This Week EBITDA. When 'Marked-to-Model'?

By: Doug Noland | Fri, Jun 28, 2002
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The final week of a tumultuous quarter did not lack for drama, while the stock market made it through the turbulence about as well as one could have hoped. For the week, the Dow and S&P500 were largely unchanged, while the Morgan Stanley Cyclical index added 1%. The Transports, Utilities, and Morgan Stanley Consumer indices declined 1%. The broader market was resilient, with the small-cap Russell 2000 and S&P400 Mid-Cap indices about unchanged. Technology stocks continue to be wildly volatile, although the NASDAQ100 ended the week with a 2% gain. The Morgan Stanley High Tech index was slightly positive, while the Semiconductors increased 2%. The Street.com Internet index added 1%, while the NASDAQ Telecommunications index sank another 4%. The Biotech stocks enjoyed a quarter-end rally, with the major index up almost 4%. The financial stocks were mixed, with the AMEX Securities Broker/Dealer index gaining 4%, while the S&P Bank index was unchanged. With bullion sinking $11.20, the HUI Gold index dropped 7%.

Fixed income experienced a volatile week, and it is worth mentioning that the yield curve steepened this week (not necessarily a surprising development considering the weakening dollar and generally uncertain environment). For the week, December 3-month Eurodollar yields declined 11 basis points to 2.27%, while the long-bond saw its yield rise 11 basis points to 5.51. The two-year Treasury yield declined two basis points to 2.82%, the five-year yield was unchanged at 4.04%, and the key 10-year Treasury yield added four basis points to 4.81%. Notably, mortgage and agency securities generally undeperformed, with benchmark Fannie Mae mortgage-back yields rising seven basis points, and the implied yield on agency bond futures adding eight basis points. The spread on the Fannie Mae 5 3/8% 2011 note widened 2 to 56. The benchmark 10-year dollar swap spread increased 2 to 53.5. The dollar index sunk 2%, with the Euro approaching parity to the dollar for the first time since early year-2000.

As long as the dollar marched ever higher, speculators had every reason to ignore other markets and make one-way bullish bets on the greenback. But now that the dollar has commenced its bear market, virtually the entire world of currencies and commodities is an oyster for speculative trading. Especially in the commodities markets, one can today virtually throw darts to pick winners. Soybeans today enjoyed their biggest gain in 11 months, with prices jumping 8% this week. Wheat has been very strong, with prices up 6% this week to a four-year high. Corn was up 7% this week to an 11-month high. Wholesale pork-belly prices were up 24% during June. Copper prices today had the strongest gain in a month, gaining 3% this week to a 15-month high. Cotton prices continue their surge, while cocoa added 2% this week to the highest level in 15 years. The change in commodity market psychology is almost palpable. We continue to stress that one cannot overstate the broad implications both domestically and internationally of a declining dollar. We are in the early stages of what will be a dramatic repricing of many real and financial assets globally.

Data this week from the two large California ports indicate that April's record trade deficit was only a sign of greater things to come. Container imports into the Port of Long Beach and Port of Los Angeles increased another 4% during May, with combined year-over-year inbound containers up 27% to a record 505,831. Outbound containers increased 3% for the month to 184,585, a jump of 10% y-o-y. Empty containers leaving the two ports jumped 19% for the month to 272,669 (54% of inbound), and are up 36% from year ago levels. Since May 1999, total inbound containers received are up 33%, while loaded outbound shipments are up 15%.

Our view that we are in the midst of the "blow off" stage of the mortgage finance Bubble continues to receive considerable support from the data. This week's release from the Commerce Department had May new home sales at a record 1.03 million annual rate (expectations of 920,000), up 8.1% from April and a notable 16% y-o-y. Annual sales were up 27% in the Northeast to 67,000, 10.6% in the South to 482,000, 4.3% in the West to 289,000, and 2.7% in the Midwest to 190,000. April's sales were also revised sharply higher. New homes are being sold at a rate slightly ahead of last year's record, and it is worth noting that new homes sold in May at almost double the 1991 pace. May's average price of $224,300 is up 6.1% y-o-y. Interestingly, the number of homes available for sale rose to 324,000, up 9.5% y-o-y to the highest level since December 1996.

Wednesday the National Association of Realtors (NAR) reported stronger-than-expected existing-home sales. At a seasonally annualized level of 5.75 million units, May's sales were the fourth strongest on record. From David Lereah, NAR's chief economist: "So far this year we've already recorded the four highest monthly sales rates on record for existing-home sales, but the pace can't stay at unprecedented levels indefinitely. What this means is that housing is continuing to be a significant factor in sustaining the U.S. economy. Going forward, the trend should be a gradual decline in home sales activity but they'll stay above last year's record." Average (mean) prices were up $3,600 for the month to $200,100, the third consecutive monthly gain. Average prices are up $7,900 y-t-d (10% annualized), and 9.0% compared to one year ago. May unit sales were up 9% y-o-y. With unit sales up 6.5% and prices up 9% y-o-y, "calculated transaction dollars" were up 16% y-o-y to $1.15 trillion. Year-over-year sales were up 1% in the South, 6% in both the Northeast and Midwest, and a booming 16% in the West.

The California Association of Realtors' (CAR) May data confirm the great California real estate Bubble continues to inflate. For the month, median prices rose 1.3% to $321,130, a new record. Single-family median prices were up 25.5% year-over-year, in what should be recognized as a case of taking very expensive prices to even more dangerous extremes. Median condo prices rose 4.2% from April, with y-o-y prices up 21.3% Housing inflation is statewide, with y-o-y prices up 26.3% in San Diego, 17.1% in Orange Country, 18.1% in Los Angeles, 18% in the High Desert, 22.5% in Palm Springs/Lower Desert, 20.2% in San Luis Obispo, 25.5% in Ventura, 25.4% in North Santa Barbara, 19% in Sacramento, and 20.3% in Northern California. Basically, the only regions not enjoying rampant inflation are those markets that had experienced spectacular booms during the previous few years (Silicon Valley!). At 2.1 months, the inventory of unsold homes is down significantly from last year's 3.6 months. In an indication of the extent of manic behavior, Dataquick confirmed that sales are surging even in the San Francisco Bay Area, with median prices reaching a record $413,000 during May (up 9% y-o-y).

Broad money (M3) supply jumped $38.1 billion last week to $8.151 trillion, easily erasing the past two-week's decline. Narrow money (M1) increased $3.5 billion, with currency up $1.5 billion and demand deposits up $2.3 billion. M2 components (excluding M1) increased $23.4 billion, with saving deposits rising $18.7 billion and retail money fund deposits up $5.4 billion. M3 components increased $11.3 billion, with institutional money funds up $13.7 billion and large time deposits up $4.7 billion, while repurchase agreements declined $4.1 billion and Eurodollars declined $3.2 billion. Interestingly, commercial paper outstanding has contracted $32 billion during the past two weeks, almost fully explained by a decline in financial sector commercial paper borrowings. However, the debt issuance boom runs unabated, with Bloomberg reporting total domestic public debt sales of $34 billion. Bloomberg's y-t-d tally stands at $777 billion.

June 27 Bloomberg - "Junk-bond investors are having their worst month ever, with falling prices for WorldCom Inc. helping to erase about $24 billion of market value. A Merrill Lynch & Co. index of 1,351 junk-rated issues [$303.5 billion] has lost 6.52 percent in June, including price changes and interest, surpassing the 6.42 percent drop in September after the terrorist attacks."

The escalating crisis in the "risk" market expanded to, in the words of hedge fund manager and statesman George Soros, "a crisis situation. The international financial system is coming apart at the seams." Certainly, a week where fraud is revealed at industry heavyweight Worldcom, Adelphia Communications files bankruptcy, and Xerox reveals enormous accounting improprieties, it is writing the obvious to state that the unfolding financial crisis made a major onslaught from the "periphery" towards the fragile "core."

WorldCom and Adelphia combined for about $50 billion of debt. The list of domestic and international banks, insurance companies, pension funds, mutual funds and investment firms that announced investment losses this week is long and diverse - from the estimated $1.6 billion exposure of state governments to the billions spread amongst the insurance and banking communities. Let there be no doubt, the wrecking ball that has been chipping away at confidence has finally broken off a large chunk. Bloomberg quoted the treasurer for the state of Iowa: "Public confidence is sinking, and so is the confidence of every institutional investor out there. Who's watching the guys at the top? They are proving to be bald-faced liars." We can only hope that our foreign creditors do not share such sentiments.

Interestingly, the major money center banks, JPMorgan Chase, Citigroup, and BankAmerica apparently have only minimal direct exposure to WorldCom. An analyst from Standard and Poor's stated, "Actual outstanding loans are small and, for the most part, covered by credit default swaps." Credit Suisse First Boston even went so far as to issue a report yesterday titled, "WCOM: Non-Event: Another Reason Why Banks Remain a Safe Haven." "...You take a step back and come to realize that this, along with Enron, is another highly visible data point that confirms the pronounced shift in corporate finance activity away from the commercial banks to the capital markets."

As systemic risk rises by the day, such thinking is the ultimate in rose-colored "analysis." The problem is that the capital markets have come to dominate the Credit mechanism, while in the process grossly over-financed a Bubble economy. The natural tendency of markets to cycle between extremes of expansive euphoria and contractionary revulsion is especially problematic when it comes to Credit. We will now see the downside of the cycle with tightening Credit conditions enveloping the economy, albeit in an atypical (Chinese water torture-style) sector-by-sector process.

As long as Credit excess and resulting asset inflation is maintained within a particular sector, underlying structural distortions grow yet remain largely hidden and unproblematic. Granted, the great experiment in structured finance has thus far fueled a spectacular telecom/technology - "The Communications Arms Race" - boom and bust with risk largely residing outside of traditional bank lending. But this is certainly not the time to be whistling past the graveyard. This week, perhaps for the first time, market participants began to appreciate that the Wall Street telecom Bubble was indeed a case of Mutually Assured Destruction with potentially dire systemic consequences.

WorldCom had $21 billion of revenues last year and basically the same amount of expenses. Unlike Enron, it had grown into a significant player in the real economy. When WorldCom and the rest of telecom industry had basically unlimited access to finance, they would borrow and spend aggressively, fueling growth across a broad spectrum of suppliers from equipment makers to media companies to consultants (not to mention investment bankers, attorneys, accountants, and stock brokers). Throughout the boom, telecom borrowings fed directly to the general media Bubble, with surging advertising dollars fueling extreme price inflation in radio, television, billboard, magazine, Internet, cable, wireless, professional sports, and advertising agency franchise values. A dollar of WorldCom borrowings could be "leveraged" many times over as it created a multiple of franchise "value" as revenue for, say, a local radio advertisement. These inflating asset prices then provided additional collateral for aggressive borrowing and spending. This broad sector became a key monetary transmission mechanism to the real "service sector" economy. Today, this mechanism is now faltering badly.

Ultra-easy Credit availability and inflating asset prices fed a powerfully self-feeding race to acquire communications and media properties. Wall Street provided the likes of WorldCom, AT&T, Sprint, Qwest, SBC Communications, and Verizon with blank checkbooks for acquisitions and system build-outs. Clear Channel communications was able to borrow aggressively and acquire radio and television stations, as well as billboards and other media assets. Viacom borrowed and paid up for television stations and media properties. Outfits such as Lamar Advertising were allowed easy access to funds to aggressively acquire advertising billboards, while others bought video stores. Nextel used huge amounts of borrowings to acquire radio licenses and franchises, making scores of "mom and pop" radio operators wealthy along the way. Six Flags acquired amusement parks and Speedway Motorsports purchased and developed racing venues. Companies such as Comcast and Charter Communications took on huge amounts of debt to acquire and develop cable franchises. Interpublic Group and Omnicom were able to borrow aggressively and acquire advertising agencies and marketing firms. Entertainment conglomerates such as AOL Time Warner and Viacom had easy access to finance myriad acquisitions. Throughout the boom, it all really did have the seductive illusion of wealth creation.

Fortunes were being made throughout, whether it was the individual or company selling out to the acquisitive, as well as the equipment supplier, stockholding manager, investor, speculator or investment banker. Rules and conventions were bent to accommodate the game of egregious borrowing and acquisition, and it is no coincidence that the most aggressive players had become the most ardent proponents of EBITDA (earnings before interest, taxes, depreciation and amortization) as a (flawed) measure of cash flow. But this historic Bubble is now bursting, and an expanding number of leveraged companies are losing access to additional finance. The leading subscribers to EBITDA are today leading bankruptcy candidates. This week the debt crisis jumped the fire line.

The issue today is the confluence of a massive amount of corporate debt, fragile debt structures, and the especially weak nature of the cash-generating capability of many underlying businesses. The market is beginning to appreciate the dire consequences for what will certainly be a protracted Credit crunch throughout the telecom/media/entertainment super-industry. This area is anything but inconsequential to a vulnerable U.S. financial system, and it has over the life of the boom become a meaningful segment of the distorted U.S. economy.

Asset Bubbles function poorly in reverse. Huge Bubbles burst. Things are destined to turn quite problematic with the commencement of much tighter Credit conditions and the resulting declining franchise values throughout the arena of radio and television stations, billboards, professional sports organizations, cable systems, advertising agencies, consulting firms, and various related media properties. Many asset values are based on an overly optimistic extrapolation of boom-time revenue and earnings growth. Yet too often these enterprises are little more than a creation of extreme monetary expansion. The Reality of the Unfolding Credit Crunch will be anything but industry growth, and the uncovering of the gaping hole between optimistic boom-time extrapolation and post-Bubble contraction will be like the shock of jumping from the hot tub into the unheated swimming pool. The true underlying economic value of many of these types of assets in a post-Credit Bubble environment will be a major issue going forward. As is the case with WorldCom, many businesses are left with little value when the money spigot is turned off. As Dr. Richebacher has always brilliantly stressed, asset Bubbles destroy wealth not create it. The banking system will not be immune.

But for today, we'll stick with our "death by a thousand cuts" approach to analyzing the unfolding financial crisis. Over-leveraged speculation was the key factor for the 1998 and other previous financial dislocations. The nature of such a crisis is that it builds up pressure as leveraged players suffer losses over time, until erupting in a panic liquidation by the speculators. As was the case with LTCM, such a market problem can be resolved with a bailout of a major player(s), systemic reliquefication, and measures to bolster flagging confidence. As we have witnessed repeatedly, the Fed and GSEs have in the past been too successful in using the power of rampant liquidity combined with enticing post-liquidation prices to quickly rekindle speculative impulses and "animal spirits."

Today's unfolding crisis is, to this point, much more an issue of severe and escalating structural problems throughout risk intermediation. It is not yet a case of widespread lender/speculator impairment, as much as it is a post-Bubble crisis of hopelessly impaired borrowers. There's simply too much bad debt and no way to make it good, and too much risk transferred to marketable securities. It is, importantly, a U.S. systemic problem - hence a dollar problem, so measures to "reflate" or "throw 'good' dollars after bad" only exacerbates systemic/dollar impairment. There will be no quick fix, player bailouts, or systemic reliquefication. We also have a hunch that the greatest speculative leverage likely exists within the "Triple-A" sector of the debt market. The good news is that this area has thus far benefited from the debt implosion at the fringe. The bad news is we expect the increasingly nervous leveraged players are another domino in wait - the General Liquidity Domino.

Clearly, recent events have only compounded what are surely major festering problems in the murky world of collateralized debt obligations (CDOs) and Credit derivatives/default swaps. We also continue to expect problems to surface in asset-backed securities, where issuance doubled to $2.2 trillion since the beginning of 1998. There are considerable telecom/tech/media loans, equipment leases, and receivables out there somewhere. To this point, the markets have been successfully playing "Hear No Evil, See No Evil, Speak No Evil." But have we finally experienced enough nonsense for increasingly risk-averse investors to question the safety and soundness of structured finance generally? From David Feldheim's Dow Jones story: "Concern about WorldCom has extended to the relatively secure asset-backed commercial paper market, where WorldCom has approximately $1.5 billion of ABCP outstanding. Dealers in bank-sponsored conduit programs that purchase ABCP are scrambling to determine if any WorldCom paper is being held in the conduit paper they own. The bank-sponsored conduits buy asset-backed commercial paper from a broad range of issuers, but are not required to identify the contents of their portfolios. Deborah Seine, managing director in the ABCP group at Fitch Ratings, said that these ABCP conduits are "blind pool financing vehicles" so that an investor doesn't know who are the ultimate sellers in the program."

It is our view that the notion of "blind pool financing vehicles" is today a vulnerable legacy of the Great Credit Bubble. In the new world of justifiable skepticism and risk avoidance, we expect investors will increasingly choose sight over blindness. We do note that asset-backed commercial paper (ABCP) outstanding has declined $8.9 billion over the past two weeks to $708.6 billion. But, then again, the marketplace apparently still doesn't have a care in the world in regard to the unfathomable Credit insurance written by the likes of Ambac Financial and MBIA - The Systemic Risk Domino.

It continues to be a rather strange environment where the market often struggles to avoid discounting a problem until it is hit over the head with it. But it is the reality of a fragile system that any discounting of potential problems in structured finance would quickly become a current problem. It is interesting to note a bit of weakness in the stocks of Fannie Mae and Freddie Mac. Perhaps investors and speculators are learning it is better to leave the party before the Bubble bursts. And while we have yet to see any meaningful market move away from agency debt or mortgage-backs (generally quite the contrary), we will be on the lookout for underperformance from higher-risk mortgage-back securities at the "periphery". We do see this week as potentially a key inflection point in market perceptions - the recognition that the U.S. Bubble goes much beyond the technology sector, and that there is much greater systemic vulnerability than was previously appreciated. Awhile back I wrote a piece title "The Tale of Two Bubbles." Well, it is fair to say we don't expect the extreme divergence between the tech/telecom Bubble and the mortgage finance Bubble to be sustained. And we don't expect tech/telecom to recover for quite some time.

Having spent a couple years fresh out of university as a "Big Eight" auditor, I am rather intrigued by the rather simple nature of the WorldCom fraud. Auditing 101 prepares future accountants to focus on the age-old trick whereby companies attempt to inflate earnings by capitalizing expenses - pretty basic stuff. That the auditors somehow missed a few billion dollars of recurring expenses that were capitalized as assets gives us little comfort in the accuracy of accounting for derivatives and other sophisticated financial transactions. One thing that's for sure, we have seen little that instills confidence that there is not one big accounting shoe to drop at some point in the financial sector. This week talk turned to "EBITDA" and "capitalized expenses." When will it be "marked-to-model" (establishing "market" prices on derivatives based on internal calculations) and derivative accounting?


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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