with at the time. Natural gas represents almost 50% of current energy today. This article from the Economist provides a good summary of the British market.

While Britain traditionally has gotten much of its natural gas from local drilling, LNG imports from overseas provide a higher percentage today. According to this article, LNG imports represent 25% of British usage, while locally drilled gas has fallen by 10% from the prior year. Britain traditionally has relied on the North Sea for its natural gas and oil production, but these fields are in long term decline.

In 2011, the UK initiated a surprise tax increase on North Sea oil and gas producers. The percentage of tax on profits increased from 68% to 80%, an increase of 12%, per this article. This sharp rise in taxation was a surprise under the supposedly Tory administration, because it is typical of more of a labor “carve up the pie” view of the world than one I would typically expect under the Tories that “incentives drive behavior”.

This article discusses the impact of ever changing tax policies in the UK on investment in oil and gas rigs.

The hike prompted furious reaction from the industry. Mark Hanafin, director of Centrica Energy, told the Telegraph: “the North Sea is the second-largest oil-producing region in the world after Saudi Arabia. It’s a national treasure for the UK. The government is utterly destroying that. I wish people would step up and say you just can’t do this. Capital is leaving the country and going elsewhere”.

Who could have predicted what would happen next? Oil and gas produced since the tax hike has dropped by the most since records have been kept, per this article:

UK natural gas production in the third quarter of 2011 slumped to the lowest level since records began in 1996, at 103TWh (terawatt hours), Department of Energy and Climate Change (DECC) data show. This also represented the largest year-on-year quarterly decrease ever seen, down 29.4pc on the same period last year.

Now that the British government has dis-incented investment and damaged their oil and gas industry through erratic and socialistic behavior, what’s next? A central-planning, top down new “plan” for the electricity sector, of course.

As summarized in the Economist article (which failed to mention the negative impact of tax incentives on natural gas’ decline, a serious oversight):

Renewable technologies account for a mere 7% of current supplies… government pledges to cut planet-heating (ed – their words) emissions and get 15% of energy from renewable sources by 2020… the industry regulator reckons that around $315 billion USD needs to be spent by 2020. Investment currently amounts to $6-9B USD / year. But the move to greener power in Britain must be achieved without infuriating voters already upset at high bills.

The government expects the private sector to finance the renewables (wind, solar and new nuclear) that they plan to have in place to meet the 15% target, while shutting down older nuclear plants and coal plants, as well. It is very difficult to entice the private sector to make these sorts of investments, however, unless they know in advance that they can recover the high and otherwise un-economical costs for these renewable power through the life of the facility (30 years or more). These costs, obviously, must in the end be borne by either residents or corporations (the business sector).

I would love to be a “fly on the wall” if you tried to convince any rational financial institution to invest in these sorts of projects, knowing that Spain just abandoned all their subsidies midway through (decimating their industry) and that the UK has a history of changing tax regimes with gas and oil extraction (see above).

Even the economist, which unfortunately is a cheerleader in this sort of central planning, sums it up dimly:

It is doubtful that the draft bill has enough detail to break the current hiatus in energy investments. It is still unclear how prices will be determined, how often they will be reviewed, and how contracts will be implemented. Uncertainty about the form of the contracts compounds existing investor fears about the durability of government price guarantees on energy.

While these government fantasies about supposedly rational private sector investors ploughing funds into un-economical renewables continues, a backup plan of sorts is occurring because they are extending the life of existing, older nuclear plants that they were planning to close. Keeping these plants alive defers the enormous (and likely significantly under-estimated) costs of building new nuclear plants, which are summarized here at wikipedia. From my perspective I would be willing to bet that none or perhaps 1-2 at best nuclear plants would ever be built going forward in the UK post the disaster in Japan; the greens are too strong and they will protest and drag the process out for an eternity. Other than one plant that came on line in the mid 1990’s, all the plants are from the 1980’s and 1970’s and dreams of a nuclear renaissance in the UK ring just as hollow as they do in the US. Here is an article about re-licensing British reactors. Britain’s ageing nuclear reactors, which were due to close in the next decade, are set to be kept open under a plan approved by the industry’s regulator.

In a move that could have far-reaching implications for the government’s energy policy, the Office for Nuclear Regulation has told the Guardian it is working with the country’s dominant nuclear operator, the French-owned company EDF, to extend the life of its eight nuclear power stations in the UK, and that it is “content for the plants to continue to operate”, as long as they pass regular safety tests.

Well there you go. Before the ink on the plans are dry, they’ve already backed down on one of the key tenets of their mad plan. I guess that is progress. But there is no way that their math can work as far as bringing new investment into the system since utilities and power generators won’t ‘add’ to their investment in this climate at the level needed to mothball such critical elements of their power generating infrastructure.

It is quite sad to see that the UK, which had once been a leader in electricity de-regulation, with lower prices to show for it than most of their European counterparts, to propose to effectively nationalize or central plan out an entire industry. All this under a Tory government, too. It seems that cooler heads have prevailed by keeping the nuclear stations open longer, and the collapse of the renewables market in Europe will likewise be a precedent that the UK will not want to follow.

Cross posted at LITGM