Junk-Bond King Michael Milken wrote an op-ed for the Wall Street Journal today, titled Why Capital Structure Matters. He argued that how a manager handles a company's capital structure is important when evaluating a stock for possible investment.
You'd think this point was beyond debate... but not according to Milken's friend, Merton Miller, and his partner, Francis Modigliani. They're the economists who won a Nobel Prize for saying "corporate capitalizations are a matter of indifference." Aside from politics, academia is the only place an idea so awful could survive, thrive, and achieve high honors... even though reality has thoroughly discredited it.
Milken says the optimal capital structure constantly changes, but depends on six factors: "The company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends." When these six factors indicate business risk, even a dollar of debt can be too much for some companies. If businesses paid closer attention to these factors, they could better manage the booms and busts.
My own research has led me to realize some companies need what appears at first to be redundant cash levels. In other words, they carry what you might view as negative debt. That's because they're highly cyclical businesses that aren't big enough to get financing at cyclical troughs, or which would be impaired or even bankrupted by the cost of such financing. So they literally can't function without a store of rainy-day cash.
Milken argues today's bond and equity markets are reminiscent of the turning point in 1975, when public and private institutions displaced banks as the source of most corporate lending.
In the first quarter of 2009, companies raised $840 billion in the global bond market... a 100% increase from the first quarter of 2008. Investment-grade companies are starting to "reliquify," setting the stage for lower-ranked companies to access credit markets. Companies are using the new cash to pay down bank debt, improving their capital structure and subsequently adding liquidity to the banks... In other words, according to the man who virtually created the junk-bond market as we know it today, things are slowly improving.
That may be so, but they're not improving all over, not by a long shot...
Well, you can't say we didn't warn you against buying stocks of big, complex financial companies. Hopefully, you weren't hurt yesterday when Bank of America's stock fell 24% after reporting higher loan-loss provisions.
According to a really good New York Times article by Andrew Ross Sorkin, Bank of America "booked a $2.2 billion gain by increasing the value of Merrill Lynch's assets it acquired last quarter to prices that were higher than Merrill kept them." Sorkin quoted Dartmouth professor Sidney Finkelstein, who said, "Although perfectly legal, this move is also perfectly delusional."
Sorkin cited other examples of accounting legerdemain among the big banks. JPMorganChase and Citigroup, for example, used a trick made famous last fall by Lehman Brothers just before it went bankrupt: writing down the value of the debt it owed and booking the discount to par as a gain.
Many smaller banks continue to look positively miserable, too. BankUnited Financial Corp.'s stock is now selling for pennies, having peaked around $30 in late 2004. After increasing its loan-loss provision recently, the bank now has negative Tier 1 capital levels, which means it has run out of money with which to absorb investment losses, a roundabout way of saying it's technically insolvent.
Two more banks failed last Friday, bringing the total to 25 this year. That's two more than in all of 2008.
Despite trillions in government bailouts, banks are still reporting horrible results, whitewashing those results with the same old accounting shenanigans, and failing at a record pace. Let's not forget the original intent of the bailouts, which were supposed to encourage banks to continue lending. It hasn't happened...
Data released yesterday showed lending at TARP-recipient banks is down from last October, though the government funds were earmarked for that purpose.
So why aren't the banks lending? One reason is that the banks are worried about borrower credit risk. Another is that banks are holding cash reserves for regulatory purposes in case their assets deteriorate further.
Two University of Chicago finance professors, Douglas W. Diamond and Raghuram G. Rajan, argue banks aren't lending because they want liquidity in the case of future fire sales. If a large institution were to become distressed in the future and forced to sell assets, the few institutions with liquidity could dictate prices. There would be little competition because the failing institution would absorb the existing market liquidity... so competing firms couldn't borrow money to bid on the fire-sale assets. Banks with cash on hand could make a once-in-a-lifetime investment.
Still another reason, one hardly anyone talks about, is that regulators are crimping the supply of wholesale lending, which banks need to fund new loans. Wholesale funding refers to so-called brokered deposits, which are CDs gathered by broker/dealer firms and marketed to banks, generally at higher interest rates. They're considered a risky source of funding because they're expensive and can be called away as quickly as they arrived. They're often called, "hot money."
If a bank is deemed "well capitalized," it can use brokered deposits without too much hassle. If it's merely "adequately capitalized," however, it has to get a waiver from the FDIC before accepting brokered deposits or paying higher-than-average market deposit rates. This is simply an artificial price ceiling, which always reduces supply. These days, the FDIC is less likely to grant such waivers because it's extra paranoid about the additional risk it perceives in brokered deposits.
Attorney Peter Weinstock, of law firm Hunton & Williams, wrote last week in an American Banker opinion piece that this shift in regulatory behavior is reducing the lending capacity of banks. It "will lead to a significant increase in the number of bank failures," he said. We've been saying that for about a year, though this particular issue hadn't come up yet.
There's also the fact that every bank CEO says conditions are getting worse across all businesses... credit cards, housing, commercial real estate, etc. This results in higher loan-loss provisions, which reduces available capital. Ramping up lending while the market is destroying more of your capital every day is a bad idea.
New high: Vanguard Short-term Tax Exempt fund (VWSTX).
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Dan Ferris
Medford, Oregon
April 21, 2009