Jim Chanos Says that MacQuarie is a House of Cards

To me, this is just one example of what is about to happen with all of these silly folks saying to buy outside the US. When you buy stocks in Russia, Brazil, India, China or even Australia, you are exposing yourself to inferior accounting rules.

I am a Australian citizen and resident. I ONLY invest in and trade US equities. The reason is precisely because of our inferior accounting standards and
in my opinion, poor corporate governance. In addition to this our regulator (ASIC) is almost completely incompetant IMHO.

Different Views of the Macquarie Story
The Macquarie Story
According to Macquarie Bank they have discovered a new way to generate consistent above average returns by buying infrastructure assets.

The basic idea is that Macquarie buys monopoly infrastructure assets and then immediately flips the asset at a much higher price (the difference is Macquarie’s fee) into one or more Macquarie trust companies called a Special Purpose Vehicle (SPV). Although these SPVs are controlled by Macquarie they are designed to transfer the risks off Macquarie’s balance sheet. The recent restructure of Macquarie into Macquarie group was another attempt to further insulate the bank from future problems. The SPVs use significant gearing to buy the asset and to pay out “dividends�. Macquarie also acts as advisors and managers of the SPVs in return for large fees.

The units in the SPVs are then sold to retirees and other investors using Macquarie’s fund distribution and investment advisor channels. The SPVs then pay distributions or “dividends� using borrowed cash. Macquarie’s justification for this unusual method of funding “dividends� is that it is a better match of positive cash flows from the infrastructure asset with liabilities along the time line.

Macquarie’s has often been criticised on the basis that interest rate increases or a tighter credit market could cause these highly geared structures to unravel. Macquarie’s answer to this is the same as the Robber Barons of old. In essence Macquarie says that that since the assets are often essential service monopolies, Macquarie can just raise the price of using these assets and the public will have no choice but to pay. I think this assumption is Macquarie’s Achilles heel.

The problem is that there is a limit to how far the costs of using essential services can be raised before they create a political backlash. The public could reasonably attribute any large increases in infrastructure usage fees to Macquarie’s huge fees and excessive gearing. The fact that Macquarie “advised� these SPVs exacerbates the problem. Why should the public pay for the mistakes and greed of Macquarie?

The Real Macquarie Story
Another version of the story is not nearly so rosy. In this version Macquarie Bank has been purchasing infrastructure assets at prices far above market value. The bank is often significantly higher than the next nearest bidder. Macquarie then marks up the already overpriced assets by a large amount and sells them into an entity (SPV) or lately distributes around several different SPVs. The markup is Macquarie’s upfront fee. These fees are some of the largest fees for these types of transactions that have ever been seen.

The only problem is that the SPVs are controlled and advised by Macquarie Bank and so the SPVs are not really making commercial or independent decisions. Instead the transactions appear to unreasonably benefit Macquarie Bank at the expense of the SPV. The problem here is that one of the main functions of an SPV is to shift risk away from the Bank proper, however:
(i) Macquarie’s control of the SPV,
(ii) the non-arms-length (related party) transactions and
(iii) the non-commercial transactions,
make it much more likely that if an SPV were to fail, then a court could “lift the corporate veil� and hold Macquarie Bank directly liable for the debts or losses of a failed SPV.

Monopoly Pricing Power and Politics Collide
A further risk to Macquarie is its claim that interest rate increases can be offset with raising tolls or fees because people have to use roads and airports, etc. The problem with this theory is that since the original transactions were non-arms-length and are arguably non-commercial it follows that increased usage costs are not a legitimate reaction to market forces, they are instead, simply the result of paying too much for the original assets. In these circumstances a popular and political backlash against the increased prices would be very likely as happened with the Robber Barons of old and is happening now with some infrastructure assets in the US.

The end result could be a cap on rising prices or special government taxes and fees on the SPVs to recoup the increased usage charges. Ultimately then the SPV becomes insolvent and is bought at a fire sale price, perhaps by the same government entity that sold it. The government is the buyer of last resort here because these infrastructure assets are essential services. However, if the SPV investors are retirees in the same country as the SPVs infrastructure assets it becomes difficult for the government. Whatever the government does, either the creditors, public or retirees get hurt. In these circumstances the government may support moves by creditors and investors to “pierce the corporate veil� between Macquarie and the SPVs and so hold Macquarie Bank itself liable for any losses or shortfall in the SPVs.

The Macquarie Influence/Distortion Factor
However Macquarie has a lot of influence in Australia. Macquarie often hires the adult children of; politicians, public servant mandarins and influential CEOs. Macquarie also hires retired politicians and public servants. For example shortly after Macquarie purchased Sydney Airport from the Commonwealth government they hired Max Moore-Wilton to run the Sydney Airport. This created some controversy since Max Moore-Wilton was the most senior public servant who held the position of “Head of the Department of the Prime Minister and Cabinet� and would have been advising the Government on the sale. It was during his tenure that the decision was made to sell the airport and the government accepted Macquarie’s tender.

Macquarie also won a tender to manage the government car fleet. Is essence this deal is a simple tax arbitrage gift to Macquarie. In Australia there is a 20% tax on new cars, however Macquarie did not have to pay this tax. So after one year of use by the government Macquarie can sell the car at close to the purchase price and pocket all the income from leasing. Interestingly, Macquarie hired Bob Carr who was the NSW Premier when these decisions were made. Are you starting to see a pattern here?

Macquarie also has had close business relationships with the main commercial media players, thus curbing criticism in the Australian domestic press. For example Macquarie have had business relationships with PBL and Fairfax, the owners of the main newspapers in Australia. As a result their has been little domestic coverage of the Chanos shorting issue or criticism of the Macquarie model, except by the public radio broadcasting (ABC) and even this was fairly brief.

Many employees attend a boot camp called “Camp Macquarie� where they are told they are “special� (read elite) by virtue of the fact they have selected to work at Macquarie. Using this simple psychological tool, new employees are inculcated into a type of Macquarie cult. In addition, Macquarie employees’ spouses, relatives and friends often get hooked in by the fervour of the Macquarie employee (“devotee�) and become Macquarie “devotees� themselves. As with many religions, Macquarie “devotees� are not very receptive to any information that contravenes their belief system.

In addition Macquarie has close relationships with the legal fraternity (e.g. judges and senior silks). This is at least partly due to the fact that Alan Moss’s wife (Irene Moss) was head of the NSW ICAC (Independent Commission Against Corruption) and then the NSW Ombudsman. Some people have commented that Macquarie appears to get favourable treatment in the courts, perhaps as a result of all this influence.

The SPV creditors also wield significant influence. At present their interests and Macquarie’s are aligned so one would expect that they would also be using their influence to keep the party going.

In any case it is not hard to see that a big player like Macquarie in a small country like Australia can exert significant influence and so exactly how the government would react to the failure of one of the SPV funds is an open question. One only has to recall the difficulty that James Hardie workers (who were dying from asbestosis on TV) had in getting compensation. The asbestos cases involved a mix of politics and litigation and it was a very long time before the dying workers achieved any sort of success.

What are the Possible Outcomes for Macquarie?
It is probably only a matter of time before one of these SPVs run into problems.
(i) Fund Fails After 20 plus Years
Macquarie is hoping that it will be a long time, perhaps 20 years or more. Apparently many of the funds have partial interest rate hedges out to 7 years. If a fund fails after a long time (20 years) then Macquarie will be able to credibly argue that any non-commercial and non-arms-length (related party) transactions were not material in the failure of the SPV. The party would be over, but Macquarie might avoid paying the piper.

Because these are mostly essential services assets they cannot be closed down. Therefore, if no other company is interested (likely if the asset has been politicised) the creditors would have to run the businesses until they could convince the government to buy it back. If new buyers could be found for the assets then the creditors would probably be ok, the users of the monopoly assets would have borne high usage costs, only the investors would be really burned and Macquarie’s reputation slightly singed

(ii) Fund Fails in Next Few Years
If one of the SPVs gets in trouble sooner (say in the next few years), then the creditors funding these SPVs may get cold feet and withhold funding or raise their rates on new deals to account for the extra risks. If the funding dries up then Macquarie is probably in serious trouble and that would be the end of the so called Macquarie model. In this case the original creditors might bear some of the costs and may go after Macquarie on using the “lifting the corporate veil� argument. However the fact that many of the loans are non-recourse and were entered into by supposedly financially sophisticated entities would make it unlikely that the creditors would succeed. The investors, however, may have a better chance of “lifting the corporate veil� and getting some money back.

(iii) Expensive Credit or No Credit
If the funding gets more expensive to account for the higher perceived risk, then the returns on the SPVs will start to look very grim. Once returns drop, all but the biggest Macquarie fanboys and fangirls will transfer their funds out of Macquarie infrastructure funds.

On the other hand poor performance of Macquarie funds does not appear to have stopped people investing in them in the past. Naive investors seem to conflate the strong performance of Macquarie Bank with the performance of its funds. In other words they seem to buy on the basis of the bank’s reputation not realizing they actually make a significant contribution the bank’s out performance. Macquarie also rewards “independent� investment advisors handsomely for signing up investors. So maybe under this scenario Macquarie will simply fade away and will end “not with a bang, but a whimper�.

(iv) New Never Before Invented Perpetual Money Machine
Alternatively maybe Macquarie really has discovered a way to turn lead into gold and the party will go on forever and everyone will live happily ever after. Arguably, Macquarie does do something like this except that the gold goes straight into Macquarie’s pockets while infrastructure investors and creditors are left with gold painted lead and a large debt.

Summary
It is arguable that Macquarie may have abused its position of trust and control of SPVs to simply pay itself large upfront and ongoing fees while attempting to transfer the risk associated with overpaying for assets and the risk of high gearing into the future and onto investors (pensioners) and complacent creditors. In other words Macquarie has attempted to engineer risk transfer in time (see interest rate hedges) and via the structuring of legal entities (SPVs and the recent restructure to Macquarie Group).

When asset prices begin to stabilise or decline, and or, interest rates rise or credit conditions tighten the model will no longer be viable. The extent of Macquarie’s influence in Australia may well allow them to avoid liability unless creditors or investors manage to “lift the corporate veil� between Macquarie and the SPVs. More likely the investors, the public and creditors will pay the price of this latest experiment in privatising infrastructure. Then many people will look back and wonder how they could have been so gullible and fallen for the Macquarie fairy tale.

If I had investments in any of these geared Macquarie infrastructure trusts I would be quite concerned. Obviously as credit conditions tighten one would have to be very worried about the sustainability of the Macquarie model and hence the Macquarie earnings stream and share price. Hopefully it will be only the most fanatical Macquarie fanboys and fangirls that end up losing money on this latest “miracle�, but unfortunately I fear it will more likely be many ordinary pensioners and retirees!

all this information sounds like really good dirt. however is it credible, i mean how come its not referenced by supporting facts and authorities?

Michael West's article in 'The Age' 19/9/2008 is one of many which explain how Macquarie has recieved "special" treatment from ASIC.
In my view ASIC can almost be considered complicit in the current market meltdown. Lack of regulation always ends up the same way in the end. The snake starts to eat its own tail.
ASIC and the ASX are almost completely incompetent in my view.
To think this company wanted to bid for the London Stock Exchange! ROFL!!!

To Mary O'Donnell.

You aRE right. AMErica is and will always BE the sole font of sRupulous accounting rulEs.

You are also right in grouping Australia with couNtries like China, India and Russia - histoRy clearly shOws that Australia has suffered from a great Number of infamous corporate bankruptcies...