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Induced Bankruptcies Costing Taxpayers Billions?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Independent financial analyst Diane Urquhart sent me her latest research report, Induced Bankruptcies Cost Canadian Taxpayers Billions of Dollars Federal Government Not Stopping the Abuses.
Here are the key conclusions:
The credit default swap
(CDS) invention of 1997 and the trend of private equity funds making leveraged
acquisitions of large public corporations over the past decade are causing a
proliferation of bankruptcies today in both the U.S. and Canada. The damages to the Canadian taxpayers and the economy
from these induced corporate bankruptcies will be in the billions of
dollars.
Canadian
Federal bankruptcy laws are allowing corporations to walk away from their
employee benefit obligations and to download onto Canadian taxpayers the
additional costs for public social security programs and lost income taxes from
the former employees whose employee benefits are being severely cut.
For example, I estimate that the Nortel liquidation will cost
Federal and Provincial Governments at least $355 million in additional social
security program expenditures and reduced income tax revenues, even though
Nortel will have an estimated $6 billion plus of cash in its global bankruptcy
estate. The Canadian economy will experience the multiplier impact of an
estimated $1,593 million of after-tax income and health care benefits lost by
Nortel's close to 25,000 affected Canadian pensioners, survivor pensioners,
active and deferred beneficiaries of pension plans, long term disabled and
terminated employees.
The impacts are based on
the present value of lost Nortel-provided annual income and health benefits,
which have the following impacts on government: lost income taxes from all four Nortel former employee
groups; additional Age Allowance and Medical Expense Tax Credits for pensioners,
increased use of the Guaranteed Income Supplement and the Medical Expense Tax
Credit for survivor pensioners, new use of Provincial means
tested drug assistance programs for the long term disabled, and additional
Federal Employment Insurance and Medical Expenses Tax Credit for the severed
employees.
The recommended
Bankruptcy and Insolvency Act (BIA) Amendment is to give preferred status for
employee benefit claims over unsecured creditors. This is the best short-term
and long-term solution to prevent corporations from walking away from their
pension and long term disability plan deficits and unpaid severance, when there
is money in the bankruptcy estate. This BIA Amendment ensures that Canadian
taxpayers' interests are protected from the increased social security program
costs and lost tax base that induced bankruptcies cause.
Key
New Information in This Research Report
(1)
Added estimates on the impact of Nortel's
liquidation on the Survivor Pensioners and the Severed Employees.
(2)
Added health benefit losses to the total
loss of Nortel employee benefits and determined that the % loss in Nortel
employee health and income benefits range from -35% to -55% in the best case of
the estimated cash settlement ratio being $0.45 per $1.00 creditor claim; and,
from -40% to -85% in the worst and likely case of the estimated cash settlement
ratio being $0.15 per $1.00 creditor claim. The worse case assumes that the
U.S. and U.K. government and U.S. junk bond creditors have improved their
relative position by their hoarding of cash outside of Canada and by
collecting their non-arms' length Debtor-in-Possession prior charge and other
inter-company loans made to the Canada Estate.
(3) Added
analysis on the % impact on the combined Nortel health and income benefits and
the government social security programs as noted in Figure 2. The % loss on
total income and health benefits from both Nortel and Government is in the range
of -20% to -55% in the best case and -20% to 60% in the worst and likely
case.
(4) Determined that Nortel's
long term disabled employees have the severest damages amongst the four employee
groups because: their future disability income has been deeply underfunded in a
self-insured plan, Nortel
has stopped making new cash contributions into the Health & Welfare
Trust (H & WT) to pay for the current LTD income and so the capital
in the H & WT is being depleted by current long term disability income being
paid during the restructuring period; the long term disabled employees have
heavy health care costs estimated at
$12,000 annually whose reimbursement will be cut off at the time
of Nortel's liquidation; the long term disabled are being threatened to lose their health benefits
sooner if they attempted to shut down the H & WT to get their capital out
now before it is depleted during the remainder of the restructuring
period; the CPP Disability Income is a low $13,272 annually and
the long term disabled cannot go back to work.
Diane's
research has wider implications for employees and pensioners of other
companies teetering on bankruptcy. If the explosion of CDS and
leveraged buyouts is inducing a wave of bankruptcies, then why should
taxpayers borne the cost? I say we tax the funds that are wreaking
havoc on the real economy with their sophisticated financial "leveraging and hedging".
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Anyone seriously looking for WMD's should find them here and should regulate this problem out of existence. It is deadly dangerous for society and is nothing less than an attach on the entire system. As a people we should not allow it to continue.
Excellent essay Leo...and i am afraid this is just one "tip of the iceberg" way that the largest players are gaming the system...I am afraid that the playbook for this scheme and all of the many others that are plaguing our "gotham city" of capital markets, is owned by the owners of none other than the privately held federal reserve.
( Where is batman when you need him" Or is Tyler actually Batman and Marla Robin? )
"Bottom line is - how can u blame a hedging tool for causing defaults? Why not blame Equity holders who buy Puts as protection?"
>>Diane has shown that they drive the price down to bring it into bankruptcy so they can profit big time. It's not all benign hedging as you claim.
Blaming CDS for 'forced' bankruptcies has been discussed to death in the MSM and blogosphere and it is evident that there is no causal link. While LBOs clearly increase the longer-term default risk of most firms, CDS can actually reduce it if the firm makes provident use of them in its Treasury function (as many actually do).
The main argument for CDS 'enabling' default is that bondholders/creditors can hedge their exposure and somehow are in a win-win in the case of default...ask CIT's bondholders how they feel on today's 68% recovery - bonds were trading down here for the last few months - no surprise there - those smart enough to see it coming either sold their bonds (tough due to the illiquidity of the bond market) OR bought protection months ago (look at DTCC data for clarity on the changes to net exposure over time).
Bottom line is - how can u blame a hedging tool for causing defaults? Why not blame Equity holders who buy Puts as protection? Equityholders have it far easier as atleast their underlying markets are liquid (you can cover an equity long at most time in size if u need to) - try unwinding a large pension-fund's benchmark-size allocation to a crappy credit without moving the market 10pts against you...
sorry for the rant but this kind of ignorance bugs those of us who live, breathe, and trade CDS (and are not trying to manhandle companies into default). Anyone still think that Lehman was driven into default by naked shorts and CDS protection buyers? - read some recent books on that story...
If I carried the mortgage on your house and I didn't think you were going to pay, but I had a CDS against your default. Of course I would burn your house down, uh I mean it would be a tragedy if your house burned down and I was recompensed 100% of my investment.
It's no different for large companies and their bondholders. CDS's have made it more profitable to destroy a company. Why would you take a 50% hit in a debt restructuring when you could just drive them into bankruptcy and get 100%.
I am also involved in this market and I do believe CDS have an impact on bankruptcy, but no more so than the objectives of bondholders who stand in difference positions in the waterfall (especially the banks that tend to lend at the OpCo level, so tend to push for restructurings that preserve these assets at the cost of bondholders who sit at TopCo - this was especially true for the Telco/ European cable sector).
Very few Treasury departments trade their own CDS, this is a myth (unless you are talking about Parmalat) - theoretically it could work, but it rarely happens in practice. I have worked on several distressed credits where a big problem has come from funds that have small debt positions and significantly larger CDS positions, so their involvement on the debt side seems counterintuitive until you realize they gain more from the downside than the upside, which is what happened with Chrysler. CDS can also be a bugger when you cannot allow economically prudent restructuring as you will trigger contracts (which has ended up with several worse defaults later down the line)
However, there is a very specific point here which is that Canada has a poor arrangement for the state, which is that the obligations to the pension fund are transfered to the state upon default, which means that the deficit in the fund could have a significant impact on the decision. Most countries I can think of (US, UK, mainland Europe) consider the pension obligations to rank pari passu with the senior unsecured creditors, because if not, the company can consider the fund a cheap source of credit (as the company's credit deteriorates, the probability of having the make the payments actually falls, so the implied cost of this falls, so why bother putting money into the fund).
This problem is amplified as the companies that tend to have the greatest problems are large mature businesses where the pension fund is often a bigger entity than the underlying commercial operation and have a higher public profile.
In the absence of a system that forces the company to provision for obligations under the scheme to account for the credit risk of the business will always result in a loss for either the workers or the taxpayers or both. The company has entered into a commercial agreement with its workers and it must recognize this - when both sides (workers and creditors) share this risk, rather than thinking they can "fob it off to the taxpayer", better decisions will be made for all.
I didn't realize a company could default on equity. Learn something new every day.
I'm wondering when all of the US gov't [Fed, State, Local] pension plans will go belly up... that is in part why state taxes and fees as stealth taxes have been rising in Maryland...at least as much as I can figure it out.
That's it exactly. The unfunded liabilities for all levels of gov't are frightening. Many states and municipalities are worse off. The other problem was assumptions that the pension funds would have rates of return of 8% or more in the 1990's. This reduced the contribution level and masked the problem. We all know about the danger of assuming.