[PEN-L:27377] Good analysis of WCOM and Credit Bubble

[Steve Diamond <sdiamond@xxxxxxx>]

>From Doug Noland's Credit Bubble Bulleting today - note the explanation of
how the credit advanced to WCOM inflated values in a broader sector of TMT
companies:

The escalating crisis in the "risk" market expanded to, in the words of
hedge fund manager and statesman George Soros, "a crisis situation. The
international financial system is coming apart at the seams."  Certainly, a
week where fraud is revealed at industry heavyweight Worldcom, Adelphia
Communications files bankruptcy, and Xerox reveals enormous accounting
improprieties, it is writing the obvious to state that the unfolding
financial crisis made a major onslaught from the "periphery" towards the
fragile "core."


WorldCom and Adelphia combined for about $50 billion of debt.  The list of
domestic and international banks, insurance companies, pension funds, mutual
funds and investment firms that announced investment losses this week is
long and diverse - from the estimated $1.6 billion exposure of state
governments to the billions spread amongst the insurance and banking
communities.  Let there be no doubt, the wrecking ball that has been
chipping away at confidence has finally broken off a large chunk.  Bloomberg
quoted the treasurer for the state of Iowa: "Public confidence is sinking,
and so is the confidence of every institutional investor out there. Who's
watching the guys at the top?  They are proving to be bald-faced liars."  We
can only hope that our foreign creditors do not share such sentiments.

Interestingly, the major money center banks, JPMorgan Chase, Citigroup, and
BankAmerica apparently have only minimal direct exposure to WorldCom.  An
analyst from Standard and Poor's stated, "Actual outstanding loans are small
and, for the most part, covered by credit default swaps."  Credit Suisse
First Boston even went so far as to issue a report yesterday titled, "WCOM:
Non-Event: Another Reason Why Banks Remain a Safe Haven."  "...You take a
step back and come to realize that this, along with Enron, is another highly
visible data point that confirms the pronounced shift in corporate finance
activity away from the commercial banks to the capital markets."


As systemic risk rises by the day, such thinking is the ultimate in
rose-colored "analysis."  The problem is that the capital markets have come
to dominate the Credit mechanism, while in the process grossly over-financed
a Bubble economy. The natural tendency of markets to cycle between extremes
of expansive euphoria and contractionary revulsion is especially problematic
when it comes to Credit.  We will now see the downside of the cycle with
tightening Credit conditions enveloping the economy, albeit in an atypical
(Chinese water torture-style) sector-by-sector process.

As long as Credit excess and resulting asset inflation is maintained within
a particular sector, underlying structural distortions grow yet remain
largely hidden and unproblematic.  Granted, the great experiment in
structured finance has thus far fueled a spectacular telecom/technology -
"The Communications Arms Race" - boom and bust with risk largely residing
outside of traditional bank lending.  But this is certainly not the time to
be whistling past the graveyard.  This week, perhaps for the first time,
market participants began to appreciate that the Wall Street telecom Bubble
was indeed a case of Mutually Assured Destruction with potentially dire
systemic consequences.


WorldCom had $21 billion of revenues last year and basically the same amount
of expenses.  Unlike Enron, it had grown into a significant player in the
real economy.  When WorldCom and the rest of telecom industry had basically
unlimited access to finance, they would borrow and spend aggressively,
fueling growth across a broad spectrum of suppliers from equipment makers to
media companies to consultants (not to mention investment bankers,
attorneys, accountants, and stock brokers).  Throughout the boom, telecom
borrowings fed directly to the general media Bubble, with surging
advertising dollars fueling extreme price inflation in radio, television,
billboard, magazine, Internet, cable, wireless, professional sports, and
advertising agency franchise values.  A dollar of WorldCom borrowings could
be "leveraged" many times over as it created a multiple of franchise "value"
as revenue for, say, a local radio advertisement.  These inflating asset
prices then provided additional collateral for aggressive borrowing and
spending.  This broad sector became a key monetary transmission mechanism to
the real "service sector" economy.  Today, this mechanism is faltering
badly.

Ultra-easy Credit availability and inflating asset prices fed a powerfully
self-feeding race to acquire communications and media properties.  Wall
Street provided the likes of WorldCom, AT&T, Sprint, Qwest, SBC
Communications, and Verizon with blank checkbooks for acquisitions and
system build-outs.  Clear Channel communications was able to borrow
aggressively and acquire radio and television stations, as well as
billboards and other media assets.  Viacom borrowed and paid up for
television stations and media properties.  Outfits such as Lamar Advertising
were allowed easy access to funds to aggressively acquire advertising
billboards, while others bought video stores and the like. Nextel used huge
amounts of borrowings to acquire radio licenses and franchises, making
scores of "mom and pop" radio operators wealthy along the way.  Six Flags
acquired amusement parks and Speedway Motorsports purchased and developed
racing venues.  Companies such as Comcast and Charter Communications took on
huge amounts of debt to acquire and develop cable franchises.  Interpublic
Group and Omnicom were able to borrow aggressively and acquire advertising
agencies and marketing firms. Entertainment conglomerates such as AOL Time
Warner and Viacom had easy access to finance myriad acquisitions.
Throughout the boom, it all really did have the seductive illusion of wealth
creation.


Fortunes were being made throughout, be it the individual or company selling
out to the acquisitive, as well as the equipment supplier, stockholding
manager, investor, speculator or investment banker. Rules and conventions
were bent to accommodate the game of egregious borrowing and acquisition,
and it is no coincidence that the most aggressive players had become the
most ardent proponents of EBITDA (earnings before interest, taxes,
depreciation and amortization) as a (flawed) measure of cash flow.  But this
historic Bubble is now bursting, and an expanding number of leveraged
companies are losing access to additional finance.  The leading subscribers
to EBITDA are today leading bankruptcy candidates. This week the debt crisis
jumped the fire line.

The issue today is the confluence of a massive amount of corporate debt,
fragile debt structures, and the especially weak nature of the
cash-generating capability of many underlying businesses.  The market is
beginning to appreciate the dire consequences for what will certainly be a
protracted Credit crunch throughout the telecom/media/entertainment
super-industry. This area is anything but inconsequential to a vulnerable
U.S. financial system, and it has over the life of the boom become a
meaningful segment of the distorted U.S. economy.


Asset Bubbles function poorly in reverse.  Huge Bubbles burst.  Things are
destined to turn quite problematic with the commencement of much tighter
Credit conditions and the resulting declining franchise values throughout
the arena of radio and television stations, billboards, professional sports
organizations, cable systems, advertising agencies, consulting firms, and
various related media properties.  Many asset values are based on an overly
optimistic extrapolation of boom-time revenue and earnings growth. Yet too
often these enterprises are little more than a creation of extreme monetary
expansion.  The Reality of the Unfolding Credit Crunch will be anything but
industry growth, and the uncovering of the gaping hole between optimistic
boom-time extrapolation and post-Bubble contraction will be like the shock
of jumping from the hot tub into the unheated swimming pool.  The true
underlying economic value of many of these types of assets in a post-Credit
Bubble environment will be a major issue going forward.  As is the case with
WorldCom, many businesses are left with little value when the money spigot
is turned off.  As Dr. Richebacher has always brilliantly stressed, asset
Bubbles destroy wealth not create it.  The banking system will not be
immune.


Stephen F. Diamond
School of Law
Santa Clara University
sdiamond@xxxxxxx