The Great Deformation

by David Stockman

  Accordingly, as the Greenspan Fed pursued a course of extreme monetary inflation, it became exceedingly rational for the wealthy to push their assets through the SEC regulatory loophole and into the hedge fund arena of momentum-chasing gunslingers and punters. Steadily at first, and then with a rush after the Fed’s September 1998 capitulation and its December 2000 interest rate cutting panic, wealthy investors abdicated their historical gating and disciplining function. Instead, they channeled trillions of capital in hot pursuit of the most recent jackpot winners.

  It is a law of economics that when both the supply and price of something rise parabolically there also exists an equal upwelling of demand. Accordingly, once the Greenspan Put was explicitly in place wealthy investors were literally chasing after new hedge funds with fists full of money.

  Thus, there were 1,000 hedge funds with a mere $150 billion under management in 1990. After two decades of bubble economics, the sector exploded to 10,000 funds and better than $6 trillion of AUM (when the embedded hedge funds of the Wall Street banks are added to the total).

  It thus happened that financial markets became warped and destabilized by whirling dervishes that inhabited the fast money complex. Unlike any financial force up till then, they were capable of launching a multi-billion-dollar dash straight over the proverbial financial cliff. Indeed, the power of hedge fund wolf packs to obliterate the signaling and disciplining mechanisms of the free market has now become plainly evident.

  So the Greenspan Put had unleashed the Furies on Wall Street. The hedge funds became marauding gangs of hit-and-run speculation, propelled by the $13 trillion outbreak of financial engineering in takeovers, buybacks, and LBOs.

  Like the dot-com version, this second Greenspan bubble was so immense, the rising debt so crushing, and the speculative trading games so reckless that sooner or later it had to collapse under its own weight. By the time it did go bust, of course, the maestro had vacated the Eccles Building. But his acolytes and accomplices were still there, momentarily frozen in place when the house of cards began to falter in August 2007.

  Then came the rant that shook the Eccles Building. Soon it was evident that the central bank of the United States had been taken hostage by the petulant Cramerite hordes. The deformation of finance would now take on an even more virulent and destructive aspect. The Bernanke Put had been born.

  CHAPTER 24

  WHEN GIANT LBOS

  STRIP-MINED THE LAND

  FINANCIAL ENGINEERING IS THE MOTHER’S MILK OF SPECULATIVE capital. Big hedge funds which can move money with massive throw weight and lightning speed thrive on it. It is a prolific generator of the exact kind of market moving events—rumors and announcements of buyouts, takeovers, and buybacks—that generate windfall gains largely unrelated to company fundamentals.

  The hedge fund flash mobs which swarm around these financial engineering deals must be consistently paid off or the speculation games would quickly die. Accordingly, during the Greenspan bubbles the vital financial lucre which kept the stock market casino going was CEW (corporate equity withdrawal).

  The business sector, however, did not generate nearly enough free cash flow to fund the trillions of CEW payouts. So companies borrowed from the credit markets prodigiously in order to fund buyouts, buybacks, and takeovers. In the process, the accumulated equity of American business was strip-mined and transferred mainly to the top 1 percent; that is, to the preponderant owners of hedge fund capital.

  HEDGE FUNDS AND THE GREAT CEW SHUFFLE

  The consequence was a deterioration of the collective balance sheet of US businesses. In December 1996, at the time of Greenspan’s warning about “irrational exuberance,” business debt outstanding was $4.4 trillion. By the time the financial system buckled at the end of 2008, total business sector debt had nearly tripled and stood at $11.4 trillion.

  From a macroeconomic perspective, this $7 trillion rise in the business debt burden could not have come at a worse time. Faced with a massive flood of cheap goods and services from mercantilist exporters, American business needed to minimize debt service costs and direct its free cash flows to heavy investment in productivity.

  This was obviously impossible given the due bill for financial engineering deals. So needing to fund $13 trillion of deals completed through 2008, companies borrowed hand over fist. This forced the collective leverage ratio for the business sector upward by more than one-third, from 44 percent of fixed and working assets in 1996 to more than 60 percent by 2008.

  Moreover, contrary to the urban legends about the post-crisis improvement of corporate financial health so assiduously promoted by Wall Street, this leverage ratio remained at 60 percent through the end of 2011. The great CEW raid of the decade ending in September 2008 thus left a permanent, heavy millstone on the collective balance sheet of American business.

  This grave impairment would not have happened on the free market. To the contrary, the severe shortage of domestic savings would have caused interest rates to rise sharply in order to clear the market. In response to a steep and rising price for debt, business borrowing would have declined, not lurched into an all-out binge as it did after the turn of the century.

  So it was the Fed which fostered the multitrillion-dollar spree of financial engineering and CEW that commenced in the years after the dot-com bust. By means of its panicked easing campaign, it generated a bow wave of borrowing and speculation. This, in turn, caused untold trillions to be transferred from the business sector of the American economy to the Wall Street financial casino, causing hedge fund AUMs to climb by nearly $400 billion each and every year between 2002 and 2007.

  The underlying cash-stripping raids on the business sector during this five-year period dwarfed all prior benchmarks. Annual stock buybacks grew sixfold, from $100 billion to $600 billion. Total M&A takeover volume quadrupled, rising from $400 billion to $1.6 trillion per year. At the heart of this surge in financial engineering deals, however, were leveraged buyout transactions which rocketed from $60 billion in 2002 to $600 billion annually at the 2006–2007 peak.

  TIDDIE BIDDIES: HOW HEDGE FUNDS GET THE CASH

  Except for a small 15 percent share of M&A deals paid in stock, all of these financial engineering transactions were funded with cash. As money poured into the accounts of stockholders, a disproportionate share was captured by fast-moving hedge funds based on their inside knowledge of the deal market. The fast money traders got to the deal stocks early, before the price had run, and it was no mystery as to how.

  The infamous Raj Rajaratnam, former proprietor of the Galleon hedge fund and current guest of the US government, did it the illegal way. Each day before Rajaratnam’s “morning meeting” at his fund, a Goldman Sachs managing director sent him an e-mail containing “tiddie biddies.” Needless to say, the latter seem to have immeasurably aided Rajaratnam’s uncanny sense of timing and the superlative returns which issued from it.

  Yet it doesn’t take illegal e-mails to circulate hunches, educated guesses, reliable sources, sage opinion, reasonable probabilities, potential scenarios, and “gut feelings” through the interconnected networks of traders, bankers, and hedge fund managers. It’s what Wall Street does all day and, in an honest market, would amount to the noble work of “price discovery.”

  But it’s not an honest market owing to the deformations of bubble finance. The latter puts an overpowering premium on information about deals and announcements as opposed to business fundamentals. Accordingly, price discovery has turned into a high-stakes scramble for “tiddie biddies” about price-moving rumors, events, and announcements.

  Needless to say, on the free market stock prices mostly rise slowly, reflecting the organic process of productivity growth and the usually measured but continuous harvest of returns on capital, technology, and ideas. Watching the grass grow in this manner, Wall Street bankers and traders would needs be in the business of heavy-duty fundamental research, not the collection of “tiddie biddies.”

  THE DERANGEMENT OF LEVE
RAGED FINANCE:

  $100 BILLION IN LBO DIVIDEND RECAPS

  The wherewithal for financial engineering came from the leveraged loan market that had been on death’s door after “risk” went into hiding during the dot-com bust. But when the Fed caused interest rates to tumble to lows not seen for generations, the market for leveraged finance literally exploded.

  Issuance of highly leveraged bank loans plus junk bonds leapt higher by $1 trillion annually, rising from $350 billion in 2002 to $1.35 trillion by 2007. Funding available for LBOs and leveraged recaps thus quadrupled. Altogether, a total of $4.5 trillion of so-called high-yielding debt was issued during this six-year interval. This astounding number exceeded all of the high-yield debt ever issued in all previous history.

  Moreover, the surging quantity of available high-risk debt was only part of the story. The deterioration in quality was even more spectacular. The riskiness of leveraged loans is usually measured by the interest rate spread over LIBOR; the more risk the larger the spread. This LIBOR spread on leveraged bank loans, for example, dropped from 375 basis points to 175 basis points, meaning that compensation to lenders for the risk of loss posed by highly leveraged borrowers virtually disappeared.

  Likewise, under a euphemism called “covenant lite” traditional borrower restrictions were essentially eliminated from junk bonds, transforming them into financial mutants. Under standard bond covenants, company cash could not be paid out to common equity holders who stood at the bottom of the capital structure unless bonds were well covered. But under “covenant lite,” private equity sponsors could suck huge self-dealing cash dividends out of a company, bondholders be damned.

  Implied default risk also increased sharply as measured by average deal multiples, which rose from 7X cash flow to nearly 11X. Moreover, near the end of this leveraged lending spree an increasing share of junk bonds were of the “toggle” variety. This meant that if the borrower came up short of cash it could just send the lender some more IOUs (bonds); that is, it could borrow to pay interest just like under “neg am” home mortgages.

  The ultimate indicator of the drastic deterioration of loan quality during this period, however, was the eruption of leveraged “dividend recaps.” LBO companies were able to issue new debt on top of the prodigious amounts they already owed, yet not one penny of these new borrowings went to fund company operations or capital expenditures.

  Instead, the newly borrowed cash drained right out of the bottom of the capital structure and was paid as a dividend to the LBO’s private equity sponsors. This sometimes permitted sponsors to recoup all of their initial capital or even book a profit within a few months of the initial buyout transaction, and long before any of the initial debt was paid down.

  Leveraged dividend recaps during the second Greenspan bubble (2003–2007) were off the charts relative to all prior experience. Thus, more than $100 billion was paid out during this period, compared to generally less than $1 billion annually in the late 1990s. Since private equity sponsors normally are entitled to a 20 percent share of profits, a couple of dozen buyout kings and their lesser principals pocketed $20 billion from these payouts.

  The real trouble, however, was not so much the greed of it as it was the sheer recklessness of it. Most of these dividend recap deals were done by freshly minted LBOs, some of them so fresh, in fact, that they had hardly gotten to their first semiannual coupon payment.

  So the feverishly overheated leveraged loan market was the real culprit. Investors were indiscriminately devouring any high-yield paper offered, and for the worst possible reason. As the 2003–2007 Greenspan bubble steadily inflated, fund managers became convinced that the monetary central planners at the Fed had truly achieved the Great Moderation; that is, recessions had more or less been banished.

  While implausible it nevertheless caused a drastic mispricing of junk bonds. They carry a high yield owing to their embedded equity-type risks, the most important of which historically had been the sharp impairment of cash flows and rise of default rates triggered by business cycle downturns.

  Now that the risk was attenuated or even eliminated entirely, high-yield bond managers started acting as though they owned a Treasury bond with a big fat bonus yield and commenced buying junk bonds hand over fist. The demand for new paper became so frenetic that Wall Street underwriters virtually begged private equity sponsors to undertake “dividend recaps” so they would have product to sell to their customers.

  This was another sign of the reckless speculation induced by the Fed’s bubble finance. During seventeen years in the private equity business, I never observed these firms reluctant to scalp a profit when, where, and as they could. But most firms believed the prudent strategy was to get a new LBO out of harm’s way as soon as possible by paying off debt and ratcheting down the initial leverage ratio. Rarely did sponsors think about piling on more debt in the initial stages, and certainly not to pay themselves a dividend. Even during the final red-hot years of the first Greenspan bubble (1997–2000), dividend recaps were rare, with volume averaging only $1.7 billion per year.

  During the second Greenspan bubble, by contrast, annual volume soared to $25 billion. Junk bonds and leveraged loans were so cheap and plentiful and the overall financial euphoria so intense that even the great LBO houses succumbed to violating their own investing rules. In fact, $100 billion of dividend recaps on the backs of dozens of companies already groaning under huge debt loads was not just a violation of time-tested rules—it bordered on a derangement and madness of the crowds.

  This eruption of leveraged dividend payouts dramatically exposed one channel by which cash from CEW was recycled to the top 1 percent. More importantly, however, it also laid bare the whole self-feeding web of bubble finance that the Fed’s monetary central planners unleashed while attempting to levitate asset prices.

  In this instance, the stock market bust of 2000–2001 and the modest economic slump which followed brought the excesses of leveraged finance to a screeching halt. Accordingly, the secondary market for high-yield debt cratered, new loan issuance slumped badly, and LBO activity stalled out at low ebb.

  The financial market was attempting to heal itself for good reason. Default rates on leveraged loans soared from an average of 2 percent of outstandings during 1997–1999 to 10 percent during 2001–2002. These high default rates, in turn, sharply curtailed the investor appetites for junk bonds, causing new issues to drop by two-thirds between 1998 and 2000. In effect, the free market was attempting to close down the LBO business as it had been practiced during the late 1990s boom years when the cash flows of buyout companies had been drastically overleveraged.

  Not for the last time, however, the Fed refused to permit the financial markets to complete their therapeutic work. When the federal funds rate was slashed to 1 percent by June 2003, the collateral effects on the junk bond market were electrifying, precisely the opposite of what the doctor ordered.

  During the twenty-four-month period between mid-2002 and mid-2004, junk bond interest rates plunged from 10 percent to under 6 percent. Since bond prices move opposite to yield, the value of junk bonds soared and speculators made a killing on what had been deeply “distressed” debt. Indeed, in a matter of months, a class of securities that had been a default-plagued pariah became a red-hot performance leader.

  This massive windfall to speculators was not the result of prescient insights about the future course of the US economy. Nor was it owing to any evident “bond picking” skill with respect to the performance prospects of the several hundred midsized companies which constituted the junk bond issuer universe at the time. Instead, junk bond speculators made billions during the miraculous recovery of leveraged debt markets during 2003–2004 simply by placing a bet on the maestro’s plainly evident fear of disappointing Wall Street.

  Wall Street underwriters, in turn, had no trouble peddling new issues of an asset class that was knocking the lights out. These gains were not all they were cracked up to be, of course, because junk bonds
had not become one bit less risky (or more valuable) on an over-the-cycle basis. But the Fed’s interest rate repression campaign made these gains appear to be the real thing, demonstrating once again the terrible cost of disabling free market price signals.

  Moreover, when the rebounding demand for risky credits enabled the issuance of nearly $3 trillion of highly leveraged bank loans and bonds during the three years ending in 2007, the result was a “dilution illusion.” The junk debt default ratio fell mainly due to arithmetic; that is, the swelling of the denominator (bonds) rather than shrinkage of the numerator (defaults).

  Thus, by the end of the second Greenspan-Bernanke bubble the total volume of leveraged debt outstanding was nearly three times higher than in 2001–2002. At the same time, the temporary credit-fueled expansion of the US economy caused new junk bond issues to perform reasonably well. Due to this happy arithmetic combination, the measured default rate plummeted sharply, dropping all the way down to 0.6 percent by 2007.

  Yet this was a preposterously misleading and unsustainable measure of junk bond risk, since it implied that the Fed could prop up the stock market and extend debt-fueled GDP growth in perpetuity. Nevertheless, having quashed the free market’s attempt to cleanse the junk bond sector in 2001–2002, the Fed had now enabled the leveraged financing cycle to come full circle.

  HOW THE GREAT MODERATION SPURRED A DAISY CHAIN OF DEBT

  During the final stretch of the bubble in 2006–2007, the junk bond yield stood at about 7 percent and was juxtaposed against what appeared to be negligible default rates. Not surprisingly, this generated a vast inflow of yield-hungry money into the junk bond market, and a blistering expansion of the market for securitized bank loans.