Something funny happened on the road to nirvana. After an unusually extended period of calm, the financial markets began acting like markets again at the end of February 2007. On Feb. 27, the Dow Jones Industrial Average plunged by more than 400 points, its largest drop since the Sept. 11, 2001 attacks (at one time during the day, due to a computer glitch, it was down as much as 550 points.) It didn't take a heck of a lot to make the February fall happen, either. Unconfirmed reports of a government crackdown on speculation in China and a disappointing U.S. economic report were sufficient to send stock investors crowding the exit doors.
Investors may be a bit jittery. But, consistent with the market's ability to shrug off bad news, by mid-April, the major stock market indices returned to pre-Feb. 27 levels. Perhaps the best barometer of market sentiment today is the Chicago Board Options Exchange Volatility Index (VIX). This index reflects a market estimate of future volatility based on S&P 500 option prices. The market's uncertainty has played out in this index as hedge funds and other so-called smart money players hedge their bets (by going long, that is to say purchasing call options on the index) against further volatility. By mid-April, though, the VIX already had returned to the low levels at which it began 2007.
Keep a watch on the VIX as 2007 progresses and global economic forces play out in the financial markets. It'll be a key indicator. Right now, it tells us that as mid-year approaches, the markets are ignoring negative news and endorsing the view that economic growth will remain sufficiently robust to avoid any sustainable market downturn for the foreseeable future. But the major financial and legal trends affecting the market present a mixed picture — offering investors as many risks as opportunities in the months ahead. Some important trends include the booms in leveraged buyouts (LBOs) and collateralized loans; the collapse of the subprime mortgage market; the criminalizing of business practices; the stock options backdating scandal; and the government's attempt to raise the bar for plaintiffs in securities lawsuits.
THE LBO BOOM
One of the major trends in financial markets is the number of large public companies seeking to go private. This is occurring for a number of reasons:
First, it's no longer more expensive for private companies to raise capital than public companies. Today, a private company can access capital at rates that are competitive with public companies. Arguably, private capital is less expensive when one factors in the significant costs of Sarbanes-Oxley compliance and the other regulatory burdens imposed on public companies in the wake of the Enron and WorldCom accounting scandals.
Second, fear that many accepted corporate practices will be criminalized at the whim of a politician or regulator is leading many public company managements to consider the advantages of private ownership.
Third, corporate executives can earn as much money working for a private as a public company.
Little suggests these first three factors will change, which indicates that the current LBO boom should continue.
Fourth, going private allows executives to make long-term, value-enhancing moves rather than kowtow to the lowest common denominator, short-term oriented public markets. Sooner or later, public shareholders may figure out that their obsession with immediate gratification is costing them a great deal of money in the long run. The enormous profits being realized by LBO firms suggest that public shareholders are leaving a lot of money on the table — raising the question why these profits aren't being realized by companies when they are under public ownership. What is it about private ownership that suddenly enables management teams to squeeze huge profits out of the same businesses that they'd been managing for years with mediocre results?
Many are asking whether the current buyout boom is a bubble that will inevitably burst. The answer is a resounding “No.” In general, the quality of larger LBO transactions today are the best the market has seen in 20 years, when measured by the amount of equity invested and the quality of the underlying businesses. The average LBO today includes an equity investment on the order of 35 percent of the total capital structure, compared with less than 10 percent in the 1980s. Moreover, the large companies going private are benefiting from the key macro-economic trends shaping the global economy: globalization, the spread of technology and free trade.
What justifiably concerns some observers is companies' ability to borrow money at tight spreads and with weak covenants that do little to protect lenders. Borrowers take what the market will give, and right now the market is willing to give (and forgive) a lot. February 2007 was the first month since December 1997 that saw zero defaults globally in the less-than-investment grade space; March 2007 was the second. As long as the default rate continues to remain low, borrowers will retain the upper hand over lenders in the marketplace. It is fair to point out that many large capitalization LBOs more closely resemble “fallen angels” than traditional single-B and triple-C borrowers of the type that have traditionally run into trouble. As a result, it's not necessarily anomalous for these borrowers to be able to wrestle such favorable terms from lenders. I believe it will require a deeper recession than we've seen in this country in a long time to cause these large transactions to run into trouble. And that scenario is not currently in the cards.
THE CLO BOOM
In view of the high quality of many current LBO transactions, the senior debt borrowed to finance them remains attractive despite the fact that the market has driven down pricing and covenant protections. Most of these loans are owned today by collateralized loan obligations (CLOs), which are professionally managed pools of bank loans that are funded by low-cost investment grade rated tranches of debt. The recent disruption in the subprime lending market (more on this later) has created an opportunity to buy some of these rated tranches — particularly those rated BBB and BB — at unusually wide spreads that do not reflect the fact that the underlying loans remain of very high quality. The subprime mess has negatively impacted the cost of funds for CLOs, because the CLO lenders are the same institutions that lend to collateralized debt structures backed by subprime mortgage paper. The question remains whether this contagion will cause CLO liabilities to rise in cost to the extent that it will make it more difficult to complete these deals. Certainly, it's something to keep an eye on in the second half of 2007. Because CLOs are such an important source of demand for the leveraged bank loans that are financing the current LBO boom, any slowdown in CLO issuance could have serious consequences for the financial markets.
THE SUBPRIME MESS
One of the biggest financial stories of the first half of 2007 has been the collapse of the subprime mortgage market. To a significant extent, the performance of the U.S. economy in the second half of 2007 will hinge on how deep the housing malaise really is. Recent housing statistics certainly give some cause for concern, though are probably not reason for panic.
In the fourth quarter of 2006 (4Q06), new foreclosures rose to a record 0.54 percent of total outstanding mortgages, an increase from 0.46 percent in 3Q06. During the last major U.S. housing downturn in 1991, that peak reached 0.35 percent. The inventory of foreclosed homes also rose to 1.19 percent of total mortgages in 4Q06, up from 1.05 percent from the quarter before. New home sales have followed the path downwards, with U.S. new single-family home sales falling in February 2007 by 3.9 percent from January 2007 and 18.3 percent from February 2006 to 848,000 units, the lowest reported figure since August 2000. Single-family home completions showed their worst performance since September 1982, dropping 23 percent. The delinquency rates of all mortgages, which include prime mortgages, rose from 4.67 percent to 4.95 percent in 4Q06. While troubling, this remains below the peak of 5.35 percent reached in 3Q01.
The media have publicized some scary forecasts showing that large volumes of adjustable rate mortgages are going to reset significantly higher. But the big numbers being thrown around need to be placed in context to get a proper handle on the scale of the problem.
The real question is whether these borrowers will be able to avoid unaffordable higher mortgage payments by refinancing at lower rates. It would be incorrect to assume that 100 percent of the borrowers facing higher mortgage rates will be unable to obtain lower-cost financing. It also would be incorrect to understand some of the numbers thrown around (one newspaper report speculated that as much as $2.2 trillion of adjustable rate mortgages taken out since 2004 could reset to monthly payments at least 25 percent higher) as equivalent to the amount of losses that are going to be incurred with respect to these loans. These loans are secured by real estate that has value, and the recoveries on loans that enter foreclosure are likely to be manageable.
In other words, the sky is not falling. A thoughtful, measured reaction is appropriate. Unfortunately, it seems like politicians, regulators and prosecutors may whip themselves into a frenzy.
The real danger from the subprime bust is that the bankruptcy of large lenders such as New Century Financial may make it more difficult for many borrowers with checkered credit histories to refinance their mortgages. That's why it's critical that the political backlash against subprime lending brewing on Capitol Hill and in the media not go too far. The Securities and Exchange Commission has begun to investigate the activities of several subprime lenders (all too predictably after the horse has left the barn.) The Justice Department can't be far behind.
Let's take a moment to acknow-ledge that we have all seen this phenomenon before: A financial product (usually some type of debt) is used to excess and leads to losses, resulting in its withdrawal from the market and borrowers' inability to obtain new financing. Remember the savings and loan scandal of the late 1980s and early 1990s (including the collapse of junk bond innovator Drexel Burnham Lambert Inc.)? The Internet bubble of the late 1990s and early 2000s? The financial accounting scandal of the early 2000s; and now the options backdating scandal of the mid-2000s?
The subprime mortgage scandal is following another tired route: Let's call it the “Casablanca Syndrome.” First, politicians sanction and regulators wink at a practice. It flourishes. Observers who criticize it are dismissed as Cassandras. Remember IPO-spinning? Research analysts crossing the Chinese Wall? Now we had lenders making loans equal to more than 100 percent of the appraised value of a home? None of these practices were done in back alleys; they were publicly disclosed as required by law, and covered in the media. And the politicians were gorging out on campaign contributions from those who were profiting.
Eventually, trouble arises. Some people — inevitably it's the less fortunate, wealthy and politically connected — suffer real economic pain and start to howl. The politicians realize there's a serious problem and suddenly announce that they are “shocked, simply shocked that there is gambling going on at Rick's!”1 Remember that famous line from the movie Casablanca, when the local police are forced by occupying Nazis to put on a show of law enforcement at Rick's café and told to “round up the usual suspects”?
In our modern day, financial market version of that charade, our politicians turn loose the regulators and the Justice Department to identify and crucify a couple of fall guys. Usually it's the businesses and individuals who are up to their elbows in the muck. But then we all have a problem. Because, suddenly, practices that previously seemed legitimate are criminalized. Businessmen who thought they were engaging in regular business practices find themselves prosecuted; their lives shattered.
It's a gross understatement to call this approach to regulation “clumsy” and “inefficient.” “Unjust” is more like it. It's time we treated as civil violations those non-violent business practices that are retroactively condemned as unlawful after being tolerated for a long period of time. Give businessmen fair warning. Bring a greater sense of fairness and predictability to the system. We are not, after all, dealing with murder. Later, if businessmen continue to ignore civil warnings, we can bring in the big guns and call repeat offenders “criminals.”
The recent indictment of former Reagan-era cabinet member David Stockman may prove to be another disturbing example of this criminalization of American finance. Stockman is being accused of engineering a $1.4 billion accounting fraud at the bankrupt auto parts maker Collins & Aikman through the misuse of parts rebates and other routine business and accounting practices. There is nothing in Stockman's past to suggest that he would engage in the kind of activity that the government is alleging. He lost a great deal of his own as well as his investors' money. Yet he provides a high-visibility target for prosecutors looking to make a move into a lucrative career in private practice defending individuals like him. As the United States recovers from a bout of post-Enron browbeating and regulatory overreaction, it would do well for prosecutors and politicians to consider that there but for the grace of God go them.
Now let's return to subprime lending and note that this type of lending serves an extremely important purpose in our economy, just as high-yield bonds and other credit instruments that charge higher rates for assuming greater risk. There is a significant difference between predatory lending and subprime lending. It was reckless borrowing that inflicted damage on borrowers and lenders alike. Unfortunately, as long as human beings are making loans, there is no cure for that. Let the market punish reckless lenders; don't bail out those who engage in making 100 percent loan-to-value loans to borrowers with poor or non-existent credit histories (just some varieties of the idiocy that regulators allowed to go on.) Lenders are doing everybody a disservice by lending money with no prospect of repayment.
The stock options backdating scandal already has claimed dozens of senior executives and will undoubtedly claim dozens more before it fizzles. Thus far, the scandal has involved more than 140 companies and resulted in more than 70 dismissals of high-ranking corporate executives. Backdating appears to be yet another business activity that was widely practiced, winked-at and ignored by the regulators. It's blatant manipulation to backdate options grants after seeing how a company's stock has traded. But you have to wonder what the executives, auditors and regulators involved were thinking (or smoking) to think that such chicanery would go unnoticed in the wake of the corporate accounting scandals (such as Enron and WorldCom), and especially after the mutual fund after-hours trading scandal (involving many name-brand mutual fund companies and several large hedge funds.)
The story took on another dimension when the Wall Street Journal reported on March 7, 2007, that while the nation was mourning its losses in the aftermath of Sept. 11, numerous companies responded to the crisis by increasing executives' compensation through backdating their stock option grants.2
The list of companies that have admitted backdating options and that granted them soon after Sept. 11 is long. According to the Journal, it includes: Corinthian Colleges, Inc., UnitedHealth Group Incorporated, Affiliated Computer Services, Inc., Broadcom Corporation, Brocade Communications Systems, Inc., Take-Two Interactive Software, Inc., KLA-Tencor Corporation, Monster Worldwide Inc. and Progress Software Corporation.3 The stock markets were closed from Sept. 11 to Sept. 14, 2001, and the Dow Jones industrial average dropped more than 14 percent the following week. A Wall Street Journal study found that 1,800 companies more than doubled their options grants in late September 2001.4 It is distasteful to think that Corporate America used Sept. 11 as a pretense to increase already overly generous executive compensation.
THE SEC RETREATS?
It looks like the SEC is trying to raise the bar for plaintiffs in securities lawsuits that accuse corporations, executives and accounting firms of securities fraud. This is angering shareholder rights advocates, while giving quiet comfort to those who believe that the U.S. litigation system needs to be reigned in. From the standpoint of creating a consistent and intellectually honest environment in which business can be conducted, however, the SEC's stance raises a lot of questions.
In a securities fraud lawsuit by investors in Tellabs Inc. v. Makor Issues and Rights Ltd.5 that has found its way to the Supreme Court, the SEC is urging that the plaintiffs be required to meet a higher evidentiary standard than that set by the lower court that heard the case, the U.S. Court of Appeals for the Seventh Circuit.6 At the core of this dispute is the interpretation of a provision of the Private Securities Litigation Reform Act of 1995, which sets forth what investors must allege in a fraud lawsuit to prevent a case from being dismissed. The act was designed to make it more difficult for frivolous cases to be filed against corporations and accounting firms — a concern that has grown more intense in the wake of the collapse of Arthur Andersen in a prosecution later shown to be wrongfully brought. It requires investors to state facts “giving rise to a strong inference that the defendant acted with the required state of mind.”
In Tellabs, the Seventh Circuit held that investors had to show that the allegations, if true, would permit “a reasonable person” to infer that the company and its executives “acted with the required intent.” The SEC now seeks to elevate that standard to one that requires a showing of evidence of “a high likelihood” that the defendant possessed the intent to violate the law. Surprisingly, the SEC brief, which also was signed by the Justice Department, argues that judges should weigh any facts that provide for an innocent explanation of the conduct in question. Normally, these agencies are the last ones to look for innocent explanations of questionable conduct, and more often than not seem to be trying to criminalize behavior that lacks a wrongful intent.
It is especially ironic that the government agencies' position is being driven by concern that there are only four remaining large accounting firms and that lawsuits could drive one or more of them out of business. On Feb. 9, 2007, the SEC's chief accountant, Conrad Hewitt, addressed a group of securities lawyers and said that the SEC had begun to consider how to shield the remaining “Big Four” accounting firms from legal liability in lawsuits brought by investors and companies. Hewitt said that as the former managing partner of Ernst & Young, he'd witnessed many meritless lawsuits against auditing firms and that the potential claims against these firms were now so large that they threatened to bankrupt one or more of them. SEC Chairman Christopher Cox elsewhere has stated that accounting industry “consolidation” (surely a post-Arthur Andersen euphemism) had prompted both Congress and the SEC to consider ways to “prevent the demise of another firm.”
Conveniently absent from these comments was the fact that it was the Justice Department that drove Arthur Andersen out of business in a flawed prosecution that was publicly rebuked by the Supreme Court in Arthur Andersen LLP v. United States.7 A unanimous decision written by the late Chief Justice Rehnquist voided the accounting firm's conviction of obstruction of justice because the trial court judge failed to instruct the jury that it was necessary to prove that Arthur Andersen intended to violate the law. The Justice Department didn't object to the jury instructions, presumably because it endorsed a view of the law that allows for conviction without a showing of wrongful intent. This is pretty appalling. (The same approach was used to wrongfully convict former investment banker Frank Quattrone of obstruction of justice. The appeals court that overturned the conviction based on the prosecution's failure to prove any wrongful intent on his part cited Arthur Andersen as the basis for its decision.) But of course vindication in the high court came too late for Arthur Andersen and its employees.
Democracy is supposed to be a system of laws. It is a notoriously sloppy and inefficient system designed to produce the best outcome from the clash of various branches of government. By encouraging heavy-handed prosecutions during politically charged times, then reversing its position when the political winds have changed, the executive branch breeds disrespect for the process and creates an uncertainty that damages business and the economy.
Recently, Nassim Nicholas Taleb published the follow-up to his 2004 book Fooled by Randomness. His new book published this year, The Black Swan: The Impact of the Highly Improbable, describes events (called “Black Swans”) that meet three criteria: they are outliers, that is to say, they lie outside the realm of regular expectations because nothing in the past reasonably points to the probability that such events will occur; they have an extreme impact; and despite their outlier status, human nature makes us conjure up explanations after the fact that render the event explainable and predictable. Examples of such events might include Sept. 11 or, in the investment world, the 1987 stock market crash.
Taleb prescribes an investment approach in which investors keep most of their money in safe and reliable investments (that is to say, Treasury bills) and then a small amount of money in higher risk investments (for example, options or venture capital) to put themselves in a position where they can take advantage of positive Black Swan events while protecting themselves against negative Black Swans. In a financial world that is currently benefiting from strong economic growth across the globe (with the United States being arguably the weakest link), the risks to a positive outlook are difficult to identify. In many respects, they are “Black Swans.” Perhaps no better investment approach can be recommended than Taleb's for a world that seems to be sound — but is always uncertain.
- Famous line from the movie Casablanca, when the local police are forced by occupying Nazis to put on a show of law enforcement.
- Mark Maremont, Charles Forelle and James Bandler, “Firms Say Backdating Used in Days After 9/11,“ Wall Street Journal, March 7, 2007, at p. A1.
- Tellabs Inc. v. Makor Issues and Rights Ltd, 127 S. Ct. 1511 (March 16, 2007).
- 437 F.3d 588 (7th Cir. 2006).
- 544 U.S. 696 (2005).