Financial Markets and Institutions
Introduction
Covered Bonds are secured debt instruments that offer potential investors the alternative to
develop their respective government securities. Covered Bond valuation is complex but they
currently form the major asset classes in most European bond market as well as the source of
credit for most mortgage lending financial institutions. The cover pool or the collateral is often
put together or consolidated in order to obtain valuable triple A rating. Covered bonds are
offered to bond investors as one of the ways of developing a country’s government securities as
they are highly rated. Besides being used as funding instruments in the financial market, covered
bonds are also used as savings deposits and also as mortgage backed securities. Introduced ten
years ago, covered bonds had an outstanding volume of €1.8 trillion by the end of the year 2005
covering more than twenty countries. (European Covered Bond Council 2006) They form part of
the efficient capital allocation systems that support economic growth in most countries.
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Credit creation is the ability of the commercial banks to expand their deposits which also means
the expansion of the money supply. The banking system is structured in a way that it facilitates
the creation of credit. (European Covered Bond Council 2006)
On the other hand credit rationing occurs where the lenders or the bankers in this instance limit
or control the supply of extra credit to their clients who are in need of the money even if they are
willing and ready to pay higher rates of interest. It’s actually a real example of how market
imperfection can occur or simply put it’s a market failure. The prices mechanism in the market
fails to balance between the demand and supply of credit hence there is disequilibrium in the
market. It’s not a situation where the interest rates are unaffordable but actually there are willing
buyers in the market but no sellers. The lenders in the market are unwilling to supply more funds
or even increase their interest rates as they have already maximized their profits. (Standard &
Poor’s 2004)
Covered bonds can be utilized during financial crisis as a way of obtaining temporary relief from
credit rationing. Banks may not like the idea of using the covered bonds as a way of financing
their projects or increasing their profitability when the banking operations are normal. The
covered bonds are issued under strict minimum conditions that are defined under the 1988
UCITS (Undertakings for Collective Investments in Transferable Securities) of the European
Covered Bond Council. (Deutsche Bank Global Markets Research 2007)
Covered bonds are very popular in Germany and most parts of Europe but are rarely used in the
US market.
Covered Bond
Ratings
Number
Rated
AAA (Ratings
%)
France 520 100
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Germany 8872 96
Ireland 52 100
Luxembourg 145 99
Spain 147 85
Others 411 85
Total 10147 95
Source: Standard & Poor’s 2004)
Covered Bond In Europe
France
Germany
Ireland
Luxembourg
Spain
Others
The bases of the covered bonds are the cash flows that outline the investment pool and which act
as the collateral for the bond issues. (Deutsche Bank Global Markets Research 2007) The
investment acts as the cover pool and it may consist of the public sector loans or mortgages.
They create cash flows for the investors just like the asset backed securities in the financial
market. The bank issuing the covered bonds reflects the loans obtained on its balance sheet and
in case the bank goes bankrupt, the investors will retain the assets on the cover pool. (Fitch Inc
2006b)
The Bank of America and Washington Mutual in 2006 issued the covered bonds but were
severely affected by the 2008 financial crisis that prompted the US treasury secretary Henry
Paulson to issue guidelines under the FDIC (Federal Deposit Insurance Corp) on how to handle
the payments of covered bonds after bank failures.
http://bonds.about.com/od/derivativesandexotics/a/CoveredBonds.htm
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The use of covered bonds to relieve a financial crisis in banks may be catastrophic if handled
incorrectly. The Australian example provides a good example of an unsuccessful covered bond
issue in the year 2012. Banks also borrow money in order to make profit by also loaning it at a
higher interest rate. The Australian banks have grown their deposits largely from the Asian trade
and the interest earned from the high household debts and increased house prices. (Denning,
2013) The covered bonds entered the Australian market in 2012 and it offered a secured debt by
unlocking the use of balance sheets as a source of collateral for the covered bond by pledging the
different pools of assets mostly the depositor’s funds and home mortgages.
The introduction of the covered bonds in the Australian market actually didn’t succeed in
lowering the cost of borrowing as expected instead they shifted the borrowing costs even higher
for the Australian banks. (Denning, 2013) The Commonwealth Bank and the Westpac sold
covered bonds worth a total of $6.6 billion in January 2012. Both banks had to pay higher
interest rates than they initially envisaged. Covered bonds attract greater premiums and are
secured unlike the banks debts that are not secured. The gap between the covered bonds interest
rates and the swap rate varies from time to time. It may be bigger or smaller and it largely
depends on the global credit market and the investor confidence. The credit crunch in Australian
banks could not be salvaged by the sale of the covered bonds hence it’s not the solution to the
financial crisis that could sustain credit rationing in the banks. (Denning, 2013)
However credit rationing comes in different forms depending on the need and type of financial
crisis that it seeks to address. The covered bonds may be used to relieve financial crisis through
credit rationing in some quarters that may be favorable or profitable to the banks.
Credit rationing occurs where the rate of interest rate 1 is greater than rate* in the diagram below
(Figure 1) The equilibrium is attained at r* where Savings = Investments. The interest rate 1
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would make the credit more expensive than the equilibrium rate and the supply will exceed the
demand. However, for credit ration to apply, the demand for loans has to be higher than the
supply in the market. There are two major types of credit rationing; Redlining represents a
situation where a group of specific borrowers are denied credit from a certain amounts of
loanable savings. The credit rationing may not be as a result of a credit hunch but just for
asymmetrical information. This group with identifiable trait cannot obtain any loans at any rate
of interest. The banks in such cases don’t need any form of loans including the covered bonds.
They are not applicable in such cases of credit rationing. (Krugman 2009)
The other type is pure credit rationing and it refers to a situation where a certain group with non-
identifiable traits can partly be given credit and partly not but only if they are willing to part with
more interest rates. The other group is disequilibrium credit rationing which is not a permanent
feature in the market as illustrated below. (Dwight & Modigliani 1969)
Figure 1 Credit Market Equilibrium
Rate 1 Savings
Rate*
Investments
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S, I
Pure credit rationing is the perfect ground for covered bonds application as it’s exposed to high
rates of interests. (Dwight & Modigliani 1969)
Harold (1969) confirmed that the credit creation curtailed economic activities as it introduces the
aspects of imperfect capital markets that make’s the monetary policy in the banking sector to be
a powerful tool. The covered bond can be used to expand the banks financial profit margin as it’s
a source of loans to the bank and whose interest rates can be pegged much lower than the ones to
be achieved through the crisis created by credit rationing. (Stiglitz & Weiss1981)
There are moral hazards associated with these kinds of credit market that can be facilitated by the
covered bonds. The 2007 subprime mortgage crisis and the credit crunch that followed led to the
financial crisis whose source could be traced to the reduction of interest rates through credit
rationing that finally resulted in excess loans landing on the hands of clients who could not pay
them back. (Cooper 2008)
Finally to conclude, the use of covered bonds may facilitate the misuse of funds if proper
controls are not instituted to protect the banks interests and its customers. But one issue that is
very clear is that the covered bonds provide the most secure investment in the banking sector.
The major causes of credit crunch are careless and inappropriate procedures for lending which
eventually leads to losses from bad debts after the loans have turned sour and unrecoverable. It
mostly occurs when leading competitors are competing for market share by relaxing their
lending standards and lending more to capture and expand their market share. Essentially it
means that the banks run out of loanable funds which they can generate from the covered bonds.
But it would be catastrophic to run into the same trouble again as covered bonds carry interest
rates that are above the market rates and as such they can serve conveniently as temporary
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relievers of financial distress. Covered bonds can be the answer to the frequent credit crunches
but they would not be very profitable hence they cannot be a source or the answer to improving
their profit margins.
2.
Introduction
The poison pill refers to the shareholders rights plan which is a defensive strategy that is applied
by a company’s board against any takeovers. The poison pill was initially devised in the 1980s
and its objective was to prevent the potential investors or the takeover bidders from engaging the
shareholdings directly and negotiating the share prices with individual shareholders instead of
the board. The poison pill is out rightly unlawful without the consent of the shareholders or their
approval especially in the UK, EU and in Delaware in the US. Its use is limited to Delaware in
the U.S. while the other states have made its application to be illegal. The poison pill discourages
the corporate control of the security market. Bestowing the powers of controlling the takeovers
on managers sets them on a lucrative position where they can enrich themselves by making
decisions that are beneficial to themselves and mostly to their own best interest not the
company’s.
The major advantage of the poison pill is twofold; a) It allows the management of a company
sometime to exploit other options that offer better prospects for the company or alternatively find
offers than can maximize the value of its shares. (Ross, Westerfield, Jordan & Roberts 2008)
b) Several studies and experience on company operations confirms that companies that have the
shareholders rights plan or the poison pill have higher propensity to receive higher premiums
during takeover bids than companies that essentially don’t have the poison pill. The shareholders
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right plan increases the value of the shareholders. The concept is that the poison pill increases the
negotiating power for higher acquisition premiums.
There are several types of shareholding rights plan or the poison pill. The following are some of
the ones that are mostly used types;
a) Preferred stock plan
These shares have tough redemption provisions that may allow conversion into larger quantities
of common shares in cases of takeover bids. These measures dilute the total percentage that the
acquirer targets and it also makes it expensive to acquire 50% of the targeted stock.
b) Flipover rights plan
The target company adopts large debts that aim at making the debt load to be unattractive and it
becomes imperative that the acquirer of such shares has to pay the debts.
c) Ownership Flip-in plan
Using stock swap, the company acquires some smaller companies which ultimately dilutes the
value of the stocks targeted.
d) Back-end rights plan
The company through its compensation policies ensures that the employees’ stock option rights
are vested should the company be taken over. The employees are allowed to exercise their
options after which they can later dump the shares. Discounted employees can comfortably quit
the company after exercising their options and selling their shares. The poison pill facilitates the
exodus of employees which affects the value of the company and which ultimately makes the
company unattractive to the takeover bidders as the company remains a shell to the new owners.
Voting plan
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Under these arrangement, the company charters preferred stock that has superior more voting
rights than the common shareholders. It makes it difficult for unfriendly bidder to acquire a large
number of common shares and also which cannot allow control over its acquisition or purchase.
The dead hand provision makes it impossible for the new management team to remove the
poison pill as only the directors who introduced it are allowed to remove it.
The poison pill was introduced in good faith but it can also be misused. The initial objective of
the poison pill was to prevent hostile takeovers by other companies who may not be interested in
the growth and development of the material company but whose only interest was to create a
strong powerful and near monopoly mother companies. ( Wachtell, Lipton, Rosen & Katz 1999)
The other reason was also the management needed time to calculate and exploit all possible
options before allowing the company to be taken over.
These reasons were noble but the current generations of managers are only interested in financial
gains at the expense of the company. Given the many provisions of the poison pill, they would
certainly take advantage of its provisions and restrictions to strike deals and arrangements that
may not be beneficial to the company as a whole but prefer the alternatives that guarantees them
substantial benefits as individual managers. In Canada for example, the bidders are allowed to
bypass the poison bill if the takeover bidders conform to the provisions of a proposed bid.
The validity of the poison pill has also been put to question. There contentious issues that need to
be addressed concerning the poison pill. It’s argued that its application contravenes the
provisions of the Supremacy clause of the American constitution as it frustrates the purpose and
application of the Williams Act of the year 1968 federal statute that governs the procedures for
tender-offer timings and also disclosures. (Lipton, Wachtell, Lipton, Rosen & Katz, 2014)
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The poison pills may delay the tender offers for longer periods of time and they have also
demonstrated weaknesses in pre-empting challenges that face the state takeover statutes.
However, there still many benefits that are associated with the poison bill. It limits the ability to
petition the members to a special meeting to a written consent. Bebchuk, Coates & Subramanian,
2002) All the special meetings must have a written consent from the shareholders
representatives. To approve mergers, the poison pill requires a supermajority vote to allow the
vote to go through. The shareholders rights plan allows them to increase the value of their stock
to 100% its recent average price. It may not stop an aggressive takeover bid but it can add the
value of the company. (Kahan 2002)
The poison pill was presumably introduced to protect the interests of the company from hostile
takeovers that may be intended only to profit a few individuals. In the case of Piper v Chris-craft
Industries which emphasized that the congress in an effort to regulate the takeover bidders and
also to protect the company shareholders from target companies supported the poison bill.
( Wachtell, Lipton, Rosen & Katz 1999) Senate cosponsor of the bill, Senator Kuchel supported
the requirement that the takeover bidders whom he described as corporate raiders and takeover
pirates to disclose their activities and intentions before the poison bill could be set aside in a
court of law. ( Wachtell, Lipton, Rosen & Katz 1999) The poison pill puts a stop the habit of
some greedy individuals who scheme to take over very proud and successful companies and
reduce them into empty shells after seizing control of such companies with resources from
unclear or unknown sources, sell or trade away the best assets of the company and split up the
remains of the target company among themselves. The tragedy of the whole exercise is that the
management or the shareholders of the target company would watch helplessly as they have no
knowledge of the secret acquisitions as the hostile takeover bidders act mostly under the cloak of
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secrecy when buying the shares necessary or needed to wrestle the control of the company and
successful place it under their supervision. The poison pill was designed with an intention of
preventing such cases. The corporate raiders are the threats that the poison pill set to address in
the first place but it has also been hijacked by the company executives who now have the control
of the companies even when the company is going under. Its needs some sense of sobriety when
dealing with the issues that affect the shareholders. The Sarbanes Oxley act of parliament spells
out the financial responsibility and disclosures on how the management of a company should be
accountable especially when the company starts making loses.
The use of the poison pill should be for the interest of the company and not the company
executives and at the same time it should not a deterrent to the prospective potential investor who
has the goodwill of the common shareholders of the company. It should be flexible and its
application should be beneficial to all the stakeholders in the industry.
To conclude, the poison pill can be advantageous and beneficial to the company as it seeks to
provide the best prospects for a company that may be in distress or in need of financial bailout.
Companies that have the shareholders right plans or the poison pills have better chances of
receiving higher premiums during takeover bids than companies that do not have them in their
provisions. The poison pill increases the value of the company and shareholders. It also increases
the negotiating power for higher acquisition premiums.
The aggressive and hostile takeovers are usually meant to streamline the external markets for
companies that may not have the interest of the target company but just its market share and
customer base. The poison pill should be allowed to operate independently but be subjected to
court petitions whenever there is a conflict between the management and prospective takeover
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bidders. It should not be disallowed as its now where most parts of the US has made its
operations illegal.
References
Bebchuk, L.A., Coates, J.C. and Subramanian, G., 2002, ‘Powerful Antitakeover Force of
Staggered Boards: Theory, Evidence, and Policy’ 54(5) Stanford Law Review 887–951
Cooper, G., 2008, The Origin of Financial Crises, London: Harriman House
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Denning, D., 2013, How Australian banks Use Covered Bonds to Play a Dangerous Game, The
Daily Reckoning Australia; Tuesday 28 May 2013. http://www.bankvictims.com.au/general-
banking-news/item/9348-how-australian-banks-use-covered-bonds-to-play-a-dangerous-game
Deutsche Bank Global Markets Research, 2007, Fixed Income & Relative Value “Overview of
covered bonds”, Deutsche Bank AG, 60 Wall Street, New York, NY
Dwight, J.M. and Modigliani, F., 1969, A Theory and Test of Credit Rationing, American
Economic Review, 59 (1969), pp. 850–72.
European Covered Bond Council, 2006, European Covered Bond Fact book, August,
Fitch Inc, 2006b, “Covered bonds and capital requirements directive”, Fitch Inc,
Harrod, R., 1969, Money, Macmillan and Co, (1969), pp. 63-65
http://bonds.about.com/od/derivativesandexotics/a/CoveredBonds.htm
Kahan, M., 2002, ‘How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to
takeover Law’ (69 University of Chicago Law Review 871
Krugman, P., 2009, Preference Loanable funds, May 2, 2009, New York Times website:
http://krugman.blogs.nytimes.com/2009/05/02/liquidity-preference-loanable-funds-and-niall-
ferguson-wonkish/ .
Leece, D., 2004, Economics of the mortgage market: perspectives on household decision
making, London: Wiley-Blackwell, 2004, pp.94-96.
Lipton, M., Wachtell, Lipton, Rosen & Katz (2014) A Response to Bebchuk and Jackson’s
Toward a Constitutional review of the Poison Pill, The Harvard Law School Forum on
Financial Markets and Institutions
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Corporate Governance and Financial Regulation,
constitutional-review-of-the-poison-pill/One Street Plaza, New York, NY
Ross, Westerfield, Jordan & Roberts, 2008, Fundamentals of Corporate Finance (6th ed.
McGraw-Hill Ryerson) 23: Mergers and Acquisitions
Standard & Poor’s, 2004, “Expanding European covered bond universe puts Spotlight on key
analytics”, July, www.standardandpoors
Stiglitz, J. and Weiss, A., 1981, Credit Rationing in Markets with Imperfect Information, The
American Economic Review, Vol 71, No. 3 (June 1981), pp. 393-410.
Wachtell, Lipton, Rosen & Katz , 1999, The Share Purchase Rights Plan in Ronald J. Gilson &
Bernard S. Black, The Law and Finance of Corporate Acquisitions (2d ed. Supp.)
