TFTF

Analyse This, Merrill

April 12, 2002

Life in the Muddle Through Economy goes on. With all of the sturm and drang going on in the markets, most stock indexes are not too far from where they were at the beginning of the year, except for the NASDAQ, which has been far from reality for a long time.

This week's e-letter is going to deal with a few dirty little secrets of the investing world, though we'll try to keep our hands clean while we look at e-mails and accounting reports. The sensitive among you might want to wear gloves for this e-letter. This promises to be an interesting ride, so let's jump right in.

Today we find more support for our Muddle Through thesis. For new readers, that means things are not all that bad, but they aren't all that good either. Furthermore, for the rest of this year, at least, it's not likely to get much better or much worse. Thus, we muddle through.

Interest Rate Swapping

The latest salvo comes from Bill Gross, of PIMCO fame. Gross sits atop the largest bond investing firm in the world, running around $350 billion or so for a variety of investors. He may also be the highest paid investment manager in the world. Naturally, he has a keen interest in what Mr. Greenspan is likely to do with interest rates.

Bill made the headlines last week when he jumped all over GE and how they finance their debt. It was an interesting spectacle, but not very enlightening. But there is a lot to learn from "the rest of the story."

GE moved $11 billion from 1.75% commercial paper to 6.5% debt. On the face of it, that would mean that GE will pay $500 MILLION more dollars per year in interest costs. While GE had a huge amount of short term debt, with their borrowing power, it was within their limits. But they decided they wanted to turn some of that short term debt into the certainty of having the money for a longer period.

But as new CEO Jeff Immelt explained, "And so while, you know, a move into long-term debt will increase our funding costs slightly,...it has nothing to do with the spread between commercial paper and long-term debt because we swap into matching funds . So you know the incremental cost is de minimus."

"De minimus" is Latin which means in accounting jargon "of minimal impact or importance."

How do you make $500 million go away, or become "de minimus"? You go to your favorite investment banker, and he arranges a "swap" with another firm. You trade your long term debt for short term debt, minus the investment banker's handling fee. You probably do not even know who is on the other side of the swap. You trust your investment banker to take care of the details.

Why would someone want the long term debt? There are hundreds of reasons. Maybe you can lock in a rate for debt that is cheaper than you could get on your own, or you are buying a long term investment and want to lock in financing. It could be part of an interest rate trade. The list is endless. As long as you can find a willing investment banker, you can arrange the swap. The swap market now dwarfs the bond market as a vehicle for financing.

Let me give you an example. "Kerr-McGee Corp. is one of the latest companies to lower its borrowing costs this way. The Oklahoma City-based oil and gas company raised $350 million yesterday, then cut its financing costs by swapping its newly issued three-year notes for floating-rate obligations.

"The fixed-rate notes it sold carried a coupon of 5.375%. It exchanged them for obligations with a rate 87.5 basis points above the benchmark London inter-bank offered rate (Libor). As a result, the company's borrowing cost would exceed the 5.375% coupon should Libor rise to 4.5% or above...."

"Kerr-McGee expects to save about 3 percentage points on the proceeds in the first year, Chief Financial Officer Robert Wohleber said. Excluding costs, that would work out to a savings of about $10.5 million." (Bloomberg)

90 day Libor is 1.98% today. That means Kerr-Mcgee would be paying 2.85% instead of 5.375%. Saving 3% a year translates into about $10 million, or about 2% of Kerr-Mcgee annual profit. The risk is that interest rates go up over the next three years. Rates would have to go up a whole lot for this to be a losing trade for Kerr. And if they started going up, Kerr would enter into another swap, presumably before the pain became too excruciating.

This is more than just theoretical for me. I am currently negotiating a loan with several non-US banks, at interest rates based on Libor. They could care less whether I take the rates for one year or 90 days. They get their spread and fees and are happy. At the point we agree on terms (which means their fees, as the cost of money is basically the same everywhere), I will have to make a decision. Do I want 90 day rates, which will change every 3 months, or do I want to lock in my rates for one year? I will tell you what I will do in a minute.

Greenspan's Dilemma: Inflation or Recession?

But let's get back to Bill Gross. He goes on to make the point I have been saying for a long time, but not nearly as clearly or elegantly: if the Fed raises interest rates too fast it will tank the stock market. Here's what Gross says:

"And that is where I came upon what might be another [new idea]- and this too is where I shall leave the GE saga and move on to the broader context of Corporate America which is what I intended to do in the first place. The fresh idea (although it's been lying in the grass for years now) was that if lots of corporations were doing the same thing, then the short-term Fed Funds rate is driving the economy. Now that of course is no brilliant observation, it has been thus for eight decades or so with a temporary disconnect in the 1940s for wartime finance. But when a creation of the last 10 years - the interest rate swap - makes it possible for Corporate America to term out their debt and still pay near commercial paper rates, then that's a revelation - or better yet, a revolution.

"It means that short-term rates are even more critical to the profitability of Corporate America - to the level of the stock market - to the growth rate of the American economy than ever before. It means that Alan Greenspan dare not raise interest rates too much or risk sinking the stock market and the economy once again; it means that because his ability to raise short rates is limited, that ultimately inflation may be higher than it otherwise would be in a still near deflationary world; it means that bond investors should do certain things and not do others."

He illustrated this by going to one of my favorite sources, Bank Credit Analyst, and shows graphs that demonstrate corporate debt it rising dramatically but corporate interest rate expense is not, even while long term rates have not come down all that much. Then he notes:

"It seems reasonable to me that if recent debt levels have risen to record highs, while interest expense remains well below 1990 peaks, then corporations have got to be loaded with lots of short-term debt exposure even as they supposedly "term out" their commercial paper. Short rates have dropped from 8% to 2% since 1990 while long rates have only declined 200 basis or so. The dampening influence which permits corporate interest expense as a percentage of cash flow to appear so benign in Chart 2 has got to have come from lower short, not long rates, which in turn have resulted from large amounts of commercial paper/bank debt/ or - which is the hidden link - long-term debt "swapped" back into floating. Corporate interest expense truly does appear to be "de minimus" and probably because of swapped liabilities into the front-end of the yield curve.

"De minimus is as de minimus does, or better yet, de minimus is as long as short rates stay low. But corporations, which load up on the short side with visible CP, bank debt, or invisible swap lines, are truly taking an open-ended risk of loss. Swaps hold no magic really - if short rates move up, one side loses while the other gets paid and if corporations with short-term liabilities are on the losing side of that trade then profits, the stock market, and the economy all feel it when the Fed marches upward. An increase of 175 basis points in short rates from 1999 to the fourth quarter of 2000 was a factor in causing a mild recession in 2001. Does Greenspan dare do more in this next tightening cycle? Nay - he will do less once the 9/11 emergency reductions have been taken back to a more normal 3% or so. Too many big time "players" are on the short side. The systemic risk is certainly anything but de minimus."

Translation: Interest rates are not going to go up as fast as the bond market thinks they will. The management at GE and Kerr-McGee and a thousand other companies who are swapping long-term for short term debt agree as well. They are looking down the road, and they do not see a robust recovery. They see what we see, which is a Muddle Through Economy. That is not an environment for robust growth. That means short term rates will stay relatively low for longer than many bond investors think, and therefore their swaps make good sense.

They are counting on the fact that Greenspan will see the same thing, and will not raise interest rates aggressively. The risk of slowing down the economy is too great.

How? Corporate profits plunged by 20% last year, which was the worst drop since WW2. Profits as a percentage of GDP in the mildest recession in memory dropped to levels not seen since 1982. "What would have happened if we had a real recession?" asks Steve Roach.

Corporation after corporation, like IBM and GE, are giving us warnings about their earnings in the first quarter. By all accounts, the first quarter will show growth of 4% or so. If these companies could not do well in the last quarter, how will they fare in the next two quarters, as we back off the pace as many expect we will?

The answer is, the only way they can increase profits is to cut costs, as most companies have no pricing power. But capital spending is already down, and cutting any more will hurt. Where to cut? Labor. And specifically they will look to management. Oddly, last year, management payrolls grew at a 2% rate, while labor took a dive. The only place to cut is to pay back debt, cut payrolls, and put off capital spending. None of this is a prescription for robust growth.

This is precisely why companies are swapping long term debt for short term debt. They are not seeing a "V" recovery, and therefore do not expect short term rates to rise all that much, at least in the near term.

Companies can muddle through without too much pain, as long as interest rates stay low. If short-term rates rise, then companies will be forced to make cuts in capital spending and labor. Depending upon the level of the rise, it could throw us back into a serious recession. Gross points to a mere 175 basis points in 1999 as causing the slowdown of 2001. What would a 3%rise do?

Yet, the bond market thinks Greenspan will raise interest rates by 2% between now and the end of the year. (You can determine that by looking as yet another swap, the difference between current rates and the rate as predicted by December interest rate futures contracts.)

The bond market is fixated on a robust economy bringing back inflation. However, that is not the ball Greenspan and crew are watching. The Fed is concerned about throwing us back into recession. But if we were to go back into a recession late this year, they will not be able to cut rates. They have no more magic bullets.

So, if you are Greenspan, do you risk a little inflation, or a recession?

Except for oil (and my insurance costs), inflation is still in check. Oil fluctuates up and down, and could be anywhere in the next year. Today, even after the recent massive jump in prices, at $24.99 a barrel it is still $3.25 less than it was a year ago. The PPI, less energy, is up only 0.1%. It is hard to find a reason to think inflation will be over 2.5% before the end of the year, which by historic standards is not all that much.

Given that benign inflation outlook, I think the Fed will say, "Better to let the economy get a sure footing, give companies more time to shore up their balance sheets, and worry about inflation later."

Even more critical, Greenspan does not want to have his last act be throwing the US economy and thus the world into a serious recession.

Side note: you can look for days and not find anything about the level of swaps for a particular company when you examine corporate audits. Investors and analysts might be much more sanguine about future earnings if they knew the risk some of these companies were putting off into the future. This is a risk, and should be disclosed. I predict law suits when and if it comes to bite future earnings.

Why Long Rates Are So High

I called one of the smarter bond traders I know, who runs a very successful fixed income hedge fund. We discussed the possibility of large amounts of long term debt being swapped for short term debt. I asked him what would be the effect on long term bond rates, and he said it would help to keep them higher, as it would increase supply more than demand.

But it also means that some time in the future, if inflation comes back and rates rise, that these companies will experience a serious impact on their bottom lines. It is easy to raise long term money now if you think you will not have to pay the long term rates. It makes your next quarter profits look good. As long as rates stay down, you can ride the tiger.

But that's a problem for next year. This year we will Muddle Through.

(Some have written and asked me what I think of the "median CPI" rising. My answer is, "Not much." It is an interesting statistic, but I have yet to see someone show that it predicts anything meaningful. It's true use is to let bond vigilantes have a number which they think shows inflation is going to 4% or so real soon. Almost any day. Just you wait.)

What about my choice on interest rates mentioned above? If I can ever come to terms with the gnomes in Switzerland (or the banks in Bermuda), I will take the same side of the bet corporate America is making. I will take the short term rates, at least for now. I don't think rates will rise all that much this year, and probably not much at all for the next 6 months. The net effect will be less interest cost out of our pocket.

Eventually, the Fed will be forced to raise rates, to show that it is still watching inflation, and to put some bullets back in the gun for the next recession. But my bet is they will do it a lot slower than the market thinks today.

Analyze This

I know you are shocked to find out Merrill Lynch analyst Henry Blodgett gave positive public reviews to internet stocks he was privately trashing.

Actually, the only thing shocking about it is that he left a paper, or rather email, trail. Let me walk you through this latest saga for a moment from a different perspective.

This letter will go to roughly 500,000 people, plus be posted on dozens of different web sites and forwarded to friends, etc. That is a lot of buying power. If I mentioned a thinly traded stock, say one I might own a lot of, there is a real possibility it would rise. If I sold that stock into the buying I created, I could make a nice profit.

Except of course I would spend all the profit on legal fees trying to stay out of jail. That is a classic pump and dump, and is illegal as hades. If one did have a loose ethical sense, but wanted to avert jail, you would go to all sorts of schemes, hidden accounts, etc. like Gordon Gekko (Michael Douglas) in the movie Wall Street.

I have written about Wall Street cheerleaders for years, telling you to ignore them. Wall Street "sell-side" analysts are just wrong too much to be relied upon. There is supposed to be a "Chinese Wall" between the analysts and the brokers who bring out the IPO's. If you take down that wall, you have stepped over into territory that the SEC frowns upon. Blodgett, Mary Meeker, and the lot helped create a frenzy that made the major investment banks hundreds of millions of dollars.

The "Chinese Wall" did not hold up. It was more like a Japanese paper wall. At Merrill it was a one foot tall onion skin paper wall.

It is now clear that Blodgett was telling people to buy a stock prior to his firm (Merrill) making huge fees from an offering, even as he (and his cohorts) privately sent emails calling the stock a piece of ****.

Merrill gave him $12 million or so to ride off into the sunset. What a deal. He touts stocks he doesn't like, Merrill sells them on his "reputation," and everyone pockets huge fees.

Let's drop back for a second and analyze this.

What if, instead of me owning the stock I mentioned above, I got a friend to buy it? Then I write about it. He sells into the fever frenzy I create. (I'm dreaming here, but go with me.) Next year, he signs a consulting contract with me, or with someone I designate, for half the profits. Tough to trace. But still illegal, and worthy of jail time.

Will someone tell me how that is essentially different from what Merrill did? Except that if I get caught, I go to jail. Merrill simply pays a fine, agrees to be better next time, change a few rules, etc. Just another cost of doing business.

Am I shocked that this went on? Of course not. Everybody knew what the game was, at least in the trade. What is shocking to me is that Blodgett left a trail. If you are flagrantly breaking the law, you generally try and hide it. At least when I was a kid, I tried to conceal the fact from Mom that I got into the cookie jar. I cleaned up the crumbs. (I still don't know how she found out. At an early age, I realized I did not have the basic skills necessary for a life of crime.)

The sheer arrogance and magnitude of hubris is staggering. How can you not know that what you are doing is wrong? How can you leave a trail of cookie crumbs back to the jar unless you see nothing wrong with stealing cookies since everybody is doing it?

There's an old joke about the man who offers a beautiful young lady a cool one million dollars to go to bed with him. She thinks about it for a moment. He's kind of cute, and no one would know. A tax free $1,000,000 is a lot of money. She decides to accept.

He then changes his offer. He drops the price to $100. She gets very angry and asks, "What do you think I am?"

He replies, "We've already established what you are. Now we are just negotiating price."

I know that some (maybe most) internet analysts may have been true believers. George Gilder is still blinded by the telecosm, whatever that is. I have no ethical problem with an analyst being wrong as long as he is sincerely wrong. I have made sincere investment mistakes in my life and will probably do so again. If you are in the investment arena, you will have many opportunities to be wrong.

But when you say what you are told to say in order to get your million dollar bonuses, even as you know it is a lie, and you know that investors are going to get creamed, I think we can safely say we have established what profession they were really in.

Juries are NOT going to be sympathetic. I have read these emails. It is very disingenuous for Merrill to say they were out of context. The context seems to be quite clear. Blodgett and others lied about what they really thought about these stocks. Wait until they depose the secretaries and assistants who have been laid off, and didn't get a $12 million good-bye kiss.

Is this only a Merrill problem? No, it will go deeper. The law suits are mounting. This could be the equivalent of "asbestos" for the investment world. It will get ugly.

Let me say that there are many analysts and economists who work for major Wall Street firms for whom I have the highest regard. I think the large majority are hard-working ethical professionals, and just like the Arthur Andersen partners are furious that they will suffer because some of their kin crossed the line. (Stanley Roach comes to mind, although I have never met him.) I differentiate between them and cheerleaders who are simply trying to get you to buy what they are selling. In the case of some, cheerleaders is a kind word.

(All four of my daughters were/are cheerleaders. I mean no dis-respect, kids. It is the adult cheerleaders who sully your hard work and efforts.)

Tragic Times

The latest Israeli bombing was by a young Palestinian girl. This is the third young girl in recent weeks. This is a very disturbing trend. It once again demonstrates that we have no understanding of the mind and passions which is driving these terrorists. I was told, as I sign off, that Powell has put Arafat on hold because of the recent bombing. I hope so. Dealing with a man who would send young girls into a suicide bombing has no hope of being productive. This is not a man with a rationale that can be reasoned with. You cannot construct a compromise with a man with no sense of the value of the lives of his fellow countrymen - or young girls.

The Palestinian people have no chance of a real peace or a separate country as long as this man is even nominally in power. His corrupt leadership is the primary cause of their suffering, and has cynically withheld prospects for development which would help his people, but would make them independent of his largesse. I do not see how others could be worse. He has done nothing to bring peace to anyone.

Travels: California Dreaming

Again, I remind you I will be in the Palm Springs and LA area April 29 through May 2. I will be available to meet with clients and prospective clients at that time. I will also be in New York speaking at the Hedge Fund Forum June 2-5, and will have time to meet with you as well. My topic at the Forum will be on the "Future Issues Facing the Hedge Fund Industry."

It's shaping up to be a great weekend. My Mother-in-law is in town for a too brief visit, and the sun is shining. She and my bride like zoos, so I suspect they will let me tag along. Then, maybe some golf with my son. I tried a new Taylor driver in Arizona, and was hitting the ball 30 yards farther than my old Taylor. The cost is outrageous, though. I may have to see my Swiss banker friends about making a small investment.

For those who get my monthly letter for accredited investors, I will finish it this next week and send it on its way. If you are an accredited investor, and would like to get my free letter on private offerings and finance, simply drop me a note and we will send you a the sign-up forms. (An accredited investor is someone who is worth more than $1,000,000 or makes $200,000 per year for two years.)

Thanks for reading, and remember I read every comment, good or bad, you send. I try to write back to as many as I can.

Your ready for the weekend analyst,

John Mauldin

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