Sand Spring Advisors LLC

Where the Excess Lies


Barclay T. Leib

September 8, 2000

Every boom in a global economy eventually results in an over-build and a bust -- whether it be “building far more lines than necessary to carry railroad traffic from Liverpool to London in the mid-1800’s, or the 400 or so auto companies created during the ‘Roaring Twenties.’” So advises Fred Hickey in the latest edition of The High Tech Strategist, a monthly publication well worth its $95 annual cost (603-888-3954).

And Mr. Hickey is of course right. It is simply a question of determining where the greatest excess lies in the current era. Is it in the plethora of new Internet portals and shopping sites where the most dangerous excess exists? Or is it in over-building of luxury loft space in Manhattan’s Trib-Be-Ca district? Or is it simply in the size of Wall Street bonus checks and suburban real estate that a dangerous bubble lies? Or perhaps it is in the excess availability of capital from America’s venture capitalists and mortgage lenders?

When all is said and done -- and the history books are written -- all of the above will have been there of course, but nowhere do we have more excess now than in one place: the telecom sector. It’s a borrow and build strategy that has seen AT&T’s debt load reach a staggering $58 billion level, but with the Qwests, Level 3s, Global Crossings, WorldComs, etc. right behind AT&T issuing debt and more debt for what are deemed as necessary “infrastructure builds.” Everyone wants their own fiber optic network, their own cellular network, and the problem is -- in the short term -- the mere announcement of such infrastructure additions has tended to push the stocks of these companies ever higher.

As we outlined in our previous July article, “Failed Accounting Standards; Mmm, Mmm, Good; and Where to Invest (if at all) in Bandwidth,” the only good business we can see out of all this are for the companies with the best franchise to connect all these duplicitous fiber strands together (UAXS) and get them over the last mile into households (mostly private entities to date like VideoNet and TerraBeam). The profitability of these fiber networks themselves – net of the costs to lay them -- is far more questionable.

Certainly many of the companies engaging in this over-build are already suffering from a devastating price war in traditional voice minutes and a similar over-build in duplicitous wireless infrastructure. Money is coming from the debt markets and literally being thrown away in projects where the costs are unlikely to ever be recouped. Consider, for example, the following thoughts from one sub-contractor to the wireless/fiber-laying industry:

“Level 3 – probably the worst managed company I have ever seen. This company has been sold a bill of goods by the highest cost vendors in more than half the build-out categories. They even require wrap-up insurance on second-tier subcontractors, costing $500 on a small sub-contract of $3,000. Their overpaying mistakes go on and on.

“Verizon – filling in a lot of holes to their wireless and fiber network, but some very questionable. To fill in one street, they spent $300,000. In many locations where there is no ability to co-locate, Verizon pays up too high for marginal facilities.

“Sprint – engineering disaster, used Chicago sweep specs in another city. Then wondered why the sites didn’t work. Subscriber base running well behind projections.”

His list goes on. In this contractor’s estimation, much of what all these companies are spending is “simply un-recoupable.”

“Lucent is also financing much of the buildout phase,” he explains, “and most recently has been offering financed equipment to central office want-ta-bees for local service. This will all not end nicely.”

In addition to Lucent financing, the convertible debt market has been another popular financing vehicle – first with the Internet sector (already imploded) and more recently with the telecom sector (yet to implode). The trend to use convertibles extends back to 1996, when one failed Times Mirror/Netscape issue was soon supplanted by an extremely successful AOL convertible bond issue. Here’s a short history on the convertible debt market from an upcoming article I have written for Derivatives Strategy magazine:

In the spring of 1996, Times Mirror Corp. came to Morgan Stanley with a hedging problem: The firm had a huge gain on its investment in Netscape Communications, and it wanted to sell its stock, but didn’t want to roil the market or pay all the capital gains taxes on its holdings.

Morgan Stanley’s brilliant solution was to underwrite a Times Mirror convertible bond that had a mandatory conversion feature into Netscape stock. That meant investors would be given a fixed-income instrument bearing a coupon, but the security would eventually morph into Netscape stock after several years. Times Mirror, meanwhile, could defer paying its tax bill for several years. Shouldn’t everyone have been happy?

Despite the nifty concept of earning a coupon while participating in an Internet high-flier, convertible investors turned a cold shoulder--deeming the issue just too speculative for the times. The deal was sold, but just barely, and at terms that made it the “cheapest mandatory convertible ever issued up to that date--and ‘jammed’ on any Morgan Stanley clients that would take it,” according to one dealer.

That well-publicized flop put the kibosh on the issuance of Internet convertible paper until 1998, when AOL issued a less scary-looking convertible with more traditional non-mandatory conversion rights and a definable bond floor value. Since AOL had a better credit rating than Netscape, as well, the deal was successfully placed. The stock of AOL subsequently vaulted higher, and any convertible bond manager who didn't buy the AOL issue suddenly looked like a dummy. "If you didn't own the AOL issue as a convert manager, you under performed in 1998--it was just that simple," says Kendrick Wakeman, managing director of the convertible bond research group at First Union Securities. "AOL simply trounced everything, and traded up to well above 10 times par. I believe it accounted for almost 98 percent of the return to the Merrill Lynch Convertible Bond Index that year.”

In January 1999, Wakeman visited some 20 outright convert investors and found a unique theme emanating from them. “Each one of these investors was wondering what to do about the Internet,” says Wakeman. “They didn't like Internet stocks, they didn't understand Internet stocks, but they knew these underlying companies were now part of the convertible indices, and they couldn't afford another AOL-type situation of being left at the gate. They just had to participate in that space, and the investment bankers responded with a flood of new issuance."

The issues that came forth stretched from, to Exodus, to DoubleClick, C-NET, Mindspring and the now-famous 10-year convertible issue. Some performed well for a little while, but most finally crashed and burned in this year’s April-May Internet market collapse. Many Internet convertible bonds fell faster in value than their theoretical hedge ratios implied. The Amazon issue now trades at only 60 percent of its face value, with a 12.5 percent yield-to-call -- not quite a distressed security but slowly moving in that direction. Outright buyers of convertibles may now be benchmarked better vs. their indices, but many of their holdings are well under water.

More recently, we have seen huge convertible issuance from Nextel, MediaOne, BEA Systems, Omnipoint, AirTouch, US Cellular, Level 3, GlobalStar, Omnicom, Qwest and others. Overall, telecom convertible debt of course dwarfs the Internet convertible issuance in the absolute dollar value of issues outstanding.

Now almost anyone you ask will say that buying a convertible bond is a less risky investment than buying the underlying equity. Not only do you have the cushion of the convertible coupon, but, by definition, a convertible is farther up the food chain of a company's balance sheet than common equity.

Notwithstanding this fact, the U.S. convertible bond market has arguably become the riskiest convertible market in the world. In Japan and Europe, most convertibles are issued by investment-grade names. But in the United States, only 12 of the 29 Internet convertibles brought to market over the past 18 months carried any credit rating at all. Young technology and telecom issues, moreover, now represent more than 50 percent of the U.S. convertible bond universe.

Indeed, in many respects, the U.S. convertible market has now largely supplanted the illiquid U.S. junk bond market of yesteryear. Mike Milkin would be most proud.

"You can't place most telecom junk paper very attractively anymore, but you can still price most telecom convert paper," explains Jeff Seidel, director of convertible bond research at Credit Suisse First Boston. "Because the volatility of the equities has been so high, people really want the embedded option, and while there is attention to credit spreads, it's generally less rigorous because that option is there. If you've got a good story, and a volatile share, the convert market still offers attractive financing terms." In other words, high equity volatility and a closed junk market results in a busy convert market.

During the week of September 4th, however, a light bulb started to illuminate itself on Wall Street. On top of being told by Piper Jaffray analysts on Monday that 95% of Intel’s chips were now basically un-saleable, The Wall Street Journal ran a story on Friday, September 8th highliting the growing problems within the telecom and telecom vendor community. The ability of some lesser credit telecoms to actually pay for their supplier-financed equipment build-out was specifically questioned.

The question remains, therefore, will many of these same companies ever really have the where-with-all to pay back all the debt they have issued? Moreover, could the U.S. convertible market seize up again in another 1998-like bout of illiquidity? According to some, the convertible market is now less exposed than it was before Long-Term Capital Management's meltdown, but according to others, it's just a matter of time until the next financial accident. Here’s a bit more from my Derivatives Strategy work, on the relatively scary state of this huge, but lightly followed market:

The low credit quality of many of today's U.S. convertible bonds has understandably encouraged many banks to cease positioning these bonds on an outright basis. "1998 and the LTCM crisis not only taught many hedge funds how to construct better delta hedges, but it also taught many banks how dangerous this market can be," says Vadim Iosilevich, a convertible arbitrage trader and director of Alexandra Investment Management Ltd. One Connecticut-based convertible arb manager adds, "If Merrill Lynch used to be running a $3 billion convertible book, now they are likely to have just a $300 million book, run in a much more risk-appropriate way."

But if the banks are no longer positioning this paper on an outright basis, who are the ultimate holders?

A quick look at a Bloomberg terminal will tell you that large aggressive mutual fund families such as Janus and AIM are often among the largest holders of Internet and telecom convertible paper. After all, back in 1998, how else could the Janus Balanced Fund actually beat the returns of the Standard & Poor’s 500 while still having bonds constitute 60 percent of its portfolio? Convertibles, of course. While not exactly creating true balanced or conservative portfolios, Janus has shown that you can take a handful of hot convertible bond issues and make them almost be as good as owning stock -- without actually having to admit to such exposure. In 1999, out of a universe of several thousand available issues, 10 specific high-tech names accounted for a quarter of the returns of the Merrill Lynch Convertible Index -- all names near and dear to the Janus fund family.

On the other side of the equation, hedge funds, ironically, are now more important than ever as the primary liquidity providers to such outright convertible buyers. According to some estimates, convertible bond arbitrage trades currently represent more than half of the secondary-market trading in convertible securities at the institutional level, and the driving force here are multibillion dollar hedge funds such as Staro, Highbridge, HBK, Ramius and Citadel. This is a group of names few outside of the hedge fund industry would be likely to recognize, and yet their behavior might prove of some importance if the large mutual funds were ever forced, through redemptions or otherwise, to liquidate some of their massive convertible holdings.

"When Janus or any other large mutual fund group takes down relatively large chunks of converts, you want them to be long-term holders," says CSFB’s Seidel, "because if they want to blow out $50 million in converts, it's not like blowing out $50 million in stock. In a major liquidation, you'd likely see a ratcheting down in bids from the hedge funds. I've never seen a situation where there is no bid in the U.S. market, but it has happened in Asia."

More dangerous than Japan
Despite the obvious problems with the Japanese economy and ultra-low interest rates in that country, the Japanese market is probably less exposed to potential liquidity problems than the United States, says James Burns, founder and president of Aventine Investment Management, which specializes in Japanese convertibles. "The market structure in the United States is just inferior," he argues. "Not only are the number of bonds below investment grade significantly greater in the U.S. than Japan, but on top of that, it's an over-the-counter market-maker structure, with liquidity being provided by all the large hedge funds, and these funds are typically all the same way until you hit a liquidity constraint problem. Then you get a black hole--an implosion. The U.S. convert market could easily be another disaster waiting to happen."

John Pagli, managing partner of global business development at Greenwich, Conn.-based Forest Investment Management, also sees a certain cyclicality to convertible bond arbitrage strategies, and concurs that liquidity can often disappear. While his fund typically keeps only 150 open positions at any one time, he explains, some of the larger convertible arbitrage funds may carry upwards of several hundred positions--and "once in a while, that's just too unwieldy to get out of." In other words, convert bond managers can at times become deer frozen in oncoming headlights.

Burns believes we may be approaching the end of the greatest concomitant bull market in equity and fixed income in America's history. While people look back at 1990, 1994 and then the fourth quarter of 1998 and "try to explain away these periods as a 'one-off events'" emanating from the Gulf War, Alan Greenspan’s preemptive actions, the Soviet Union or Long-Term Capital Management, "for me, I've just seen liquidity crisis after liquidity crisis develop, and I think the next one is going to be more severe than the other ones."

One potential catalyst for such a crisis, as he sees it, is that telecom companies are currently throwing money at their infrastructure build-out, and getting this money from convert issuance. "In some instances, the debt coverage may not really be there," he speculates, highlighting default risks that few on Wall Street may be focused on today. "Japan is also subject to these risks, of course, but much less so,” he adds.

Taking an even longer-term perspective, Forest's Pagli feels that the current telecom debt issuance might someday end in a vale of tears -- following the example of the Latin American debt crisis of the 1970s, the oil company overbuild, the savings-and-loan debt debacles of the early 1980s, and the leveraged buyout debt craze of the late 1980s. He is quick to note, however, that there are likely to be numerous profitable trading opportunities along the way.

Here is one possible disaster scenario: Assume convertible issuance steps higher into the fall, as most expect. Then imagine what would happen if hedge funds begin reducing their exposure to protect year-end returns, and insurance companies, concerned about FAS 133, also begin pulling out of the market. Add in a round of mutual fund redemptions--should the market, say, be disappointed by the Presidential election results--and things could turn downright ugly in a flash.

In this scenario, convert arbitrageurs, as the primary providers of liquidity to this niche market, could have the Janus Fund and the entire mutual fund industry effectively at their mercy--unless, of course, these managers don't see the mutual fund supply coming and are caught offsides themselves.

As the last part of this analysis mentions, what if debt issuance steps up into the fourth quarter? Well, it certainly looks likely to do so. At the moment an ever-increasing flood of telecom debt and equity issuance – particularly out of Europe – is on this autumn’s calendar. British Telecom plans a once-delayed $10 billion corporate bond offering in the next few months. Telefonica Europe has a multibillion deal upcoming. And France Telecom’s New Orange is also expected to come to market for some significant size. Albeit better quality type names, the U.S. market is still going to be asked to absorb a tremendous amount of new paper on top of already owning too much junk.

Throw into this equation the new SEC rules that companies can no longer “guide analysts estimates lower” in private conversations but must now make instead public earnings pre-announcements. This creates a whole new set of rules that -- while genuinely more egalitarian and fair -- stand ready to leave not only nave investors, but now high-paid Wall Street analysts, with increased mud on their faces.

Wall Street used to get inside information and then leak it slowly to their best clients, while quietly adjusting their own earnings estimates, playing a symbiotic dance with the analyzed company not to upset anyone’s apple-cart too much. If there was “surprising” news of some sort, at least some well-connected hedge fund managers were always “set-up” in advance to take advantage of it, and then help cushion the impact on the actual news event. Now far fewer will be “set-up” for anything. As well intentioned as the SEC ruling is, look for earnings-related “jump moves” to become even more dangerous and dramatic as a result. Loss of conviction in Wall Street analyst prognostications can also only follow over time.

The bottom line: If Japan had its land bubble supported on excessive debt financing in 1989, America now has its telecom bubble built on similar stilts. This is where the excess lies, and we’ll be hearing about it in bankruptcy courts, Congressional hearings, and the media for years to come. The bubble hasn’t popped yet, of course. Indeed, investment bankers are still feeding out as much paper as they can, sewing the seeds for the day when this bubble is indeed destined to go “pop.”

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Sand Spring Advisors provides information and analysis from sources and using methods it believes reliable, but cannot accept responsibility for any trading losses that may be incurred as a result of our analysis. Our advice should be deemed our personal opinion and not a recommendation to invest. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities, and should always trade at a position size level well within their financial condition. Principals of Sand Spring Advisors may carry positions in securities or futures discussed, but as a matter of policy we will always so disclose this fact if it is indeed the case. We will also specifically not trade in any described security or futures for a period 5 business days prior to or subsequent to a commentary being released on a given security or futures contract. Barclay Leib, principal of Sand Spring Advisors, is currently long the stock of UAXS.

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