Show Us the Money

Many clients have heard my theory that the nadir of the “Sub-prime Crisis” was in July and that we had almost turned the corner on the recovery in mid-September when the tide washed out at Lehman Brothers, leaving a bunch of overpaid derivatives traders at Lehman and elsewhere standing buck naked in a sea of worthless paper. Lehman’s bondholders were nearly wiped out in the subsequent bankruptcy filing and the market for financial paper (at least what was left of the market by that point) completely disappeared. A new phase was launched. We can call it a “Debt Rollover Crisis,” and we are early in what will likely be a long and painful unwinding of debt across the globe.

Fixing the Sub-prime crisis was a walk in the park compared to the effects of the new Debt Rollover Crisis, as is clearly evidenced by the unprecedented carnage in the stock market. What happened to our $700 billion bailout, and why doesn’t it seem to be working? What does the “de-leveraging of America” mean to investors, and to the country?

When investors stopped buying bonds for Shearson, AIG, Wachovia and others, these companies had no way to pay off bonds as they came due. In a normal functioning market, companies issue “commercial paper” to borrow money for 90 days and when the issue matures, the company issues another piece of commercial paper to pay off the original investor with the money loaned when the new issue is sold. Rolling over debt is just a normal part of doing business.

The companies with the most debt that needs rolling over are, of course, the so-called “financial companies” which are so named because they use a lot of debt as a normal course of doing business. Banks, insurance companies, mortgage lenders, government agencies, real estate investment trusts, consumer finance companies, and real estate investment companies are some of the largest borrowers, and also constitute a Who’s Who list of who is struggling to remain a going concern in this new crisis.

The inability to roll over debt raises the ugly possibility of having to file bankruptcy, as Shearson faced in September. Pretty quickly, none of the financial companies were able to roll over debt and nearly all of them became potential bankruptcy candidates. AIG went from high-grade issuer to nationalized bailout poster child in a matter of a few days.

It is mostly a matter of trust. The problem is that Federal Reserve Chairman Bernanke, Treasury Secretary Paulsen, President Bush, President-Elect Obama, corporate CEO’s, Barney Frank, Barney Miller, and Barney Fife cannot restore trust by anything they say. Such is the nature of trust. Only by what they do can they begin to rebuild trust, which might take years to re-establish. This de-leveraging era is not a phase, but a new reality for business in America.

Nonetheless, I have been expecting that a $700 billion bank bailout, along with another $4 trillion in other stimulus moves (worldwide), would get things moving again in short order.

• Still waiting.

This week the market fell to new lows because we are still waiting for signs that the money is starting to flow. Instead, good companies still cannot roll over debt. To hoard cash so that they can pay off their next bond maturity, employees are being laid off and capital spending plans have been slashed to preserve cash. Without a bond market, corporate America is operating in survival mode. This is literally why the recession will now last longer and be much deeper than I had anticipated. The derivatives speculators earned millions in the short-run but have left a critically injured bond market in their wake, forcing companies to de-leverage their balance sheet (reduce the amount of debt they are using) because they are currently unable to issue new bonds to roll over their maturing debt issues.

A simple, though undesirable, solution is to take all of the high debt companies and send them through bankruptcy, which would wipe out current shareholders and eliminate the debt and leave the current bondholders as the new equity holders for these companies. It is probably this possibility that has the stock market spiraling down, however investors are not doing a very good job of distinguishing between leveraged and under-leveraged companies. Everything except for U.S. Treasury Bills is getting dumped.

Paulsen and Bernanke have probably succeeded in saving the banking system through the bailout, which is an important first step. The money they’re investing in banks and insurance companies seems to have prevented a “run on the banks” which was one of the factors that led to the Great Depression.

Unfortunately, the banks aren’t making that money available to others. The intent was that if a large industrial borrower can’t issue new bonds to roll over maturing debt, then they could go to the banks for a syndicated loan offering instead. The banks, however, have tighted their lending standards. Instead of the old rule of thumb (we’ll be glad to give you a loan, unless you don’t have any money and need it), the new lending regime is only willing to lend money to entities who need it more than the bank itself – and their view is that nobody needs it more than themselves. They’re lending it out on a “need to borrow” basis, but they stand at the front of the line and are using the money to roll over their own maturing bonds. This has stabilized the banking system, but left just about everyone else still in crisis.

Money is being sucked out of the U.S. economic system. Stock investors have sold stocks to sit in T-Bills that pay next to nothing. Bond investors with corporate bond maturities refuse to repurchase corporate bonds with the proceeds when their existing bonds mature, but sit in T-Bills instead. Companies are canceling growth plans so they can have cash available to pay off their next bond maturity. Tax revenues are set to plummet, so municipalities are planning cutbacks. New school buildings aren’t financed because voters are frightened and the capital markets might not fund many of those projects anyway. Banks are hoarding their own precious dollars. The downward cycle continues. Only the government is in a good position, with three-month Treasury Bill rates recently going all the way down to 0.02%!

The Treasury’s response has been to try to get the money back into the real economy in any way possible. The Treasury is buying commercial paper for its own account to try to get money back into the hands of large creditworthy borrowers. It can borrow money at 0.02% and turn around and loan it out for 3%. Since the banks aren’t doing it, the government has stepped in. The Treasury can borrow money for 5 years at 1.88% and turn around and invest it in preferred stock in order to give an insurance company the liquidity it needs to continue doing business.

We will certainly see a tax stimulus package to get more money into the hands of consumers. Furthermore, there is a lot more money to be spent. Less that half of the $700 billion bailout package has been spent thus far. The Fed is trying to prime the pump, so to speak, and eventually the economy – once we can get it moving again – can move forward under its own momentum. Until that happens, inflation isn’t a problem, government borrowing isn’t a problem (the government isn’t “crowding out” other borrowers), and Treasury interest rates will stay low.

• What happens when we turn the corner?

Once the debt rollover crisis is past, though, some of these factors reverse themselves. Once corporate borrowers can again go to the bond markets to raise money to pay off outstanding debt issues at maturity, the interest rates that the Treasury pays will have to go up to compete. That won’t happen until some basic level of trust and confidence is restored, however. With the bankers at Goldman Sachs and Morgan Stanley still hoping the taxpayers will foot the bill for seven-figure bonus payouts, and with the Big Three auto CEO’s flying in on their corporate jets to request carte blanche taxpayer bailouts, trust is understandably a scarce commodity.

There will probably be a series of events that lead us out of the debt rollover crisis. First, the bond market will start working for higher quality borrowers. There is some evidence that is beginning to happen. The bond prices of non-financial investment-grade bonds have been moving up, though these issuers are still paying very high rates relative to where the Treasury can issue debt. When people talk about today’s “low interest rates,” they are referring to Treasury rates. Borrowing rates are still fairly high in the corporate bond market.

After the corporate bond market begins to recover, the junk bond market should improve. Junk bonds set new lows this week. Some high yield bond and bank loan indexes now show that the debt of a typical lower quality issuer yields about 20%. Imagine, if you will, funding Qwest’s entire regional phone company…on your credit card. Such a high rate effectively shuts out borrowers from the new issue market. Who can afford to borrow at that level? As we move past the debt rollover crisis, however, these rates will probably be cut in half.

For financial companies, I continue to prefer to be higher up in the capital structure. I’d rather own their bonds or preferred stock, where I’m not at risk of having my cash flow diluted by outside investors and today’s high cost of money. In the meantime, the bank bailout bill money seems to be falling into a black hole, funding the bank’s own operations as they de-leverage their own balance sheet. It’s good to have confidence that Wells Fargo and BankAmerica and J.P. Morgan and U.S. Bank can survive. But it would also be nice if some other deserving companies were able to access the capital markets, through these banks, so that they can survive as well.

Come on, Wall Street. Show me the money. We're still waiting.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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