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Character is Destiny - Especially on the Downside

What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.

For one, they all ran major companies. Tanzi was CEO of Parmalat, an Italian food company; Ebbers was CEO of WorldCom, an American telecommunications firm; and Groves was CEO of ABC Learning Centres, an Australian day care provider.

For another, each was a hard-driver who started small and made it very big. Tanzi built a global company from one pasteurization plant. Ebbers turned a rural telephone exchange into the third largest telecommunications company in the United States. Groves began with a single childcare center and grew it into the largest day care company in the world.

Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.

Yet another common point is that all of them were involved in massive misstatements of their companies' finances. Tanzi kept enormous amounts of debt off Parmalat's balance sheet, while Ebbers and Groves kept tremendous amounts of costs off their companies' income statements.

The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.

So what does all this mean? Is owning a professional sports team an early warning sign of financial fraud? Not really. But it does mean Tanzi, Ebbers, and Groves shared traits that led to their misdeeds, and those traits may be useful signals of misconduct in others.

What these three malefactors had in common is some combination of these behaviors, which are based on Sydney Finkelstein's "Seven Habits of Spectacularly Unsuccessful People" from his book Why Smart Executives Fail.

1. They were domineering. They resisted any outside control, including accounting rules. 
2. They had no sense of a boundary between their interests and the company's. What was good for them must be good for the company.
3. They thought they had all the answers. Since they were always right, they made their own rules.
4. They eliminated resistance. They quashed dissent and had no one to warn them about the risks they took.
5. They were the public face of their companies. They reveled in public attention and professional rewards, and they saw financial statements mainly as public relations tools.
6. They underestimated difficulties. It never occurred to them they eventually would be caught.
7. They relied on what worked in the past. They were sure that if a little bit of deception worked before more would work even better now.

It's a truism of credit analysis that character matters, but it doesn't just matter in small and medium-sized businesses. It's crucial in big companies too.

Tanzi, Ebbers, and Groves did not set out to create criminal enterprises. But their own flaws pushed them and their companies across the boundary between aggressive reporting and fraud, with grim consequences for shareholders, bondholders, and lenders. And disastrous consequences for at least two of them.

Risks Drive Debt Spreads

The return investors receive for owning a debt instrument, whether a loan or a bond, is driven by the various risks of owning debt.  This Job Aid from Financial Training Partners does a good job in explaining the major risks faced by debt investors.


Click on it to see a larger version.

Primary and Secondary Markets for Corporate Debt

In earlier posts, we compared the pricing of corporate loans and corporate bonds.  Here, we'll look at how these markets interact, both in primary issuance and secondary market trading.  First, some definitions:

• The Primary Market is where financial instruments are sold from the issuer to investors.  This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market).  As part of this process, securities often pass through an intermediary, such as an investment bank.
• The Secondary Market is where financial instruments are sold from investor to investor.  The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).

The Investors

• In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors.
• In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds.

The key to rational pricing in these markets are the crossover investors - institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets.  By analyzing the relative value of loans and bonds, they decide which to buy.  For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans.  This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market.  Eventually, the spread between loans and bonds will narrow.  Thus, the secondary markets for loans and bonds are related.

Likewise, the primary and secondary markets are related.  The spread a company will pay on new bonds or loans should be about the spread at which its existing debt is trading in the secondary market (or, if the company has no debt outstanding, the spread at which the debt of companies with a similar risk profile are trading).

Risk Flows Through All Markets

Thus, if debt investors becomes more risk averse, as happens at the beginning of a recession or credit crunch, we would see it first in the most active market, say the secondary market for corporate bonds, where spreads would widen dramatically.  This would lead to a sharp rise in spreads in the secondary market for corporate loans, and finally to the primary markets for both loans and bonds.  Finally, investors will also be comparing loan and bond prices to the other market for corporate credit risk, credit default swaps (CDS).

Loan - Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond's cost is 50 basis points higher than the loan's cost.  Since both debt instruments were issued by the same borrower, shouldn't they cost the same?

Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).

Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. "high yield") bonds is typically higher than the yield on non-investment grade (i.e. "leveraged") loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:

1. Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds.
2. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have "bullet" maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time.  This longer maturity and lack of amortization make bonds more risky to own than loans.
3. Covenants:  Loans have more (and more restrictive) covenants than bonds.  Thus, as a company's operating performance begins to deteriorate, the loan will default long before the bond.  This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.

Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.

Issuer: Risk vs. Cost
As with Jarden,  for non-investment grade issuers, bonds typically have a higher all-in-cost than loans.  This is because bonds are less risky for issuers and provide issuers additional flexibility.

1. Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it.  If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk.  Companies can reduce their refinancing risk by issuing debt with longer maturities.  The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
2. Flexibility: Bonds place few restrictions on a borrower's operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.

Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.

Loan-Bond Relative Value

When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis.  In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.  

• If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.  
• If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.

Jarden Compares Loan and Bond Costs

Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam.  On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012.  Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities.  Over the next 7 months, it completed two transactions.

August 2009: "Amend and Extend"

• In August 2009, the company extended the maturity of $600 million of Term B loans ("TLBs") from January 2012 to January 2015 through the creation of a "Term B4" tranche.  This new tranche was priced at LIBOR + 3.25%.  The remaining $724 million of term loans remain due through 2012.
• Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.

January 2010: Senior Subordinated Notes

• In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020.  The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
• The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
• The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.

So which is cheaper?

With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond's effective cost is 7.625%.  So the loan is a cheaper source of capital than the bond?  Not so fast!  The loan is floating rate - if LIBOR goes up, the company's interest cost will go up with it.  The bond is fixed rate - no matter what happens to interest rates, the coupon on the bond will not change.  So we cannot just compare the current loan cost of 3.5% to the bond's cost of 7.625% - that would be comparing apples to oranges.

Combining a Loan and a Swap

In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate.  This is done using an interest rate swap.  Let's swap the loan to a fixed rate, as follows:

• Step 1: The company borrows at LIBOR + 325 basis points.
• Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.  
• The current quote for such an interest rate swap is about T+10: 
• The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
• The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract. 
• These transactions can be expressed as follows:

We can now calculate the effective fixed rate cost of the loan-swap combination:

• Payment to loan holders:          LIBOR+325 basis points
• Received from the swap bank:   LIBOR
• Payment to swap bank:            Treasury +10 basis points

The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders.  The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335.  The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.

The Loan is Cheaper

The effective cost of the bond is 7.625% while the effective cost of the loan is 7.125%, so the loan is cheaper by 0.50%, or 50 basis points.

Why is the bond more expensive?  And why would the company issue the bond if it is more expensive than the loan?  Watch the blog for answers to these questions.

Lehman Brothers v Morgan Stanley

We hope everyone is having happy holidays. Last time, we defended Lehman Brothers from Andrew Ross Sorkin’s attack in Too Big to Fail. We’ve stolen some time from the seasonal festivities to take another look at the numbers, and we still feel there’s a strong case to be made for the way Lehman Brothers managed its finances right before its fall.

We compared Lehman to Morgan Stanley from November 2007 through August 2008, the three reporting periods leading up to Lehman’s collapse in September 2008. We looked at the progress each firm made improving three key measures of financial strength: leverage, exposure to mortgage-backed securities, and liquidity reserves.

We calculated leverage as the ratio of total assets to shareholders’ equity, exposure to mortgage-backed securities as the book value of residential and commercial mortgage-backed securities as a percent of shareholders’ equity, and liquidity reserves as total cash and unpledged liquid securities. To gauge the improvement in each measure, we calculated its value in August as a percent of its value in November.

 

In Sorkin’s account, Lehman Brothers went bankrupt because it had too little capital to absorb the potential losses from its real estate investments. But Lehman did much more to reduce leverage and cut exposure to mortgage-backed securities than Morgan Stanley, yet Morgan Stanley survived.

It’s true that Morgan Stanley did a better job of boosting liquidity than Lehman, but it needed to. Morgan Stanley did much more prime brokerage business with hedge funds than Lehman. It was the run-off in prime brokerage funds that brought Bear Stearns down, and it nearly ruined Morgan Stanley too. In the week after Lehman failed, Morgan Stanley went through nearly all $180 billion of its liquidity reserves and had to go to the Federal Reserve for rescue.

So what’s the risk management lesson in all this? Did Lehman Brothers deserve to die? Did it commit suicide, or was it killed? Could it have done anything to save itself? Too Big to Fail makes Lehman’s fate seem inevitable, and we agree.

Like any investment bank, Lehman relied on confidence-sensitive financing, and in September of 2008 the financial markets lost confidence in Lehman – and Morgan Stanley and Goldman Sachs. Nothing they could do about leverage, exposure to mortgage-backed securities, or liquidity reserves mattered.

It’s nothing new. As Walter Bagehot observed more than a century ago, “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

Lehman Did Everything Right

Except convince anyone it was doing anything right at all. In his new book Too Big to Fail, Andrew Ross Sorkin portrays the firm’s fall as a tale of arrogance, blindness, stupidity, complacency, and greed – nearly every vice but gluttony and lust. But the numbers don’t bear that out: Lehman reacted decisively to the problems it was facing.

	November 2007	February 2008	May 2008	August 2008
Assets	$691,063	$786,035	$639,432	$600,000
Equity	$22,294	$24,832	$26,276	$28,443
Leverage	30.7x	31.7x	24.3x	21.1x
Liquidity pool	$35,000	$34,000	$45,000	$42,000
Repo financing1	37%	35%	33%	NA

¹ as a percent of total funding

For financial institutions in trouble the prescription has always been: reduce assets, increase equity, improve liquidity. What did Lehman do? It cut total assets and raised shareholders’ equity, driving leverage down by 31%. It boosted its liquidity reserves to $42 billion, and trimmed short-term repurchase funding.

Lehman’s $2.9 billion loss for the third quarter of 2008 was hardly good news, but it came from what the Wall Street Journal called “savage cuts” to the value of its real estate. The Journal went on to say, “even longtime bears on the stock thought the firm was finally marking its residential portfolio to realistic levels.”

By the end of August 2008, Lehman had written down its troublesome real estate assets by 25% from the beginning of the year to $46 billion. With $28 billion in equity, it could afford to write them down by another 39% without destroying its capital base.

So why did Lehman’s damage control efforts fail? What sank the company? We’ll explore that in future posts, but it’s clearly not because Lehman ignored its problems, failed to act, or didn’t make real improvements to its finances.

Liquidity Position

There are lots of measures of liquidity. The classics are the current ratio and the quick ratio, but they've fallen out of favor because they don't include cash flow, a critical component of liquidity. Cash burn is too recent to be classic, even though it's been around for a while. But it's limited to on-balance-sheet sources of liquidity.

The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here's a short slide show about it.

Off-Balance-Sheet Debt at BT Group

The heavy burden of hidden debt
BT Group, plc, is one of the world’s largest telecommunications companies. Since the telecom crash in 2001, it’s been struggling with operating, management, and reporting problems. You can add financial problems to the list as well.

Its leverage – or “gearing”, as the English put it – is high. Reported debt to capital (adjusted for actuarial losses in its pension plans) is 66%. That’s based on the numbers reported on the company’s balance sheet.


Look beyond the balance sheet, and leverage gets much worse. BT has retirement benefit obligations that exceed pension plan – or “scheme,” as the English say --- assets by £2,870. If you consider that to be debt, leverage increases to 71%. Treat operating leases as a form of debt financing, and BT’s leverage climbs to 75% (capitalizing annual rental expense at 8x).

Off-balance-sheet debt equivalents
What explains the difference between BTs reported leverage and its adjusted leverage? Why treat pension and lease obligations as the equivalents of debt? How do you tell if an off-balance-sheet liability belongs in your leverage analysis?

We use these criteria. To be the equivalent of debt, an obligation has to:

• Be a financial obligation, not money owed to a supplier
• Have an imputed or actual interest rate
• Have a fixed payment schedule
• Allow the holder to demand payment in full on default
• Be a substitute form of capital

By these standards, unfunded pension obligations are debt because they are financial, are discounted at an interest rate, and often have a payment schedule that is enforced not just by pensioners but by government regulators as well. Operating leases are debt because they are another way of financing assets. If BT securitized its trade receivables, that would be another form of off-balance-sheet financing equivalent to debt.

U.S. and international reporting rules are precise about what debt is, but those rules don’t always capture the economic reality of how companies finance themselves. Sometimes reported leverage understates real leverage. That’s the case for BT.