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The end of free market principles

Tuesday, March 21, 2023
  • Writer's pictureK

Remember how people used to queue for Hello Kitty toys at McDonalds?


Consider this extreme: You are queueing in line for that limited edition item and suddenly realise that it'll be sold out by the time it reaches you.

The thought of walking away empty-handed drives you to think of other ways, including negotiating with the folks in front of you.

But everyone respects the unwritten rule of the queue - first come first served, get in line and wait for your turn.

Desperate and frantic, you decide to go bat-crap crazy and threaten to burn the whole store down if you don't get your toy, putting the entire queue and McDonalds store in jeopardy. Suddenly the store manager comes over to appease you, bringing you to the front of the queue, effectively guaranteeing a reward for your troubles.

Make enough noise, create enough damage and you'll get something.


For years, practitioners in the industry have been taught, have understood, and have accepted that equity holders stand behind debt holders in the queue to redeem cash flows of a business. These are the rules of the game relating to the priority of how cash in a business would be distributed, if and when assets are being liquidated.

It's a basic principle codified in financial markets theory.

But that rule seemed to have changed forever when Credit Suisse decided to write off a huge chunk of their AT1 debt last week and facilitate any residual payments to shareholders.

On Credit Suisse's AT1 bonds, the FT also commented:

"Protectionism, geopolitical self-interest and state intervention, in other words, seem to have over-ruled free-market principles."

By allowing the "free market principles" to take reign and go its natural course, the Swiss government runs the risk of embarrassing a certain influential Middle Eastern shareholder who recently invested in Credit Suisse, and in the process, taking the rap for the bank's current state of affairs.

Investors and onlookers would ask, "why bother even doing a capital raise in the first place only to write it all off within months?".

There would be a crisis of confidence in management, possibly wider overhanging doubts over stability in the region, including the country's position as a global wealth management hub. And then no one would put money in Switzerland anymore, a cost possibly too high for the government to bear.

When the reputation of your country is at stake, all concepts of equity and debt gets thrown out of the window.

Bottomline: Rather than adhere by the rules governing capitalist theory, it is far better to offend those who can afford to be offended than to risk a systemic meltdown.

Of course extreme situations call for extreme measures.

Under the normal course of business, every one is happy to stand in line and play by the rules. Decent wages for decent work, a fair share of the pie for a fair amount of effort invested. Most investors who walk into a share agreement try not to think too much about a material adverse outcome.

But when the house is on fire, everything is up for grabs and all stakeholders - equity and debt - will scramble for the exit.

I think the uncomfortable truth today, that no one talks about explicitly, is that: rather than fight a war using conventional arms, political decision-makers around the world have found a way to weaponise the workings of financial markets and monetary policies to drive their own agendas, in the process distorting how we perceive value.

Any country in world can 'own' another country by simply imposing trade sanctions, ridiculous tariffs, and in extreme cases, confiscate assets - assuming one country is heavily reliant on the other for the import of certain critical goods and services.

By creating dependency, you are weakening the bargaining power of the other party, and lesser bargaining power generally comes with lower value. Nassim Taleb also talks about this under the chapter of "How to legally own a person" in his book:

For good or for bad, sovereign risk has become even more closely intertwined with equity risk.

When you buy a stock or a bond, it is no longer as simple as taking a view on profitability, future cash flows and room for improvements, but also the strategic importance of a company's position in the ecosystem.

DCF does not capture all of that.

In fact, no amount of number crunching and analysis allow for an accurate appraisal of any company's fair value today, primarily because the so-called free market is no longer that free. Instead of willing buyer, willing seller, the market economy is now to a good extent, influenced by statecraft, driven by the common interests of various governments.

The treatment of Credit Suisse's AT1 bonds has also further demonstrated and reinforced how loosely-held and trivial the definition of equity and debt can be when push comes to shove.

For what it is worth (as it has always been), value will forever be driven by the willingness of another party to take the asset off your hands at their own free will.

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