Leading us out of bondage

“Our word is our bond” is a famous expression. It is just fine when that word is worth something, but it should not be used to answer away the lack of proper documentation behind an agreement. Should this attitude be acceptable when Israel’s largest companies are seeking money from Israeli institutions?

The President’s Conference played host last week to a panel entitled “Israel’s Economic Tomorrow in Light of the World Financial Crisis”. The eminent panel was moderated by Hagai Golan, Editor-in-Chief of Globes, and included eminent economists, Professors Lucian Bebchuk, Dan Galai, and Eugene Kandel. The latter is more than an academic – he heads Israel’s National Economic Council and sits on the Trajtenberg Committee. The panel was rounded out by Ori Yogev, Chairman of Israel Railways; and former President and CEO of Bezeq.

A question was put by AIMB‘s David Cohen to the panel about the recent “haircuts” which were discussed in a previous posting. These were events where major Israeli companies had raised corporate bonds, funded by the largest Israeli financial institutions (banks, pension funds, insurers and so on), then sought to renegotiate them when the underlying assets weakened due to the world financial crisis.

David’s point was directed at Professor Bebchuk, who had expressed his view that the “haircuts” could have been avoided by having higher regulation of bond issues by Israeli companies. This was to protect the creditors against the companies and their owners, who appeared to be getting away without a threat to their control or their own equity value, whilst bondholders shouldered the burden of risk and loss.

David asked whether the onus ought to be on the bond purchasers, who had apparently ignored the risks involved in these “doc-lite” bonds. In other words, the fact that they were bonds entitled them to an institutional rating as an asset, allowing the banks, pension and insurance funds to buy them, but the terms and conditions turned out to assure the investor no protection at all.

The role of “doc-lite” bonds is potentially positive, provided they are understood to be fundamentally more risky, and rated as such, to only be purchased according to the strictures of proportionality within a portfolio. The issue here is that the terms must have been perfectly well known, but were conveniently ignored by investors when buying these bonds.

Not only was there a forcible cut in the capital value of many bonds, and also delayed or cancelled distributions, but there was almost no leverage for the bondholders to hold the company’s management to account. This is a sorry state of affairs, and something the Trajtenberg Committee should be looking at. In Western markets, this would simply not be allowed, and for sure the market would react against the underlying company and future bond issues.

Here however, there has barely been a pause in the rate and price of acquisition of new corporate bonds. This indicates perhaps that there are simply not enough places for Israeli institutions to warehouse their capital, and that the sellers now call the shots.

With this in mind, it seemed a little alarming that Professor Kandel, in response to David’s question, stated that if the bond purchasers had bought access to these companies through equity instead of a debt instrument, they would have lost equal value.

This statement might seem reasonable at first. However, it should be a concern that institutions who should have a conservative portfolio of investments are being hoodwinked into buying bonds that turn out to have in some ways even less protection than equity.

Whilst the value of an investment might fall either way, there is supposed to be a massive difference in the tiers of risk and exposure to that investment, depending on whether one holds debt, equity or some subset of the above. The fact that investment managers made a decision to take what looked like a bond, but actually afforded no such protection, is at best a horrific oversight, and at worst, a clear sign that there is a systemic problem in asset allocation.

It is high time, if this analysis is correct, for the regulators to permit higher asset allocations outside Israel and chase the best value for fund constituents. There should also be much higher scrutiny of any continued conflicts generated by the small pool of owners of major companies, even if post-Bachar Reform, there is no formal tie.

Even if this is just a perception, markets may react to it, to the detriment of the cost of borrowing and the underlying liquidity issues that this could cause. Already, this is being picked up by respected foreign media, such as the Financial Times, ahead of a draft bill at the Knesset which the FT says is too lenient.

Surely then Israel must come into line with the world’s senior financial centres by enforcing a higher duty of care by bond purchasers. The lack of nuance between types and classes of assets needs to be addressed by the regulators, as it appears to be the legacy of a much simpler time that there are geographical controls on Israel-based institutional assets, but fewer strictures on distribution between levels of real risk (rather than nominal paper ratings).

Ultimately there seems to be a lack of governance at key levels, between the bond-raisers and bond-holders, to protect the underlying investors – ordinary people who have policies and deposits.

In turn, as alluded to in the previous article, the Israeli public has failed to understand the connection between themselves and the headlines in Globes or Calcalist. When your retail bank, insurer or pension provider allows itself to make such investments, it is doing a disservice to you, and you should vote with your feet if nobody can be held accountable.

Once again, this is an example of the Israeli public being taken advantage of by the concentration that exists in the economy. The solution is for middle class Israelis to vote with their feet and diversify their portfolios, away from investment managers who allow and perpetuate this situation, and into a more transparent structure where they have the right balance of investments and above all, clear sight-lines and accountability between manager, investor and asset.

Companies will get away with whatever they can to get cheap and soft terms on their money. It is for the regulators to ensure that the buyer is sufficiently sophisticated to make the purchase, and to oversee that financial instruments are correctly rated for real risk. We only have to look at the collapse of the world financial markets on the back of sub-prime loans being repackaged as A-grade assets to understand the consequences of that.

To effect real change, rather than protestors calling for social justice by blocking highways and smashing up banks, this needs an educated public, which, as the FT points out in its editorial, is hardly helped by the same oligarchs controlling many media outlets! We await the outcome of the draft bill at the Knesset with considerable interest.