On April 14 we posted a discussion entitled “How Deficits Are Financed Does Matter”
(see link below). We pointed out that the government was missing an opportunity to finance its deficits and stimulus measures at once in a lifetime 30 year long term rates in favor of cheaper short term levels. We suggested that that rate rises were inevitable, could come quickly and that waiting would have significant incremental costs to the US taxpayers as well as US corporate debt issuers whose bonds are priced at a spread to US Treasuries. The analogy of Americans who are using ARMs rather than financing long today is an apt comparison that most Americans can readily comprehend. They would not do what the Treasury is doing!!
At the time of our April post, 30 year Treasuries were trading at approximately 3.6%. Today 10 year treasuries are at 3.93% and 30 year Treasuries are now at 4.69%! A 100 basis point or 30% rise in six weeks is bad news. Worse yet, the 10 years are only at that level due to intervention by the Fed and treasury to keep yields below 4%.
That 100 basis point swing alone would result in an annual financing cost of an incremental annual cost of $10billion on $1trillion of debt. Even if we were to just finance for 10 years rather than the previously suggested 30 years, the cost would be $3billion more annually than had we financed for 30 years 7 weeks ago. To make matters worse, Brazil and Russia are making serious noises about dumping upwards of $10billion in treasuries in favor of new IMF bonds. This could be a leading example for other foreign governments to diversify their foreign reserves away from US Govt. obligations. India and China frequently follow in tandem with the actions of Brazil and its Central Bank wizard, Henrique Meirelles. The cost to taxpayers and US corporates would be huge and could significantly impair prospects for economic recovery.
I find it tragic that a socialist nation like Brazil is exhibiting far more economic discipline in financing its deficits and managing its reserves that the United States.
They are not confused between acting in their economic best interests vs. using the Treasury or Central Bank as an instrument of social policy. Likewise, they are very careful to evidence a strong respect for lender rights and the rule of law as it impacts their access to the capital markets.(
Add to these problems is the fact that investors at home and abroad are increasingly worried about the US Government’s lack of respect for the rule of law regarding lender rights in bankruptcy (e.g. GM and Chrysler). America won’t go the way of Weimar Germany but stagflation (inflation without growth) is a real possibility. Savings will be diminished and businesses will become less and less competitive globally. As an investor, government policy leads me to buy mostly foreign securities and inflation hedged companies with assets like oil and iron ore. As a card carrying Democrat, I am troubled for my country’s economic future. We can and must do better.
Follow the links below for copies of prior posts on financing the Treasury and Brazil’ Central Bank President
Greg Mankew, former economic adviser to President George W Bush and currently an economics professor at Harvard, had an interesting article in yesterday’s New York Times entitled “That Freshman (economics) Course Won’t be Quite the Same.” In it he suggests that recent economic events necessitate the inclusion of four new topics into an introductory college economics course:
1) The Role of Financial Institutions-
“The current crisis has found financial institutions at the center of the action. They will have to become more prominent in the classroom as well.”
2) The Effects of Leverage-
“If housing prices (and other leveraged assets) have fallen only 20%, why did the banks lose almost 100% of their money? The answer is leverage, the use of borrowed money to amplify gains and, in this case, losses…there is no doubt that its effects have played a central role in the crisis and will need a more prominent place in the economic curriculum.”
3) The Limits of Monetary Policy-
“When the economy suffers from high unemployment and reduced capacity utilization, the central bank can cut interest rates and stimulate demand…what would happen if the central bank cut interest rates all the way to zero and it still was not enough to get the economy going again? …The Fed is acting with the conviction that it has other tools to put the economy back on track. These include buying a much broader range of financial assets than it typically includes in its portfolio. Students will need to know about these other tools on monetary policy.”
4) The Challenge of Forecasting-
“Students should understand that a good course in economics will not equip them with a crystal ball. Instead, it will allow them to assess the risks and be ready for surprises.”
While a terrific list and spot on in its insights, one may argue that it is not sufficiently inclusive. This author and sometimes finance professor would add four incremental topics for consideration:
1) The Globalization of Credit Markets and Economies-
Globalization has changed the game significantly and reduced the power of any one nation or region’s central bank to solve a crisis by itself. Today, America’s largest creditors include investors from around the world. Similarly, economic demand is global. When America reduces consumption of Chinese goods, both nations have a problem. It is exacerbated globally when the Chinese then reduce their purchases of Brazilian iron ore, Middle Eastern oil and products from other parts of the world. The impact of this ever increasing economic interdependency must be studied by even an introductory economics student.
2) The Impact of Debt Instruments on Every Day Life-
Forty years ago, few Americans carried credit cards, had variable rate mortgages or leased automobiles. There were minimal securitizations of debt instruments and, as Greg Mankew points out, leverage was substantially less a factor in the US or other economies. Today such financing vehicles are ubiquitous. The internet and saturation advertising by entities like Di-Tech.Com and others have encouraged even the least credit worthy consumers to become part of the game. Investors from around the globe, from Atlanta to Reykjavik to Beijing have become part of the global investment community directly or through mutual funds, hedge funds, their employer’s pension funds and even money market funds. Unlike the past, when primarily the “investor class” and marginal workers were those at risk, now almost everyone is exposed and has suffered. Issues of regulation and general investment risk/appropriateness are now important to most Americans. Education about these investments becomes essential to one’s economic well being.
3) Deleveraging -What it Means-
Just as Greg Mankew is correct in his point that we need to understand the impact of leverage, students will need to know a great deal about the methods and the impact of deleveraging. A simple explanation is that, if not done carefully, it can be as painful as drug withdrawal for a heroin addict! Deleveraging in its simplest form means reducing debt. While easy to comprehend in concept, the implications of how it is done can vary significantly. Today we are witnessing the ramifications of lenders demanding repayment and foreclosing on mortgage loans. Similarly, when banks seek to reduce leverage by not renewing credit lines, this can strangle a business’ operations and potentially lead to bankruptcy, investor losses, job losses, negative growth etc. Raising equity to reduce debt may be a possible solution; however, it is easier said than done. It requires available capital and a positive investor view toward risk. Recently we have seen the US government play an important role as a “last resort” source of capital for deleveraging to stabilize our financial institutions. Arguably the actions of TARP, including direct equity infusions, have restored investor confidence and facilitated over $50 billion in new equity offerings in the month of May. Learning from these lessons and understanding the successes and the failures should benefit our understanding of how to deal with 21st century economic crises.
Unlike any time in the last seventy years, bankruptcy has become a major risk factor in the US and global economies. While US laws are seemingly well established, and based on legal precedent, the rules of the road are now changing dramatically. US government intervention in the bankruptcy of Chrysler and the possible fall of General Motors is changing everything. Heretofore senior secured lenders had priority claims over junior creditors. Now, in part as a result of its equity ownership and capital support of US banks through TARP, the government is negating or minimizing such claims in favor of less senior lenders and unions. The ramifications of this activist approach raise many issues which may help or hurt the restoration of a major American industry, economic order and the vibrancy of the American capital markets. Regardless of one’s views, the actions and impacts must be studied carefully to provide a basis for prudent investing and to understand economic forces in our changing world.
It has been suggested by some that “education is wasted on the young.” In the case of the study of economics, this is hardly the case. Just as our parents learned economic lessons from the Depression, tomorrow’s leaders must learn from the new issues and actions of today. For Boomers, regardless of educational background or age, a refresher course based on current economic events would also be a welcome development!
To paraphrase Mark Twain, rumors of the demise of Ford and the major homebuilders is greatly exaggerated. While GM, Chrysler and a number of private builders are in or near bankruptcy, some of their larger public competitors are evidencing something even more significant than rising stock prices. They are raising significant amounts of capital!!
New capital is significant in many ways. It can allow companies to refinance maturing debt, reduce leverage and facilitate growth. Most important, it requires investor confidence. Raising new capital can only be accomplished when large groups of investors simultaneously commit to buy a company’s debt or equity securities. It is axiomatic that this is a formidable task if a company’s viability is in doubt. We are increasingly starting to see new capital commitments becoming the new “Good Housekeeping Seal of Approval”. They can signal that investors believe that a good company in a troubled industry should survive. The capital commitments often assure this inevitability and lead to post financing price increases from the abyss.
In the last few weeks we have seen the following financings for Ford and a group of large Builders:
Issuer Amount Security
Ford $1.6 bil equity
Toll $400mil bonds
Ryland $230mil bonds
Lennar $400mil bonds
Horton $450mil converts
Lennar $275mil equity
In the wake of these financings, including those who issued equity or converts that diluted existing shareholders, the newly issued debt and equity securities are trading at generally higher levels. While not necessarily a guarantee of long term success for the issuers, it has to be construed as a near term positive for both equity and debt investors. All have already registered gains in companies which the market sees as improved risks.
In a larger sense, the ability of companies in weaker industries to access the capital markets is a very positive indicator for a broad based recovery and further market advances. Six months ago Ford was a supplicant at TARP’s table. Today it is viewed as the long term winner in the US auto industry. As recently as three months ago, few would have made any bets on even one US homebuilder being able to access the capital markets for the foreseeable future. The foreseeable future is NOW!! Four builders have successfully financed and the securities issued are all trading at premiums.
Virtually all experts agree that the opening of the capital markets is essential to the end of the recession. The ability of Ford and the larger builders is a clear and significant harbinger of a major market opening. Like Mark Twain, the demise of the markets and the dire prospects for Ford and the large public builders was greatly exaggerated!
PS It is also very interesting to note that Citibank sole lead managed all of the builder financings. Their ability to execute such transactions also suggests that their demise as an underwriter may also be overstated.
Harvard Law School Professor Mark Roe made some extremely thoughtful observations in a Friday “Op Ed” piece in the Wall Street Journal (“A Chrysler Bankruptcy Won’t Be Quick”). Central to his discussion are the following key questions:
• Are Chrysler’s secured lenders receiving fair value for their claims as is their legal right in bankruptcy?
• Was the 70% lender vote to accept $.32 on the dollar valid or was it coercively tainted by government influence on banks who had received TARP funds? The law requires a 2/3 vote of secured creditors to accept a settlement. TARP banks make up the vast preponderance of the lenders who accepted the govenment’s proposal. Non-TARP lenders can reasonably ask if TARP lenders would have voted to accept if the government did not have an ability to influence their operations.
Professor Roe makes it clear that there is a reasonable basis for lenders to resist the settlement “mandated” by the Obama Administration. If so, creditor claims may make the final outcome less than clear and the process long and contentious.
What is not said but also must be considered is the generally heavy hand of the government to obviate the contractual rights of secure lenders. This does not begin to address the issue of unions gaining majority control of the Company.
The overall process raises significant and pernicious issues for our national economic future. If lenders rights are not protected, the appetite for U.S. corporate debt will diminish significantly. This will have severe adverse implications on economic growth, employment and our national standard of living. We have already seen how unilateral government interference has caused a significant measure of investor reluctance to play in TALF programs to buy “Toxic Loans”. The Chrysler bankruptcy could make matters worse. Fears of government intervention against indenture terms will not necessarily be reduced by higher interest rates, though higher rates will be one possible outcome. They will more than likely result in reduced lending until fears abate. The government will find that it has a hard time forcing lending by any institution that it does not control (ie foreign banks etc). If the over arching goal of Treasury policy is to get credit flowing, the government’s role in Chrysler is a major step backward.
Just as the American government was wrong in condoning torture against the laws of the nation and the civilized world, so too are actions which disregard freely negotiated loan terms which are critical to financing American industry. If we learned anything from the disastrous policies of the Bush administration, we need to understand and believe that our laws can’t be selectively followed or enforced.
Economic price theory suggests that optimal prices are achieved where supply and demand are evenly matched. The theory follows that, when there is an excess supply, prices should decline to a level which stimulates sufficient demand to consume the excess supply. Conversely, when supply is tight, prices should rise to a level where demand is satiated. When applied to ticket pricing by Major League Baseball teams, the task involves a measure of pre-season judgment to estimate demand at various price levels vs. a finite supply. The 2009 pricing policies of the New York Yankees, Boston Red Soc and New York Mets represent three very different approaches to the issue.
The Yankees took a course that bifurcated its ticket pricing between premium seats and non-premium seats. The premium seat policy involved per ticket prices of between $500-2,600. Their view was predicated on several key facts and assumptions:
• The quality of the Yankees’ teams makes their games a high demand event. To make sure of this, the Yankees spent heavily in the recent off-season on high priced pitchers and a slugger. The plan was to have great players to stimulate demand which would allow them to largely fill their stadium regardless of the opponent.
• The Yankees were building a new $1 billion plus stadium which they had to finance
• A finite number of premium seats with deluxe services would be attractive to corporations, hedge funds and New York’s plethora of big spending plutocrats
• The new Yankee Stadium, with reduced seating capacity and dramatically improved amenities, would enhance already strong demand
• The Yankees believed that “Scalper” prices at the old stadium were a strong reflection of the supply demand dynamic for premium Yankee tickets. Scalper pricing suggested a large divergence between prices paid for field level seats and those in less desirable locations. In many instances scalpers were attaining four figure prices per seat for top locations in the larger older stadium. A corollary was that scalper pricing pointed to an ability to raise non-premium prices, albeit at a lesser percentage increase than for premium seats (ie up 10-50% vs. 500%)
• By raising prices, the Yankees believed that they could disintermediate scalpers, achieve optimal pricing and generate significantly more revenue than in prior years.
The Yankees’ theory had merit. The scalpers’ pricing differential to face price, with 100%+ mark ups, suggested the potential for more efficient pricing. The challenge was making the right pricing decisions and factoring in the adverse economic developments occurring at the time of the Yankees annual early October exit from World Series contention.
The Red Sox’ approach to optimal pricing was dissimilar due to differing facts and strategies:
• They did not have a new stadium to finance and their payroll is significantly less than that of the Yankees and about $30 million less than it was in 2008
• The Red Sox have sold out every home game since mid-2003 despite raising prices annually to what, by 2008, were then the highest priced tickets in Major League Baseball.
• They did not have a significant base of large corporate season ticket holders. Rather, they rely on individuals, small businesses and ticket brokers for the majority of their season ticket sales. Such season ticket holders could be considered to be more economically sensitive than the likes of Citicorp, Lehman Brothers and Bear Stearns who the Yankees were counting on!
• Because the Red Sox played much deeper into the playoffs in 2008 (the Yankees did not make it at all), they were forced to start their 2009 ticket pricing deliberations at later date. This had the benefit of giving them more economic market input to influence their price thinking
• Scalper prices indicated that 50-100% premiums were being achieved in 2008. This might have provided impetus for a price increase, however, unlike the Yankees situation; there was no new stadium, no major increase in amenities nor a decrease in the supply of seats. More important, those scalper prices reflected pre-crash demand.
The Red Sox approach, which was rolled out in December, was to keep prices at 2008 levels. Flat prices were marketed as a fan friendly act in recognition of tough economic times. This was accompanied by a healthy dose of derision toward the Yankees’ pricing policy. The comparison was intended to help to make the Red Sox’ look like the Sisters of Mercy compared to their rivals in Gotham City. The goal was for goodwill and continued sell-outs despite hard times while laying the groundwork for future price rises when the economy improves.
The Mets’ strategy was the most innovative. Arguably it had to be because the team lacked both consistent on the field performance and a level of fan support equal to that of the Red Sox or Yankees. Other facts and issues were also important:
• Citi Field was replacing Shea Stadium. It is a beautiful new state of the art ballpark with somewhat reduced seating capacity than Shea Stadium and an even more dramatic increase in amenities than at the new Yankee Stadium
• Because of their consistently weaker on field performance, the Mets corporate season ticket support is much less than that of the Yankees. Their season ticket holder base more closely resembles that of the Red Sox with a high level of individuals and small businesses
• In recent years the Mets rarely sold out games at Shea Stadium except for a few games with the Yankees, serious contenders or with teams with special appeal like the Dodgers for old Brooklynites.
• Scalper prices saw minimal price premiums to face value and limited demand for many games other than with top teams or in big game situations
Given these facts of life, the Mets chose a 2009 pricing strategy to achieve a balance of supply and demand on a game by game basis rather than on a seasonal basis. This meant higher prices for Yankee and Dodger games than for the Pirates or the Marlins. Premium seats, with far greater amenities, saw prices double from 2008 levels while non-premium seats experienced lesser increases in the 10-20% range (justified by reduced capacity, greater non-premium amenities and a unique new stadium). The net result is that premium Met seats behind home plate for Yankees games now range from $200-500 per ticket, while they are only $100-300 for the Marlins. Prices for similar seats at Fenway Park range from $85-500 for every game. At Yankee Stadium, they cost from $500-2,600 per ticket.
Which team had the best 2009 micro economic strategy? The answer is not easy. The Mets are filling their stadium for games against teams like the Marlins (it helps that the “Fish” are playing well). The Red Sox continue to sell out regardless of the economy. What is easy to say is that the Yankees did not achieve optimal pricing. Empty premium seats abound. Scalper prices are below face value and the Yankees have just announced that premium season ticket holders will receive incremental free premium seats as a concession to over pricing.
Reasonable people are questioning whether the Yankees are compounding prior economic mistakes with these latest steps. Though the market has rejected their pricing strategy for premium seats, they are neither making refunds nor reducing the aggregate cash outlay for their customers. Rather they are just admitting that they have an excess inventory of premium tickets and giving away unsold high priced seats which they probably can’t sell. If the team’s on the field performance does not improve, it will be like a parent rewarding a child for eating much hated cauliflower by giving him more to eat!! This “great deal” is only being offered to premium season ticket holders who bought 82 game packages. It offers nothing to those who bought less thn 82 game premium packages except to dilute the value of their tickets as full season premium ticket holders unload their newly received tickets at discounted prices. Perhaps worse, from a public relations perspective, it does nothing for loyal fans who downgraded their seating locations when the per ticket prices of their season tickets went from $10-12,000 to $40-80,000. While I am not a behavioral economist like my scholarly namesake at the University of Chicago, my guess is that the policy will be less than well received by the majority of Yankee Season ticket holders (see attached article from the New York Times).
Why were the Red Sox and the Mets approaches more successful than the Yankees? Were the Yankees blind to economic realities or just completely insensitive to their fan base? Arguably the same answer works for all of the questions. While it would be nice to say that the Red Sox and Mets were more sagacious than the Yankees because they are owned by self made entrepreneurs rather than 2nd and 3rd generation arrogant rich boys, that is probably only a secondary factor. The real answer is that the Yankees’ revenue base dwarfs that of the Red Sox and Mets. Unlike the Red Sox and Mets, they can afford to be wrong in their pricing strategy. For this reason, they were willing to take a pricing risk for even more revenue. The Yankees do have the potential to inflict long term damage to their brand but it probably won’t happen. As in the past, they will spend ungodly amounts of money to improve the team and, at some point, do a high profile “mea culpa” with free tickets to poor kids and a cut in ticket prices for all. Then, as the economy improves, the price increases will return to obscene levels. Red Sox and Mets fans could be upset if this happens. They should not be. Rather, they should view this as like hitting the daily double. The Steinbrenners will have to admit to an egregious mistake and Yankee fans will have to admit that they supported a team that tried to screw them!!!
When Winston Churchill lost the Parliamentary election of 1945, his wife advised him that it was “a blessing in disguise.” His response was that the blessing was “very well disguised!” Many recently laid-off young bankers and college seniors who are NOT receiving investment banking jobs are feeling a lot like Churchill in 1945.
Unlike Churchill, the blessing may be closer to reality than they realize. As a long time investment banking group head, recruiter and, for the last two years, a college finance professor, I have seen far too many bright young twenty year olds pursuing a false dream on Wall Street. The allure was the trappings of the job, not the experience or nature of the work. High compensation, an exciting life style, prestige, material possessions and other superficialities were part of a bargain made in exchange for 100+ hour work weeks, sublimination of personal creativity, foregone time with friends and, at times, abuse by obsessive compulsive ego maniacs who may have suffered similarly and view mistreatment of junior bankers as an outward sign of their power and success.
The real question is whether investment banking is what they really want(ed) to do or whether it is just a means to achieve the fruits of a Faustian bargain. Was or will it be worth it for them? Will they be happy? Will they even last long enough to achieve the fruits?
For a few, the answer is yes. They will be either the lucky or those who genuinely enjoy the challenges and sacrifices attendant to the career. They will tend to be people who possess various requisite skills and aptitude for specific jobs on the “Street.” Facility with numbers, problem solving talents and an enjoyment algebra and statistics are crucial prerequisites for success at virtually any Wall Street position. Knowledge of psychology, legal concepts, salesmanship and recognizing recurring historical patterns are also important. An entrepreneurial spirit, a proven ability to recover from severe setbacks and a desire to make money are a must for all.
Sadly, the last point is probably the only common thread with the vast majority of young Wall Street job seekers and the freshly unemployed. Few actually would ever see the relevance of most of the skills enumerated above except maybe for the quantitative aspects and regrettably, few would ever mention a love of algebra or statistics less they be viewed as “geeky” or unsophisticated.
Typical arguments made by “twenty-somethings” when seeking investment banking jobs include variants of the following:
• “I am really a hard worker and love putting in 100+ hour weeks as a “work unit”
• “I have always received top grades and have never been anything but the best academically”
• “I know what it takes to be a success and I have it”
• “I have always wanted to be an investment banker”
Too infrequently asked or sincerely answered are questions like:
• Would you work 100+ hours per week as a banker next year if your pay were to be $20,000 per year with no bonus and limited economic upside?
• If you have never experienced a serious setback in life or evidenced an ability to recover from adversity, why should one believe you can do so in a high pressure and now low paying job?
• What does it say about your intellectual curiosity or self realization that the only thing you ever wanted to be is an investment banker? Explain why this will still be the case in a low pay environment
• When asking about skills to be an effective banker, see how many, if any, cite knowledge of legal concepts, historical methods, psychology or even statistics, algebra and salesmanship
The point to glean from such questions and observations is that the preponderance of the 35-50% of the classes at Princeton, Harvard, Yale or any other college that now seeks Wall Street jobs are not appropriate candidates regardless of their inherent intellect. They would likely be happier in other pursuits if they could only get over trappings of Wall Street. Sadly, many recruiters have been as misguided as the students in recognizing this verity or in selecting appropriate candidates.
The good news is that the allure and job availability are now significantly diminished. Only those who “really” want jobs, regardless of compensation, are likely to land such positions. Ridicule of bankers, a scarcity of positions and limitations on economic upside will do much to reorient thinking.
Where will the young people go for employment? Is it really a blessing that they won’t be on Wall Street?
It will be a blessing if the students and newly laid-off exercise self realization and pursue jobs which excite them because of the content rather than the compensation or perceived prestige. It will be a blessing if they experiment, explore and take chances pursuing dreams rather than dollars. Who knows, maybe some would be bankers will instead join the Peace Corps, start a business, become teachers, coaches, artists, work with autistic children or even become community organizers. Most importantly, maybe they will find satisfaction and happiness doing something because they enjoy it. They may even find a great truth to be that enjoyment and happiness with one’s job can lead to significant career success. History would suggest that this is what happened to Barack Obama, Bill Gates and Bill Belicheck. None can argue that they pursued traditional jobs or were the highest paid when they left college. They were bright, hard working and blessed because they sought careers doing what they enjoyed when they were young!
The attached article from the New York Times provides further insights on this topic:
Note: While the author did spend a significant number of years on Wall Street, he was a history major who liked algebra and statistics and remained a practicing Democrat to the chagrin of his loyal clients. His immediate post college years included selling advertising, travel to Brazil without a job in pursuit of adventure and an around the world trip mostly by public bus. He arrived on Wall Street in the sustained and severe downturn of the late 1970s and early 80s with 20% interest rates, low salaries and minimal bonuses. He stayed because he enjoyed the work, liked the clients (despite their political predilections)and was excited by the markets. Eventually the compensation got better and he did not complain!
Today is Tax Day all over America. Unlike our current Secretary of the Treasury, more than 65% of all Americans now have professionals prepare their tax returns. With incomes down, few if any capital gains to offset losses and a $3,000 limit to investment losses against non-investment income, tax returns have become less complicated for a lot of people. As I have talked to friends, family and acquaintances ranging from my 89 year old mother (living on a fixed income) to former students in their first year of work, they all have had a similar complaint: the tax preparation cost me as much or more than I saved.
Perhaps Tim Geithner’s do-it-yourself plan was a harbinger of today’s lament!!
In any case, as is almost always true, the Wizard is a source of great wisdomon this subject!
Fortune magazine’s Allan Sloan poses some excellent questions and raises some ugly issues in his piece “Structuring the Treasury’s bet for a Long-Term payoff.” His central thesis is that the Treasury makes a mistake financing the majority of its new debt in the short term debt markets at .2% today rather than locking in long term (30 year) rates at about 3.6%. It is his belief that long rates are likely to rise as the US deficit increases. While he makes no judgment on the merits of a deficit driven stimulus plan, financing such long term deficits in the short term markets may make the near term savings extremely expensive in the long run.
Rates may rise regardless of what action the Treasury takes today, however, the actions taken today may make tomorrow worse than it need be. Rising rates are usually what happens when business conditions improve from recessionary levels. Financing an increasing deficit in the short term market today exposes the Treasury to greater refinancing risk in the future in what most likely will be a higher rate environment. Laws of supply and demand will also have an impact on the US Treasury’s cost of capital. The larger the amount to be financed, the more leverage the buyers will have in terms of rate demands. The Chinese are already talking about holding less dollar debt. Is this a precursor for a “Sino-Hold-Up” that would make John Dillinger proud? While there is still faith in the United States Treasury, that faith could have an unattractive price tag attached!
The implications for a rise in long term rates and strategies to minimize the long term interest cost do more than just add varying levels of incremental debt to our national balance sheet. Corporate bonds are usually priced on the basis of a “spread” over Treasuries. Higher Treasuries, regardless of the maturity, mean higher corporate borrowing costs unless spreads decrease; the exact opposite may happen in a rising rate environment. Weaker and smaller less-than-investment-grade companies can expect to be hit the hardest. In a worst case scenario, it is possible that no spread would be sufficient to compensate investors. To put hard numbers to this, in today’s market, B rated companies’ 8-10 year bonds are trading in the 14-15% range. Similar bonds of BB rated businesses are in the 10-12% range. Were ten year Treasury rates to rise 2.5-3% and spreads to remain constant, the cost of ten year bonds for B rated businesses would rise to 16.5-18% and BB rated bonds to 12.5-15%. Any upward movement in spreads would make rates higher, taking them to potentially prohibitive levels. Though such rates would not impact the cost of pre-existing bonds, they would be a severe impediment to the refinancing of maturing bonds and/or to finance growth or capital projects.
Dick Cheney was famous for saying that “deficits don’t matter.” Time will tell if he was right. What is for sure is that how deficits are financed can make a big difference!
To paraphrase Mark Twain, “Rumors of the demise of the homebuilding industry are greatly exaggerated”. The recently announced acquisition of Centex Homes by Pulte Homes is a bold move that speaks volumes about where the business is going. Several points worth noting about the deal include:
1) It is a stock for stock transaction-Centex directors want to capture some of the upside which is created. They are not heading for the door.
2) The synergies are huge, probably amounting to $.75-!.00 per share annually. On a net present value basis over five years, this represents between 30-40% of the purchase price.
3) The structure materially improves the pro forma company’s balance sheet
4) Centex had near term (ie next 18 months) maturities in excess of $500 million. This has not been talked about by analysts but must have been an important consideration for their management and board. The questions around the debt included:
a) Could Centex refinance all of the debt?
b) What would be the cost to refinance the debt if it could be refinanced ? Arguably the cost would have been a coupon in the mid to high teens with limited ability to call if a deal could be done? And that is a HUGE if!
c) What sort of operating constraints would the banks put on Centex in terms of revolver availability etc? Banks do not like bondholders paid out in front of them. They would have forced the issue and turned a $500million maturity problem into a portential muli-billion dollar issue. Any impairments or other issues which caused bank covenant violations would have led to truly significant problems for Centex.
d) Could the problem have forced them into some sort of bankruptcy proceeding?
This writer believes that the debt issue played significantly into Centex’s thinking. They opted to be pre-emptive rather than risk that someone would beat them to Pulte and leave them a universe of less likely acquirors, forcing them to suffer the vicissitudes of a prolonged bad debt market
5) Centex’s bonds did not have a change of control clause (“COC Provision”). This basically would allow a buyer to assume the Centex bonds as part of the transaction rather than having them “put” at 101 and forcing a major refinancing. This was a major transaction advantage to any buyer. That said, it was also something of a “wasting” asset which could be lost if Centex were to default on its bank debt and trigger a cross default with the bonds. It is very likely that Pulte viewed the lack of a COC provision as a major attraction to Centex. Centex probably viewed it as a “use it or lose it” opportunity and chose to use it.
6) Did Centex have alternatives to Pulte? Looking at the other big builders, Pulte and, to a lesser extent, NVR were clearly the most logical. Pulte had a relatively high stock price in terms of PE and multiple to book. Moreover, it only has $25million in near term maturities vs some $318million for DR Horton and over $500million for Lennar. While NVR has the industry’s most enviable balance sheet and stock multiples, it has generally operated with a “land light” strategy and high margin construction strategy. Buying Centex could have hurt their multiple and been a huge undertaking for them operationally. This was less the case for Pulte where it was much better set up to cut employees, plug Centex subdivisions into their infrastructure and play. From my soundings around the industry, Centex did not do a significant market test, opting to cut the best deal it could with Pulte and then hope that the combined entity’s stock performs.
7) Could Centex have achieved a higher price? Maybe. To do so would have involved a game of corporate “chicken” with Pulte. The odds were not stacked in their favor as most strategics (ie other builders) were not likely buyers and the size and industry precluded private equity from becoming engaged. My guess is that Pulte started at a price below book and was worked up to book value. Going above book value in this market, with attendant goodwill and impairment issues was a bet Centex could only make if it were willing to “walk from the deal” and continue on a stand alone basis. They also knew that the odds were high that their bet would be called.
8) Is this a harbinger of other deals? If so, who is next? The answer is a resounding maybe! The same issues of debt maturities, form of consideration and price will be at play. Pricing will be tricky because of all of the usual constituencies involved including common shareholders, bondholders and banks. Fair deals for all will work. Banks and bondholders do not want to operate homebuilders and, in many cases, managements own significant stock (ie Toll, Lennar, MDC, Horton, Hovnanian et al.). Land positions, size and the quality of management will also be issues
All in all, this looks to be a decent deal for Centex shareholders relative to the downside risk. They traded off a low price for their shares for comfort that they would not be crushed by their near term debt maturities. They also believe that they will still have terrific upside in Pulte shares due to the synergies and general deal structure. They are probably correct in this thinking. For the same reason, the biggest winners will likely be the Pulte shareholders
PS The bank lenders, many of whom were lenders to both Centex and Pulte, will also be very happy because they will probably be able to significantly reduce their aggregate exposure to the combined entity.
Who’s kidding who? The fact that PAC contributions fell only 6% in the first two months of 2009 vs. 2007 is remarkable. Big banks which are receiving TARP funding have been virtually out of the PAC business. Add to this the facts that businesses are facing tight liquidity, major losses and an administration espousing squeaky clean policies on political giving. Down ONLY 6% is the new up! The Wall Street Journal and others can write all they want about how political giving is way down. Anything in the range of a 10% or less decline in PAC giving says to this author that PAC giving is actually deemed as an important business priority for the givers’ employers. Anyone who has been in any significant role at a major US corporation knows that PAC giving is voluntary in name only. Whether you are a Democrat or Republican, you never want to receive a call from your boss asking why you have not given to the firm’s PAC! If employers are making such calls today, they must really mean business.
Is the Wall Street Journal in cahoots with business to mask this story or do they just not get the joke?