Covered Bonds and Poison Pills - Essay Example

Covered Bonds and Poison Pills By Covered Bonds The present world is characterised by a rapid expansion of global markets, as well as rapid advancement of technology. There are different factors and challenges in the economy today that have necessitated the dire need for credit. The aspect of liquidity rationing is not new in the current economy, as this has been experienced even in the past decades. This comes about when the credit market freezes, hence impacting adversely on financial markets. For this reason, it has become paramount that when markets are volatile, different strategies should be implemented as a means of increasing liquidity. However, for the increase of liquidity in a volatile financial market to be achieved, there must be different instruments that should be applied effectively. Nonetheless, covered bonds have become popular as instruments that banks can use in order to increase their liquidity in a situation of financial crisis. A credit crunch also referred to as credit rationing is experienced more during a financial crisis. This is a situation whereby loans or credit are not readily available, as their availability becomes limited. According to Browne, and Rosengren, credit crunch is strongly connected to housing and housing mortgages (Browne, & Rosengren, n.d). In addition, the conditions that are required to obtain a loan or credit from a financial institution become highly limited during this time. Credit rationing does not depend on interest rate movements. However, credit rationing results in a change in the association between interest rates and credit. In this case, the availability of credit at a given interest rate becomes limited. Either way, credit rationing might separate credit availability and interest rates, so that these tow do not have an association (International Monetary Fund, 2007). Nevertheless, there are various factors that are responsible for causing credit rationing. Among these is unregulated lending that later results in bad debts for financial institutions. The last financial crisis is a clear situation of credit rationing that threatened the global financial markets. However, some governments offered bailouts in order to restore liquidity (Schwartz, 2011). Covered bonds are an important tool that is used to increase liquidity. These mainly are debt securities that are supported by cash flows from either the public sector loans or mortgage (Kreitzer, 2012). Covered bonds are quite similar to asset-backed securities. However, a major difference between covered bonds and asset-backed securities is that covered bonds do not depend on any isolation of assets in order to gain bankruptcy remoteness. Unlike covered bonds, asset-backed securities are also “backed by the cash flow of a variety of pooled receivables or loans” (Agarwal, Cun, & De Nardi, 2010, p. 1). These are issued by a credit institution, either as a program or as a part of a single issuance. These also bear interest and have a low risk with a maturity of between one to 30 years. The cover pools are an important element for bond holders in covered bonds in cases where issuer defaults payment. Cover pools consist of assets of high quality that have low rates of default. These include residential mortgage loans or government or public obligations (Kreitzer, 2012). The issuance of covered bonds can be either where a financial institution issues the bond directly, or issues through a special purpose entity that acts as issuer. For financial institutions, issuing covered bonds is considered an answer to credit rationing. This however can be considered as having the potential of increasing the margin of financial institutions. However, some arguments have been made to indicate that covered bonds are not the answer to credit rationing during a financial crisis. Therefore, both arguments can be put into consideration, basing on the available evidence. Nevertheless, covered bonds are considered an important source of long-term funding that can be used to finance the long-term activities of a credit institution. In addition, covered bonds have a high rating, and are cheaper, as compared to unsecured debt. Furthermore, their issuance is less expensive as compared to other types of financial products such as securitization. The financial markets today continue to experience the effects of the past global financial crisis. Although the economies of some countries such as Australia fared well during the crisis, as compared to other countries, their financial markets remain affected, and this is evidenced by the overall pull-back in liquidity and quality of credit. In different parts of the world, there is a renewed need for forms of funding that are transparent and accountable. The securitization market is considered to be slow to recover, while other sources of lending are quite expensive; therefore, a covered bond market is most appropriate and efficient, and would provide an alternative and more diversified source of funding. There different factors that can be considered with regard to the effectiveness of covered bonds as a tool for increasing liquidity and addressing credit crunch. Apart from covered bonds serving as an efficient and cost effective means for financial institutions to enter into the bond market, there are other important factors that pertain to covered bonds and justify their effectiveness and use. The first factor is with regard to liability management. Covered bonds, as opposed to other funding products such as securitization, provide liability management. This is because they are a medium to long-term financing resource and are well suited to fund mortgage loan portfolios (Chami, Sharma & Fullenkamp, 2009). With regard to liquidity management, covered bonds provide a variety of benefits for the liquidity management of financial institutions. This is mainly because covered bonds offer access to an alternative funding market that is also highly rated (Mufford, n.d). The recent global financial crisis and credit crunch has revealed the need for diversified and resilient funding structures with regard to addressing the risk of liquidity. In a financial crisis, when a bank accesses capital markets, it is possible to experience lower funding costs hence leading to them writing more business at good interest rates. Covered bonds have a high rating, as compared to other financial tools. The ability to analyze the risk of the underlying collateral of the credit strength of issuers independently means that it is possible to achieve the highest ratings of credit regardless of issuers’ ratings (Mufford, n.d). Covered bonds have the ability to offer to financial institutions a clear opportunity to broaden their base into the high ranking markets. This opportunity would not be possible in the case of other lower rated and unsecured tools. In addition, triple-A assets are the largest fixed income investment segment in the world. Therefore, covered bonds allow for a strong investor demand; in addition to the fact that bond markets operate on a wholesale basis where large volume lending is common, provides the ability to finance assets through benchmark transactions with large volumes of issuance (Rixtel & Gasperini, 2013). Therefore, with these benefits of covered bonds, it is possible to consider them as a solution to credit crunch in a financial crisis. On the contrast, for different reasons, offering covered bonds might not be the solution to credit rationing in a financial crisis. Covered bonds are just an additional product in the giant mortgage market, like any other products. In the wake of the financial crisis in the year 2008, the covered bond market in Europe experienced different convulsions. For instance, “Primary market issuance of covered bonds has continued until mid-September 2008, albeit at a lower volume, shorter maturities and higher spreads” (European Central Bank, 2008, p.4). This simply meant that all was not well, even in the covered bond markets. Although covered bonds were adopted in Germany, these did not adequately address the problem of credit crunch. Foreign investors in Germany reduced their appetite for covered bond during this period and they were buying in smaller sizes. This therefore, led to the reduction in the amount of credit that had not seen an uptick during the housing bubble, and which was available in the mortgage market in Germany (Harrison, 2008). Therefore, it can be noted that while offering bonds might help to address credit crunch in a financial crisis, this also has also the potential to fail, hence cannot be regarded as an absolute solution to credit rationing. Poison Pills Companies go to great lengths to maintain control of firms and to prevent hostile takeovers. The poison pill is one of the effective strategies that companies utilize. This strategy mainly involves making a company prohibitively expensive so that the takeover company’s interest in acquiring it is diluted. Although poison pill securities have been popular, these are sometimes considered with significant controversy (Forjan & Ness, 2003). Poison pill securities play a significant role; however, depending on the situation in which they are used, these can turn out to be detrimental to shareholders. According to Alija, Ochoche & Zhou (2010), there are two major opposing perspectives on the poison pill tactic, hence research can be applied in order to validate one perspective over the other. Essentially, poison pill securities are used to dilute acquiring company’s ownership (Turk, Goh & Ybarra, 2007). This is achieved mainly by issuing stocks and warrants, and other options to shareholders that become exercisable after the takeover company acquires a fixed percentage of the stock of the target company, which is often at a considerable discount to the current price (Alija, Ochoche & Zhou, 2010). Usually, poison pills are triggered when one investor obtains an ownership interest of 20 percent (Brown, 2004). There are different ways through which poison pills can be utilized. One way is allowing the current shareholders of a company to purchase more shares at a great discount (Machiraju, 2007). This would in turn make it expensive and impossible for the target company to be acquired. There are different situations that might prompt a company might to use poison pills. For instance, a company might want to prevent a hostile takeover in order to maintain jobs for its employees. On the other hand, a company might be interested in being bought out, but not by a specific that wants to acquire it (Forjan & Ness, 2003). Throughout time, poison pills are known to be highly effective. These are considered among the most effective strategies that are adopted to fight a hostile takeover (Smith, 2014). Therefore, poison pills can be an effective tool for investors. This is especially in situations whereby investors feel that a takeover will not be greatly of benefit to their organization. Flexibility is an important characteristic of the poison pills. This provides a great length of flexibility, which can be adopted differently, depending on the needs of the company. The informal structure of poison pills makes it possible for companies to structure which assets the pricing terms apply to, such as convertible bonds, options, bonds, and stocks, among others. Poison pills equally play an important role in protecting companies against unscrupulous buyers (Smith, 2014: Brown, 2004). Usually, a hostile takeover is initiated by a company that aims at fulfilling its own selfish interests. For instance, a company might plan to acquire another company in order to dismantle it and sell it piece by piece. Similarly, a company initiating a hostile takeover might lack experience and knowledge on management and how to maintain the effectiveness of the target company. The unscrupulous buyers therefore, prompt the target company to create poison pill in order to shield itself from a buyer that would mismanage and injure the company together with its shareholders (DePamphilis, 2010). Poison pills are known to enable companies that adopt them to obtain higher premiums. According to Brown (2004), findings of different studies indicate that companies that have poison pill in place receive a 10% to 20% higher premium from companies that acquire them, as compared to those companies that have not adopted poison pill, hence fail to experience additional premiums. Poison pills also play a major role with regard to granting the management of a company time to seek other offers. Apart from preventing a hostile takeover, poison pills provides the management of a company with ample time to find better offers or create a bid (Smith, 2014). This therefore, increases the board’s clout in takeover negotiations. For instance, if an acquirer offers 20% above market price, despite enough shareholders accepting this offer, with a poison pill, the board can block the attempt and insist on a 25% instead of a 20% premium. For completed takeovers therefore, shareholders of poison pill companies therefore, enjoy a large increase from the initial offer as compared to shareholders of non-poison pill companies (Heron & Lie, 2006). As seen, poison pills play a significant role in a company that adopts them. This bears different benefits for the company and its shareholders. However, poison pills can also bear detrimental effects on a company as well as its shareholders. In addition, the use of poison pills as a means of deterring takeover of a company has sometimes been considered in a controversial manner, and both courts and critics have subjected this to scrutiny in the recent years. Banks should explore more grounds in order to gain control of the mortgage collateral that are reflected on their balance sheets. This will give the bamks a better cance of dealing with the current liquidity that is increasingly gaining predominance and the stop in securitization markets. Covered bonds are effective in this regard in the sense that they enable financial institutions like bakns to issue covered debts. Usually the covering of such debts is effected through the use of a pool of morgages (Klein, 2008). When banks cover debts, the mortgages so covered will be taken care of by the isssuer because the issue will hold custody of the balance sheet used. The debts so issued comes at a low cost because of the collateral security provided by the issuer. It means that bedts funding in hthis manner will be cheaper to repay than those funded by other methods such as securitization. Although Cover bonds are popular in Europe, it expansion has not yet reached the United States on large-scale basis. Unlike Washington, many cities within the United States have not embraced cover bonds to realize its full benefits. Perhaps it could be because of unawareness or fear of the risks involved in the process (Klein, 2008). Brown (2004) notes that poison pills are bad for shareholders going by the fact that the supporters of poison pills do not dare speak their name. Instead, poison pills are referred to as “shareholder rights plan” by nearly all companies that have adopted them. This name implies that the rights of shareholders to buy additional shares are initiated when the pill is triggered. Nonetheless, the name might suggest that poison pills increase the rights of the shareholders. On the contrary, poison pills do not increase the rights of shareholders. When a company has not adopted the pill, shareholders of the company are free to sell their shares at their own chosen prices. However, when the pill is adopted, shareholders are prevented from selling their shares to the hostile acquirers. In relation to that, poison pills also make investors to forgo profit from a takeover. In a situation where investors accept a takeover, they are paid a premium for their stock. However, when investors take the poison pill, they will not receive this premium, in which case, these might have been potentially hefty (Heron & Lie, 2006). Therefore, this makes the shareholders, as well as the general company to lose out. Poison pills might dilute the value of stock of a company. This is mainly through the issuance of new shares at an attractive discount. The issuance of new shares in the poison pill saturates the supply of stock (Diamond, et al 2009). The resultant situation is that the value of the existing shares in the company becomes greatly reduced. When this happens, investors are forced to make a purchase of new shares that will act as a replacement so as to maintain the initial ownership percentage. This therefore, will reduce the shareholder value significantly (Brown, 2004). The credit crunch of 2009 resulted from a deminishing influence of businesses and financial institutions, leading to financial instability on many parts of the United States. Furthermore, many regional and national banks came under sharp criticizms for acts of either ommission or commission that led to the credit crisis. the securitization of lending was the only way to go as far as the united states department of treasury was concerned. tt also made a primary decision to allow banks to let go of the mortgage loans that they had previously committed to, especially in 2008. The primary recommendation by the United States Department of Treasury was to include cover bonds in all debt transactions in order to cusshion the banks and the customers from further inancial crisis (Flantsbaum, 2009). The introduction of covered bonds in the finacial sector of the United States was aimed at helping banks to issues morgages withiout the fear of defaulting or inancial instabilities. Investeor would be able to secure mortgage loans and service them appropriately withiut any hitches because the loans were backed up. The national and regional banks in the United States would benefit immensely from the use o covered bonds in the issuance of morgages. It would be so in the sense that such financial institutions would begin to enjoy high ceedit ratings that would in turn attract both foreign and local investors. The cost of funging morgages would also drop, compared to the unsecured coroprate debt that are issued at senior level (Flantsbaum, 2009). Companies that are targeted for takeover are usually characterised by poor performance. Datta & Datta (1996) and Chakraborty & Baum (n.d) argue that poison pills protect poor managers, as the motivation of managers to adopt the pill is a result of their interest in wanting to be shielded from the disciplinary actions of the corporate control market. The company that wishes to acquire the target company recognizes that the target company has high chances of improvement and increased productivity, if it is under effective management. However, the fact that poison pills prevents the acquirer from getting the target company shows that the management of the target company uses poison pills to protect their own jobs and deprive the acquirer of a better management team. Poison pills are also considered to play a role in hindering institutional investors. Poison pills make it quite easy for managers of the target company to make selfish decisions in creating the poison pills in order to keep their jobs, at the expense of the shareholders of the company (Chakraborty & Baum, n.d). Highly paid CEOs might turn down any takeover in order to preserve their high salaries. In any case, shareholders usually stand to benefit from the high premiums that are acquired during a takeover. This therefore, might lead to less interest in institutions to takeover their target company. For this reason, the stock prices of a company may be affected negatively, considering that institutions are the largest buyers. It is less likely that institutions will be interested in companies that have adopted poison pills in order to scare away potential investors. Nonetheless, although poison pills are faced with significant controversy, these continue to play a significant role in companies, hence will remain helpful even in the future (Collins, 2011). References Agarwal, S., Cun, C., & De Nardi, M. (2010). Rescuing asset-backed securities markets. Chicago Fed Letter, (270), 1-4. Retrieved from https://www.chicagofed.org/webpages/publications/chicago_fed_letter/2010/january_270.cfm Alija, T., Ochoche, O. & Zhou, X. (2010). Poison Pills: A management-shareholder benefits comparison. Jonkoping International Business School. Retrieved from http://www.diva-portal.org/smash/get/diva2:322397/FULLTEXT01.pdf Brown, A. (2004). Grading the Goldfield Poison Pill. Retrieved from http://people.stern.nyu.edu/igiddy/cases/goldfield.htm Browne, L & Rosengren, E. (n.d). Real Estate and the Credit Crunch: An Overview. 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