-Caveat Lector- from: http://www.economist.com/finance/displayStory.cfm?Story_ID=393171 Click Here: <A HREF="http://www.economist.com/finance/displayStory.cfm?Story_ID=393171"> Economist.com: Is the end in sight?</A> ----- Is the end in sight? Oct 12th 2000 >From The Economist print edition Wall Street is rediscovering fear—this week in its high-tech stockmarkets, but more particularly in the junk-bond market THERE is trouble brewing in the world’s capital markets, especially at their most speculative end. Although the blue-chip Dow Jones Industrial Average has fallen by only a bit—well, 10% actually—this year, Nasdaq, the main market for high-tech shares, has had a torrid time. Since its high point in March, it has fallen by some 40%, and it shows few signs of hitting bottom. The profits of technology companies are failing to meet expectations—and even the rare ones that do, such as Yahoo!, find that this is not always enough to spare their share price a beating. Telecoms firms are saddled with huge debts. Internet firms are near-untouchable. At mid-week, the Nasdaq Composite index had fallen for 13 of its 15 most recent trading days. Disappointing profits, sales and advertising revenues, plus the fact that many shares were crazily overvalued to start with, have all caused problems. Intel, Lucent Technologies, Motorola: all have seen slower sales growth than investors had previously been led to expect, and have been punished severely for their shortcomings. Even when sales growth has been better than expected, as was the case with Yahoo!, some other factor, in this case signs of a drop in advertising revenues, has spoiled the picture. So much for shares. But an even scarier story may be unfolding in a market mostly ignored by those who day-trade Nasdaq’s dreamy paper: that for corporate debt. In recent weeks, disappointing profits have meant that some blue-chip companies have seen their investment-grade debt pummelled. The victims include Xerox, Eastman-Kodak, and just about every telecoms firm (“death, taxes and the long-term deterioration of the phone sector are among the few certainties in life,” wrote Credit Suisse First Boston in a recent report). After announcing bad results, yet again, last week, the spread on Xerox’s bonds over Treasuries tripled to 330 basis points. Hitherto, investment-grade bonds had generally stood above the fray. Cowboy junkies The fray has, in particular, surrounded those bonds without an investment-grade rating: described by Wall Street’s marketing folk as “high-yield bonds”, but formerly (and perhaps again) known simply as “junk”. These bonds, particularly those issued by non-blue-chip telecoms and tech companies, have been by far the worst of a poorly performing bunch. Merrill Lynch’s high-yield index is now nearly as ugly as in 1998, during the panic over the failure of Long-Term Capital Management (LTCM), a hedge fund that owned lots of junk (see chart). This week, some big investment banks were rumoured to have lost a fortune—$1 billion is the gossips’ favourite sum—on junk debt they underwrote but could not shift even to their most gullible customers. Among the names bandied about in the market were Morgan Stanley Dean Witter, Deutsche Bank and CSFB. Each denied, more or less, that it had lost lots of money on junk debt. Morgan said junk would hurt fourth-quarter profits by at most only $45m, causing a rebound in its shares, which had plunged by 11% on October 10th. Shares in other investment banks also fell. Since Credit Suisse bought Donaldson, Lufkin & Jenrette (a high-yield-bond specialist), $12 billion—coincidentally, the price it paid for DLJ—has been wiped off Credit Suisse’s market value. Investment banks hold many billions of dollars of debt and have lots of risky loans on their books. One market participant reckons that there is, perhaps, $25 billion at serious risk in the big investment banks’ portfolios. It is conceivable, he says, that among them, they could lose $10 billion of this. If so, the grim reaper seems likeliest to be the telecoms sector—which is fast looking less like the foundations of a glorious Internet future and more like another outing for the emperor’s new clothes. Deutsche Telekom, France Telecom and British Telecom, to take but three, have had their credit ratings slashed. These would have been cut by even more had the companies not persuaded the rating agencies to hold fire while they try to flog any assets they can. But, done in a hurry, this may be a less lucrative process than they hope. And Credit Suisse Asset Management, for one, reckons that Deutsche Telekom, for example, should already be closer to a BB credit (ie, junk) than its current A rating. That might reveal something about those telecom firms that are already rated as junk. The sheer volume of high-yield debt is causing spreads over Treasuries to soar. But so, ominously, is the draining of liquidity from the market, which has never really recovered from the drought caused by LTCM. Two things are mostly to blame. The first is that there are fewer investment banks. Now that Credit Suisse has bought DLJ, UBS has snaffled up PaineWebber, and Chase is acquiring J.P. Morgan, the number of banks willing to take risky positions, particularly as middlemen, has fallen sharply. As yet, nobody has entered the market to fill this risky, but potentially lucrative, space. The second problem is the prevalence of sophisticated risk-management models that increasingly appear to cause more problems than they solve, at least in times of market stress. So-called value-at-risk models (VAR) blend science and art. They estimate how much a portfolio could lose in a single bad day. If that amount gets too large, the VAR model signals that the bank should sell. The trouble is that lots of banks have similar investments and similar VAR models. In periods when markets everywhere decline, the models can tell everybody to sell the same things at the same time, making market conditions much worse. In effect, they can, and often do, create a vicious feedback loop. Incentives in the junk-underwriting business only make matters worse. Risk-adjusted, this is a terrible business for banks’ shareholders. A large slice of the profits goes to bank employees, who are increasingly prepared to gamble by underwriting low-quality debt which, if they prove unable to offload it, could do serious damage to their bank. “I am happy to tell you that we are continuing to increase market share during this difficult period,” Deutsche Bank’s Edson Mitchell told employees working on high-yield bonds this week. This news should not make his shareholders happy. If the game is up in the junk market, there will be severe consequences for the equity market, especially those shares that have not already been mauled. No firm would find it easy to raise new finance, however good its prospects. Indeed, today’s loans to telecoms firms may turn out to be much like property lending a decade ago, a fad that caused economic downturn and, for a while, stopped the bull market in its tracks. For today’s bulls, it is not at all clear where the next good news is going to come from. Still, a gloomy outlook may suit a certain sort of grizzled investor, who believes that the best time to buy is when there is blood on the streets. Such folk have not enjoyed the past few years, when any lucky punter in shares looked like a genius. But their time may be coming soon. © Copyright 2000 The Economist Newspaper Limited. All rights reserved. ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, All My Relations. Omnia Bona Bonis, Adieu, Adios, Aloha. Amen. Roads End <A HREF="http://www.ctrl.org/">www.ctrl.org</A> DECLARATION & DISCLAIMER ========== CTRL is a discussion & informational exchange list. 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