But what was actually going on in the interior of the stock market was nightmarish. All of the checks and balances which ordinarily discipline the free market in money instruments and capital securities were being eviscerated by the Fed’s actions; that is, the Greenspan Put, the severe repression of interest rates, and the recurrent dousing of the primary dealers with large dollops of fresh cash owing to its huge government bond purchases.
This kind of central bank action has pernicious consequences, however. By pegging money market rates, it fosters carry trades that are a significant contributor to unbalanced markets. Carry trades create an artificially enlarged bid for risk assets. So prices trend asymmetrically upward.
The Greenspan Put also compounded the one-way bias. For hedge fund speculators, it amounted to ultra-cheap insurance against downside risk in the broad market. This, too, attracted money flows and an inordinate rise in speculative long positions.
The Fed’s constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By pegging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and rehypothecated existing securities; that is, pledged the same collateral for multiple loans.
The Fed’s peg on short-term rates thus fostered robust expansion of the shadow banking system, which as indicated previously, had exploded from $2 trillion to $21 trillion during Greenspan’s years at the helm. This vast multiplication of non-bank credit further fueled the “bid” for stocks and other risk assets.
Fear of capital loss, fear of surprise, fear of insufficient liquidity—these are the natural “shorts” on the free market. The paternalistic Dr. Green-span, trying to help the cause of prosperity, thus took away the market’s natural short. In so doing, he brought central banking full circle. William McChesney Martin said the opposite; that is, he counseled taking away the punch bowl, thereby adding to the short. Now the punch bowl was overflowing and the short was gone.
Speculators were emboldened to bid, leverage their bid, and then to bid again for assets in what were increasingly one-way markets. As time passed, more and more speculations and manipulations emerged to capitalize on these imbalances.
“Growth stocks” were always a favored venue because they could be bid-up on short-term company news, quarterly performance, and rumors of performance (i.e., “channel checks”). During these ramp jobs, which ordinarily spanned only weeks, months, or quarters, traders could be highly confident that the Fed had interest rates pegged and the broad market propped.
Financial engineering plays such as M&A and buybacks came to be especially favored venues because these trades tended to be event triggered. Upon rumors and announcements, these trades could generate rapid replication and money flows. Again, speculators were confident that the Fed had their back, while leveraged punters were pleased that it had seconded to them its wallet in the form of cheap wholesale funding.
At length, the stock market was transformed into a place to gamble and chase, not an institution in which to save and invest. Since this gambling hall had been fostered by the central bank rather than the free market, it was not on the level. That means that most of the time most of the players won and, as shown below, the big hedge funds which traded on Wall Street’s inside track with its inside information won especially big and unusually often.
Needless to say, frequent wins and hefty windfalls created expectations for more and more, and still more winning hands. As the Greenspan bubbles steadily inflated—both in 1997–2000 and 2003–2007—these expectations morphed into virtual Wall Street demands that the Fed keep the party going. Wall Street demands for a permanent party, at length, congealed into the presumption of an entitlement to an ever rising market, or at least one the Fed would never let falter or slump.
Finally, this entitlement-minded stock market became a blooming, buzzing madhouse of petulance, impatience, and greed. Cramer embodied it and spoke for it. By the time of his rant, the Fed had become captive of the monster it had created. Now, fearing to say no, it became indentured to juicing the beast. After August 17, 2007, there was no longer even the pretense of reasoning or deliberation about policy options in the Eccles Building. The only options were the ones that had gotten it there: print, peg, and prop.
DEAL MANIA I: THE RISE OF “CHASE AND CRASH”
One of the great ironies of the Greenspan bubbles was that the free market convictions of the maestro enabled the Fed to drift steadily and irreversibly into its eventual submission to the Cramerite intimidation. It did so by turning a blind eye to lunatic speculations in the stock market, dismissing them, apparently, as the exuberances of capitalist boys and girls playing too hard.
By the final years of the first Greenspan bubble, however, there were plenty of warning signals that there was more than exuberance going on. Hit-and-run momentum trading and vast money flows into the stocks of serial M&A operations were signs that normal market disciplines were not working. Indeed, the M&A mania was a powerful indictment of the Fed’s prosperity management model.
These hyperactive deal companies with booming share prices were being afflicted ever more frequently with sudden stock price implosions that couldn’t have been merely random failures on the free market. Yet, as in the case of the subprime mania, the central planners undoubtedly read the headlines about these recurring corporate blowups and never bothered to connect the dots.
The WorldCom train wreck of 2001, for example, was as much a consequence of Bernie Ebbers’ penchant for serial M&A as it was the result of his desperate efforts to cook the books when his deal making failed. Years of overpaying for acquisitions and the incurrence of massive debts finally came home to roost when WorldCom announced a shocking $20 billion goodwill write-off in the spring of 2001. Celebrated for years by the financial press for its prowess in deal making and as a pioneer in the deregulated long-distance phone market, the stock imploded on the spot. It had been a debt-ridden house of cards all along.
The two telecom equipment flameouts of that era, Nortel and Lucent, had also been hotbeds of serial M&A. In the short span between April 1998 and late 2000, for example, Nortel had completed nearly two dozen deals valued at more than $30 billion. Not to be outdone, Lucent had executed a new deal almost every month during the same period, racking up $44 billion in total M&A transactions in less than three years.
Yet after the 2001 crash landing of these two telecom equipment giants, any residual value from this barrage of acquisitions was hard to find. By September 2002, for example, Lucent’s market cap had plunged to just $4 billion, meaning that its three-year spree of M&A deals were being valued at essentially zero after giving even minimum value to its massive base of assets, customers, and technology inherited from its prior one-hundred-year history as Western Electric.
Likewise, Nortel’s market cap peaked at $400 billion. Twenty-four months later it crashed and burned, its market cap reduced to a $5 billion rounding error. Again, Lucent and Nortel had not been shooting stars off the pink sheets or highflyers inhabiting the margins of the economy. They were the giant former equipment divisions of the Bell Telephone monopolies in the United States and Canada, and had $60 billion of sales and 200,000 employees between them.
As monsters of the deal maker’s midway, they had dominated financial TV and were omnipresent in the investment banking and trading precincts of Wall Street. So when they imploded in a sudden, fiery crash, it was a sign that something was haywire in the stock market.
Still, the ultimate monument to the merger mania which became pandemic by the end of the first Greenspan bubble was the JDS Uniphase acquisition of SDL. The deal had been announced on July 10, 2000, a date which was virtually the high noon of the tech frenzy. At that moment the market cap of JDS Uniphase was $90 billion and it paid $40 billion for SDL.
Soon thereafter, however, the market value of
the combined firms deflated so rapidly and violently as to evoke Ross Perot’s famous “sucking sound to the south.” By early 2002, the post-merger company traded at just $2 billion, meaning that 98 percent of its high-noon market cap had been wiped out. What had been advertised at the time as the largest M&A deal in tech industry history had, in fact, been a merger of bottled air all along.
THE GREENSPAN PUT AND THE DEFORMATION OF M&A
The first Greenspan bubble provided fair warning about the dangers of rampant financial engineering. This unprecedented wave of M&A had not only supplied rocket fuel for the final stock market blow-off, but also had frequently generated the flaming mishaps mentioned above; that is, failures too ludicrous to be chalked up as ordinary business mistakes on the free market.
In fact, the Wall Street coddling monetary régime which became institutionalized during the Greenspan era had deeply transformed M&A. What had traditionally been a limited tool of corporate business strategy became an all-encompassing mechanism for speculative finance. It generated a steady diet of windfalls for takeover speculators and generous exit stipends for the top executives of target companies. On the other side of the table, top executives at acquiring companies obtained a mechanism to build empires, stock options, and an interval of apparent, if unsustainable, earnings growth.
Another attribute of this new-style financialized M&A was also critical; namely, that it put paid to the idea that there existed an honest “market for corporate control.” Irrationally high takeover premiums, giant golden parachutes for target company executives, blatant abuse of merger accounting reserves, and spectacular crash landings of M&A empires like WorldCom and Lucent were evidence of an excess supply of takeover finance, not an abundance of undervalued corporate assets.
By the late 1990s, M&A had more often than not become an instrument of corporate value destruction. Companies were routinely paying such huge takeover premiums as to preclude any reasonable probability that they could be earned back through synergy. Yet the free market failed to arrest this spree of value destruction because its natural checks and balances were disabled.
As in so many other venues, monetary distortion was the culprit. During the final forty-month interval leading up to the April 2000 stock market peak, the Fed fostered a speculative environment on Wall Street that rivaled the late 1920s. The S&P 500 index doubled and NASDAQ quadrupled. At the same time, the Fed’s panicked response to the LTCM crisis in September 1998 left no doubt that downside risk had been sharply neutered by the Greenspan Put.
Given this febrile environment, it is not surprising that deal making quickly became nonsensical and reckless. Empire-building CEOs in the tech, telecom, finance, and diversified sectors, among others, had little reason to fear that their stock prices would be punished owing to dilution from overpaying for acquisitions. Potential hits to earnings per share were being obfuscated by short-term “accounting benefits” from merger reserve kitties and wildly expanding PE multiples.
Owing to Wall Street expectations that the Fed wouldn’t allow the market to falter, the damage from rampant financial engineering remained hidden below the surface. The normal disciplinary forces of the free market were thus disabled, even as the runaway M&A spree was heralded as an expression of free market vigor.
In the late 1990s professor Mark Sower of Columbia University published a startling finding from an extensive study of M&A deals; namely, that 65 percent of large mergers destroyed shareholder value: “Clearly this negative evidence raises serious doubt over the value of the takeover market as a mechanism for disciplining poor-performing or self-dealing managers as proposed by the market for corporate control hypothesis.”
That was a heavy-duty proposition because it stripped corporate takeovers of their beneficent aura. The dislocations visited upon takeover targets were supposed to generate efficiency gains, improved asset utilization, and other economic synergies which would yield higher profits. Yet if shareholders of acquiring companies in the main do not benefit from M&A deals, then takeovers are just a random generator of unearned rents.
This goes to the very heart of bubble finance: it took M&A out of the toolbox of corporate asset management and transformed it into a thundering stampede of Wall Street rent seeking. In fact, the huge “announcement” gains in takeover stock prices are exactly the type of capricious windfalls generated by casinos, not honest capital markets. On the evidence, therefore, Wall Street became a veritable geyser of unearned M&A rents during the bull market top of 1998–2000, a pattern which would repeat itself in 2005–2007.
That most M&A deals fail was taken as a given by the Wall Street cynics who practiced the merger trade. But as that truism became evident in the 1990s M&A takeover spree, it posed an acute challenge to Greenspan’s own doctrine, under which it was axiomatic that the free markets could not be wrong two-thirds of the time.
The monetary central planners in the Eccles Building did not resolve this contradiction, or even acknowledge that the eruption of M&A was destroying value, not expressing free market impulses. Instead, they embraced the merger wave because their prosperity management model required that stock prices be levitated at all hazards.
DENNIS KOZLOWSKI: BUBBLE FINANCE PERSONIFIED
The Fed should have been embarrassed by the M&A frenzy, and Dennis Kozlowski was striking evidence of why. He had been Wall Street’s favorite 1990s deal maker and master builder of Tyco International Ltd., a confection of serial M&A deals which put AOL Time Warner, WorldCom, and the rest of the corporate deal junkies to shame.
On their face, Tyco’s facts were absurd. Between 1992 and 2002, for example, it completed upward of one thousand M&A deals worth a stunning $70 billion. The result was a motley hybrid: part deal machine, part closed-end mutual fund, and mainly a hodgepodge of cast-offs and orphans from throughout corporate America.
When this pell-mell acquisition spree caused Tyco’s reported sales to soar from $7 billion in 1997 to $34 billion by 2001, the 50 percent per annum rate of sales growth did not signify that underperforming business assets were being recycled to better and more efficient uses. Instead, it showed that Tyco was a whirling dervish of financial engineering that had no plausible business justification.
In fact, its real purpose was providing a vehicle for absorbing the powerful waves of Wall Street speculation unleashed by the Greenspan Fed. The hapless Dennis Kozlowski didn’t create Tyco International; Wall Street did, stampeded by speculators who had come to believe that the Fed would never let the party fail.
Indeed, the veritable explosion of Tyco’s stock price after the mid-1990s was proof positive that the Greenspan stock market bubble was rooted in a monetary deformation. Tyco was the very embodiment of an anti-dotcom enterprise: a prosaic assemblage of old-economy businesses which on an organic basis grew at less than 3 percent per year by the company’s own reckoning. Yet its stock price soared from $25 per share in early 1994 to a peak of $250 per share in January 2001.
This tech-style 10X gain in its share price was not due to a commensurate explosion of profits. What did explode was the company’s valuation multiple. The latter rose from 17X EPS in 1994, which was already too generous for an industrial conglomerate, to a peak of 67X in late 1999, which was pure madness.
At that point, the stock market was obviously turning a blind eye to the warning signs emanating from virtually every pore of the company’s balance sheet. Between 1994 and 2001, for example, the company’s $500 million of debt soared to $43 billion, meaning that its debt burden grew ninety-fold in seven years. Not surprisingly, its goodwill zoomed from $1 billion to $40 billion, reflecting the company’s chronic overpayment for acquisitions, while its tangible shareholder equity went straight south, reaching negative $20 billion by the end of 2001.
Kozlowski ended up the chump whose visage in the pantheon of America’s greatest CEOs was removed at a speed rivaling that of politburo portraits in Stalinist Russia. After a hurried do over by the financial press, Kozlowski was rechristened as t
he rogue CEO who stuck his shareholders with $6,000 shower curtains and a $2 million birthday party on Sardinia featuring an ice sculpture of Michelangelo’s David urinating Stolichnaya vodka.
The true sin in the matter, however, was a financial environment that carried Tyco’s market cap to $125 billion by 2001, when it was plainly a disheveled trunk of pots and pans from America’s industrial pawnshop, led by a crude schemer who couldn’t resist the bait. The bait, of course, was the kind of bull market hagiography which put him on the cover of Business Week in 2001 as America’s most aggressive CEO.
Needless to say, the deflation of Tyco’s wildly bloated stock value came fast and furious. By the time Kozlowski was forced out in June 2002, the company’s market cap stood at only $25 billion. More than $100 billion of market cap had vaporized in less than six months.
That kind of violent repricing does not occur on the free market, and wasn’t owing to the discovery that some of Kozlowski’s pay and perks had not been diligently vetted by the board. Rather, Tyco was the poster boy for Greenspan’s first stock market bubble and its sudden, violent demise was a wake-up call that was wholly ignored.
WHEN MOMENTUM TRADERS STRIPPED CEW FROM THE LAND
The Fed’s frenetic interest rate cutting and renewed commitment to the Greenspan Put after December 2000 generated another spree of financial engineering. In all three variations, buybacks, buyouts, and M&A takeovers, the common effect was equity extraction from the business sector. However, unlike the case of mortgage equity withdrawal by households, where the cash windfall was distributed widely across the middle class, corporate equity withdrawal resulted mainly in cash distributions to the very top of the economic ladder. In generating a cornucopia of CEW, therefore, financial engineering functioned as the ATM of the prosperous classes.
That CEW went overwhelmingly to the bank accounts of the wealthy is a balance sheet given. By the end of the first Greenspan bubble, about 80 percent of financial assets were owned by the top 10 percent of households, which therefore got at least 80 percent of the cash from buyouts and buybacks. In fact, far more than a proportionate share went to the top, and even then the windfall was not so egalitarian in the manner in which it was whacked up among the affluent classes. Among the 10 percent at the top, it was the 1 percent at the very top who got the lion’s share of the CEW.
The Great Deformation Page 66
