Newspaper Article

There are two interesting articles that appeared in the press in the last couple of days. Friday's New York Times article titled "Chinese Savings Helped Inflate American Bubble" is long but instructive. It demonstrates how all nations are linked to each other in this global economy. Yesterday' Wall Street Journal included a major long article titled "The Isle That Rattled the World ". Please make sure to read at least one of these articles.

Not Quite Global Finance

Some years ago I was frequently hosting in my office a representative of one of the largest textbook publishers. The guy is no longer with this company and, yet, he felt compelled to write me for advice regarding the situation in capital markets. Here is his message:


It has been a long time. I hope you and your loved ones are doing well. I was just contemplating the repercussions of an over supply of T bills and thought you might explain what the treasury and fed can do to counter this serious problem. I thought at first the fed could print more money which may result later in hyper inflation, but I still need your opinion. Please see the Bloomberg article below:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aiw3cE2FfsLU&refer=home

Thanks for taking the time to respond.


Following is my response:
Hi:
Good hearing from you. I believe the Treasury is in a bind. Currently, it is able to sell a bunch of T-bills because of the flight-to-safety effect; investors, motivated by anxiety regarding capital markets, are more than glad to lend their money to the Treasury at practically zero interest. Should the Treasury be successful in comforting investors, interest rates will go up as they will require higher rates. At some point, to avoid too high of interest rates, the Fed will have to interfere by printing money. High inflation might follow. I was aware of this possibility in September when I moved a bunch of money into TIPS (Treasury Inflation Protected Securities) and promptly lost 7%.Markets' fear of deflation pushed down the value of such inflation-linked securities (they pay less interest when the CPI declines though their face value cannot sink below 100%). Markets have reversed themselves to a large extent. My current loss on such TIPS has declined to just 1.2%.
At my stage of life, my goal is to guard the purchasing power of my savings. I was not hyperventilating over the 7% loss because, had deflation taken place, my consumption would have cost less. In this sense, I was hedged. Since you are far from retirement and you might need the money for your daughters' education, I am not sure that long-term TIPS are for you. You may want to consider I-Bond sold directly to the public by the Federal Reserve Bank (of Richmond, given your Roanoke domicile). I believe that currently, you can do so up to $10,000 per year (down from $30,000 a couple of years ago). Your wife can purchase a similar amount.

I Hope all is well with you.

Happy New Year.

A concluding remark: my students too are invited to write me in the future when they encounter a work or personal life financial dilemmas. I am proud for granting my students five-year warranty on they finance education.

Vareity of WSJ Articles

There are several good articles that you should read in today's Wall Street Journal. Even before you get to the Money and Investments section, you should find in page A12 an article describing (for the n-th time) what the carry trade is all about (I intend to write a special entry on this). The second paragraph refers to the "policy rate". This is no other than the federal funds rate. You might recall how the FRB controls this rate (not always successfully) by lending and borrowing Treasury securities through repurchase agreements (see previous posting on repos). A similar reference to the federal funds rate can be found in page C2 ("For Dollar, December Blues").

Let's move to the Market Place section. The main item is titled: "Siemens to Pay Huge Fine in Bribery Inquiry". Corruption is a major problem in international trade. The book (Bekaert and Hodrick (p. 510) provides a short analysis of this issue. The book mentioned the Transparency International Index. Table 14.1 provides a table of Legal Systems Quality. I fail to see why these measures convey any information. For example, is the U.S. legal system more efficient than Germany because it evicts tenants faster (40 vs. 331 days) or is this a reflection of the fact that capital has more say in our country?
At any rate: The book refers to the Transparency International corruption index. In its 2008, this organization ranked Germany as number 14 in the world in terms of transparency while Argentina is 109. Is a country "transparent" because it gives rather than takes bribes? Another good source is the Global Integrity organization reporting that The wealthier G8 (Investigate!!!)countries suffer from similar corruption challenges as developing countries.
And then there is the Journal Report section whose subject today is Business Insights. Why don't you look into the Global Business article titled: "In Emerging Markets, Know What Your Partner Expects". All of these expectations have something to do with thuggery. The "pleasures" of doing business in emerging markets: first you have to look for a partner who will help you with bribery and then you are pursued by the SEC for paying bribes. Usually the "partner" is the ruler's cousin (as is often the case in Saudi Arabia) isn't that some type of bribery?

Sovereign Risk

Bekaert and Hodrick (p. 508) define sovereign risk as the risk of a government defaulting on its bonds payments (this is different from what appears on Investopedia and YourDictionary). You should read an article in today's Washington post titled:"Calling Foreign Debt 'Immoral' Leader Allows Ecuador to Default". Yesterday's Wall Street Journal also had an auricle on this subject that you might (or not) want to use for your next submission. I am using the Post's article because it relates a comment from a Moody's senior analyst. Well, less than a month ago,Moody's has downgraded Ecuador's sovereign debt but gently: it moved it to Caa1. It was only last April that Moody's still rated Ecuador as B3. At any rate, as you can read in the Post's article, investors have already taken this into consideration and traded this debt at a very deep discount (though not as bad a discount as Moody's stock which lost 75% of its value in the last two years.

The relevant chapter to read is: Chapter 14. BUT: please skip all sections that contain formulas Such as 14.2.

No Extraordinary News

I have not found something of value in today's press. I suggest you watch the Short View from yesterday about the end of the dollar rally.
In a different vein (it has nothing to do with Global Finance)read the press today about the Adventures of Mr. Madoff. The guy stole $50 billion from his customers. These customers included some of the biggest finance brains on Wall Street and, yet, they believed his record of 1.00% to 1.20% (per month ) month after month for years. This is the equivalent of offering the Brooklyn Bridge at a discount

A Common Fallacy Regarding USD "Abroad"

A Tuesday (12/9) column in the New York Times suggested the following partial solution to the current credit crunch: Give U.S. MNC corporations a tax holiday so that they repatriate their foreign retained earnings.
Many U.S. Corporations have foreign subsidiaries that do not use their earnings to pay their American parent company dividends. The writer suggests a tax "amnesty" (since these companies broke no law why is that an amnesty?) that will encourage the U.S parents to order their subsidiaries to start paying dividends. This, according to the writer, will "bring home dollars held abroad without paying corporate taxes of 35%". These extra dollars should supposedly help alleviate the credit crunch.

To understand why this argument is nonsensical you should recall that foreign subsidiaries keep their retained earnings in foreign currencies abroad. For them to bring this money back home they will need to convert it into USD. When selling their foreign currency, these corporations are going to be paid with a check drawn on a U.S. bank. The final outcome of this exercise would therefore be for ownership of these dollars (that are already deposited in a NY bank) to change. No new dollars are added to the banking system and liquidity remains unchanged.
Besides, What is the columnist talking about when he refers to a 35% tax rate? According to the U.S. Tax Code, parent owes no tax on dividends paid by a wholly owned subsidiary. Even dividends from a partially owned subsidiary are not taxed at this rate. Is there any tax accountant in this class who can help me with this?

Chinese Yuan (CHY)

A student sent me the following question:
China for some time has undertaken policies to devalue its currency (speculated to be ~15-40%) to maintain its competitive position in regards to pricing of exports. First question is does China use it reserves to maintain this artificial valuation? Secondly, the money expansion in the Chinese economy could have contributed to the free capital bubble of late; is this a reasonable conclusion?


Here is the story: Until recently, all foreign currency collected by Chinese importers had to be converted in the People Bank of China (PBC) into Yuan at a rate that most economists consider as artificially low. This favorable rate made Chinese goods over-competitive in world markets. The undervaluing policy achieved two things:
1. It kept the Chinese economy humming (full employment is extremely important to the Chinese government)
2. It allowed the People Bank to accumulate huge foreign currency reserves that it invested mostly in the U.S. (this serves as a buffer against quick capital outflow from China)
Look at the above graph extracted from Yahoo Finance. As you can see, the yuan (CHY) was convertible at the People Bank at 8.26 CHY/USD for a long period. Starting in mid 1985, due to pressure from the U.S. and Europe, the People Bank started revaluing the yuan (lower number means more value; member this?). So my answer to this student is: yes, China is maintaining its currency on what most economists consider an artificially low level. But no, it does not use its reserves to do so. It actually accumulates reserves in the process.
A note: because the current global crisis brought about a decline in demand for Chinese manufactured goods, the PBC started recently to, again, let the CHY slip in value to increase demand. It is currently trading at about 6.8563 CHY/USD

China's Currency

Today's Currency section of the WSJ has an article on the status of China's currency (Yuan or Rininmbi; two names for same currency. You may want to complement this article with a short video on the Financial Times Short View section (under the title The China Fear)

Doha Talks

There is a short note in today's WSJ relating to the Doha trade talks. Please read it and connect it with the information provided in our textbook (pp. 3-4). To enhance your understanding, you might want to use a search engine. The list of tariffs levied by the U.S. on foreign goods is just mind boggling. You can access the International Trade Commission's to inspect the list. Note that horses can be imported for free but asses require some tariff!! Likewise, a tariff of 9.9 cents/kg is levied on Brazil nuts while only 4.4 cents/kg should be paid on imported Cashew nuts.

REPO Transactions

Did you know that there is an extremely active market in which banks borrow from (lend to) each other overnight? This market is called the . Banks usually borrow in this market for one of two reasons:
1. They have reserves shortage and borrow in order to reach the reserves ratio required by the FRB (currently, this ratio (reserves to demand deposits) is 10%.
2. When they need to respond to customers' cash needs immediately and simply don't have the money.

One of the most important tools available to the FRB in controlling the money supply in the economy is by intervening in this market. For example: If the FRB aims at increasing the money supply, it should lend money to say security dealers. This loan is made by crediting they accounts in their commercial banks. Banks have now more money to lend and the money supply goes up. To contract the money supply, the FRB will call back such loans. Let's look at the cash flow associated with such a loan:



The problem is that the dealer in the above transaction may default on her loan. The Fed therefore needs some collateral. This is achieved by tailoring this loan as a repurchase agreement:



Note that if the security dealer fails to repay the loan on Tuesday (by repurchasing the securities from the FRB for $10,001,100), the FRB keeps the securities “sold” to it on Monday.

Exercise:
Do you see the similarity between this repurchase agreement and the “forward” transaction executed between Goldman Sachs and in Example 3.7 in the book? (page 89).

Leveraged Buyouts

Here is a short Tutorial about leveraged buyouts (LBO)

An LBO firm (such as Carlyle, the Apollo Group) is acting along the following line:
1. Identify a firm that is inefficiently managed (call it target)
2. Obtain a bridge loan from a bank (say $10 billion)
3. Use the loan to purchase the stock of the target in addition to $0.200 billion of its own equity
4. Once the LBO firm owns 100% of the target's equity, it makes it borrow A LOT (say $9.8 billion)
5. The LBO firm makes target pay it a dividend of $10 billion
6. The LBO firm repays the bank
Final result:
The LBO firm invested $200 million in a highly leveraged target.
If target does well, the LBO firm is bound to double or triple its money. This is usually carried out by selling the levered company to a third party or by selling it in a public stock issuance. If the opposite is true, the target will go bankrupt and the LBO is not likely to recoup its $200 million investment.
A relevant articles from the WSJ are: "The Bell Tolls for Private Equity" and "Appollo VI Faces a a Bumpy Landing"

Where else can the process fail?
By the time the takeover deal is finalized, the bank may withdraw the bridge loan leaving the LBO firm in hot waters.

Foreign Direct Investments

Definition
This term appears in Chapter 1 that I requested you read before our first meeting. As you may recall from this chapter (p. 15) FDI occurs when a company makes a significant investment that leads to a significant ownership (usually >10%) of a company in another country.
Example
BMW establishes a manufacturing facility in South Carolina. It establishes a fully-owned U.S. subsidiary and invests money in it.

In contrast:
Portfolio Investment is an investment that does not result in influencing the foreign company. (see page 119)
Example:
A U.S. mutual fund buys 5% ownership in a Japanese company.


How significant is FDI?
Exhibit 1.6 in the book is supposed to inform us that FDI is really important. Problem is, unless you are a developmental economist, the term in this table make no sense to you (what is the difference between FDI inflows and FDI inward flows for example?). To point out the importance of DFI, I refer you to a very important publication: The Federal Reserve Bank’s Flow of Funds Accounts of the United States. In page 30 of this publication you will find (Line 36) that in the first two quarters of 2008, foreign residents poured $696.8 billion into the U.S. in the form of DFI while, from line 56, you may learn that during the same two quarters U.S. residents invested $618.60 billion abroad. In sum, we are talking big bucks here.

Argument in favor of FDI (bottom of page 27)
1. Allocative efficiency (is that English?). Employing capital when it is most
productive.
This is nothing but a code word for employing labor where it is cheapest.

2. Technology spillover. Proponents claim that when U.S. companies manufacture in China, the host country gain access to U.S. technology not available to China.
Why is that good? Usually, host country operators will sooner or later confiscate this new technology and compete with the U.S. directly.

3. Additional savings Missing from the book is an obvious argument: to sell in Thailand for example and avoid shipping cost, you may want to establish a plant in Thailand.

Before committing to any FDI, the risk associated with such investments should be fully understood. This risk is usually referred to as country risk (the whole of Chapter 14 is dedicated to this subject. READ IT!!!)

Country Risk is usually divided into two components:
a. Political risk
i. Probability of nationalization. See the case of how Exxon has been kicked out of Venezuela. So the book’s claim that “outright expropriations have been rare in recent times” is somewhat outdated. You may also want to learn about the travails of BP in Russia
ii. Contract repudiation. See examples in the book (page 509).
iii. Taxes and egulations. In addition to the examples in the book, see yesterday’s WSJ article (12/6/08) about how the Indian tax authority decided to levy a $2 billion retroactive capital gains tax on Vodafone.( “Vodafone's Tax Bill to Slow Deals in India”)
iv. Exchange controls
v. Ethnic unrest
vi. Home country restrictions

b. Economic/financial risk
See factors in page 508 in the book.

What Are They Talking About?

Today's Journal contains an article (Lehman's Demise Triggered Cash Crunch Around Globe). Many in the press and the finance community blame Credit Default Swaps (CDS) for the current travails of capital markets. The article reports that Fed (FRB) has been pushing Wall Street for month to establish a clearinghouse for CDS. This means that unlike the current situation, all such contracts will have to pass through a central body that will record them. This will enable the Fed to, first, have a general picture of what is happening in this field and, second, allow it to regulate it.
Recall: CDS are in essence insurance contracts. Like all insurance types they make sense only when the risk is non-systemic. To understand this, consider home insurance. The insuring company will be able to honor it when the risk is non-systemic. But if a giant hurricane is going to hit the whole U.S. at once (systemic disaster) all insurance companies will fail to honor their obligations. The same holds true for credit insurance. In normal times when a few companies default on their loans in a random manner, credit swaps on such companies will be honored. But what happens if the economy hits a bump and thousands of companies default on their loans? So, I really don't understand how regulation could have prevented the current crisis.
The only way top remove the risk of systemic failure of the CDS market is to ban this type of contract altogether.

Covertible bonds

I recommend you read yesterday's WSJ article "Short-Sale Ban Wallops Convertible-Bond Market" It might serve you in both my forthcoming exam (it falls under the Bond Classification subject) and the derivatives class.
Make sure you understand the claim regarding who issues such bonds and the statement that 75% of convertible bondholders also go short on the stock of the bond-issuing company. Obviously, without knowing what a short sale is, this article will make no sense to you. So if you are a bit hazy about this sale, look it up on the Internet.

Debt Market Distress Spreads

An article in today's Wall Street Journal provides a description of the commercial paper market and its recent upheavals. Read it!!!

Toxic Mortgage Pools

You probably heard a description of the recently proposed $700 billion rescue plan as cash for trash. This plan calls for the Treasury to purchase from financial institution mortgage backed security that are completely illiquid; nobody want to buy them. You may want to ask why is that that these securities are untouchable. The answer lies in the uncertainty surrounding the cash that will ultimately will flow from them. As more borrowers whose mortgages are part of the pool default, the less is the payoff from the securities backing the pool. This is not a problem for conventional (or prime) loan whose cash flows are now guaranteed by the U.S. Treasury. Subprime loans that were securitized by private banks are at risk; they are not protected from borrowers defaulting.
Yesterday's New York Times had an EXCELLENT description of the toxicity of one mortgage pool. Please read this article titled "Plan’s Mystery: What’s All This Stuff Worth?" Make sure to examine carefully the multimedia table in this article.
Once you read this article, you will be able to understand why (in my opinion) the $700 billion rescue plan will reap off the tax payers. Suppose a bank is currently holding securities from two different pools:a high quality Pool I and a low quality Pool II. The bank cannot get rid of either one of them because buyers believe that the bank will try and get rid of the bad pool first. George Akerloff was awarded a noble prize (2001) for this idea (he titled his article "The Market for Lemons"). Enter the cash for trash program: the banks can now sell to the Treasury either the Pool I or the Pool II security. Which one do you think the Treasury is going to end up owning?

Is The Crsis Winding Down?

The DJ Industrials average closed today some 400 points up. Do market believe that the worse is over?
many commentators argue that there is at times a dichotomy between the bond and the stock markets. The bond market "predicted" the current crisis by demanding historically high risk premiums on LIBOR and on junk borrowings. It is my view that the bond market is more "rational" because fewer small investors play this market. I would wait to see if the other shoe (commercial real estate, Credit card ABS) drops before passing judgement.
At any rate, my suggested reading for today is Steven Levitt's blog in the New Your Times titled "Diamond and Kashyap on the Recent Financial Upheavals"

The AIG Crisis

9/17/08
These are momentous times. Current events in the fixed income area may paralyze the world’s economy and push it eventually into a deep recession. This is not a forecast but rather one of several potential scenarios.
I could elaborate in person on current events. Fortunately, because of the centrality of fixed income securities in the current crisis, better persons than me comment on the situation and it is my pleasure to refer you to several excellent sources:
1. In today’s New York Time read “Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis” In particular, examine the Multimedia chart in this article titled “AIG Troubles and Why They matter”. You should review the concept of Credit-Default Swaps that I discussed in an earlier posting.
2. The front page from today’s WSJ (print!). The article titled “U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up” mentions the fact that even money market funds are no longer safe. This means that for the first time in two decades, investors who park their cash in a MM funds can actually collect less than 100% of what they deposited. In short: their buck may break.
3. You should also listen to an excellent interview conducted today with Professor Michael Greenberg, (a U. of Maryland law professor) on Fresh Air – an NPR podcast. It takes 38 minutes to listen but it’s worth it.

To me the most worrisome development is that banks stopped lending to each other. This may have happened either because banks don’t have excess reserves or because they don’t trust each other.

Last: it is easy to forget but the FNMA-Freddie Mac dominated the news only a week ago. Are you sure you can describe the nature of the business conducted by those two institutions?

The Financial Markets Crisis

In my most recent posting, I elaborated on the murkiness of the default-credit swap market and pointed out the risks involved. In page 8 of today's Section C (The WSJ)there is an excellent article making the same point: "Credit-Swap Players Puzzle Over Fan-Fred Fallout" I suggest you read all parts of the newspaper today. In a way this crisis can be a positive development. Lehman Brothers is sunk because it revealed that its mortgage security holdings are worth only 39% of their face value. Many other institutions will have to take a similar bath now (marking their investments to market). This will encourage investors to step in knowing that 39.000 is probably a fair price. Reality may however refute this optimistic view.
Life has never been so interesting in the fixed income securities area.

Credit Default Swaps

1. What is a Credit-Default Swap?
I am going to make my life easy today. I have found a WSJ blog explaining exactly what I had planned to write about: bond insurance. The blog posting is titled “The Vicious Circle” . I would like to emphasize the paragraph to the left of the graph:
“The credit-default swaps, a measure of protection against default, have exploded. Today it costs $1.2 million, along with $500,000 annually, to protect $10 million in bonds against default, compared with $680,000 on Thursday, according to Phoenix Partners Group.”
A credit swap is a put on a bond. The trigger is a default event. Let me give you an example using the numbers in the above paragraph: Suppose I hold $10 million AIG bonds and wish to protect myself against this bond defaulting. I can buy such insurance by: paying $1.2 million upfront plus an annual premium of $500,000.
The question is why is that contract called a swap? The answer is that if default occurs, the insured can swap the bond with the insurer for its face value of $10 million.
Note: this swap has very little in common with interest rate or currency or equity swaps.

2. Why Are Credit-Default Swaps So Important?
When two counterparties enter a credit default agreement, they do not have to report this agreement to anybody. According to some estimates, credit-default swaps have been written on bonds with more that $60 trillion. This amount is a multiple of the amount of actual bonds outstanding in the U.S. (Government and private). It is reasonable to assume that many of these swaps have been entered for speculative purposes (if you bought such swap on AIG last week you could sell it this year at a huge profit).
Now, several financial institutions hold bonds that lost a lot of their market value but have not, as yet, defaulted. These bonds appear on their books at 100% of face value because, on the face of it, they are insured, or rather, “insured”. Nobody knows if the insurer (who can be AIG or a hedge funs or a bank) will be capable of making its commitment whole in case of default.

Credit market column-more on LBO

The previous posting described the general structure of an LBO transaction. Today's Credit Markets (http://online.wsj.com/article/SB122113907477223393.html) column in the Journal touches upon the effects of the current credit crunch on LBO transactions. You might recall that private equity firms secure a bridge loan from banks prior to actually "LBOing" a target firm. The article discusses what happened when two private equity firms (Thomas Lee Partners and Bain Capital- not mentioned in this article) took over Clear Channel Communications (CCC - http://www.clearchannel.com/). Part of the bridge loan agreement (also known as the credit agreement) written at that time, required CCC to issue $1,400 million ($14 billion) in junk bond aimed at retiring the bridge loan. Unfortunately, the market refuses to buy these bonds at the current situation and the bonds have to be issued in chunks. The current intended chunk is $980 million. Even when these new bonds were discounted to 70% of face value, the underwriters who market these bonds for CCC were able to find buyers for only $228 million.

What are the implications of this inability to sell these junk bonds? CCC cannot repay the bridge loan. Most bridge loan agreements prevent the lending bank (or syndicate) from suing the private equity firm so the banks are stuck with a huge loan that was meant to be short-term in nature. The numbers are staggering: as you can learn from this article, banks are stuck with $48 billion of bridge loans that carry relatively low interest rates.

The Saga of CCC is long. You can go for example to a previous June 14 Journal article (http://online.wsj.com/article/SB121336291248771553.html). I am quoting from article so that you can familiarize yourself with the concept of PIK or toggle bond.

“The $2.31 billion of Clear Channel bonds are split between a pay-in-kind toggle note, which allows a company to make interest payments in debt rather than cash. Such a bond is risky for investors because, should the company run into trouble and go bankrupt, it has the potential to leave them with more debt and lower recoveries.”

Private Equity Firms

9/10/08

To All Fixed Income/ Interest Rates Students:

I would like today to discuss the activities of private equity firms.

A pretty good summary of the activities in which these firms engage may be found in Wikipedia (http://en.wikipedia.org/wiki/Private_equity), namely: Leveraged buyout (LBO-remember this acronym!!!), venture capital and growth capital. I would like to briefly concentrate on the LBO issue that is not illustrated very well by the Wikipedia page (http://en.wikipedia.org/wiki/Leveraged_buyout). The following description of the LBO process is a general scheme and may have other variations. In essence the process entails finding other people to pay for the deal while keeping all the upside potential from equity ownership of the Company.

Step 1: The private equity firm (“the Firm”), identifies a target with (preferably) the characteristics described by Wikipedia. The Firm thinks that it is a good idea to take over the Firm because of the following potential advantages:

a. The Firm judges the Company's management lacking.

b. The Firm owns other companies with potential synergies with the Company under consideration

c. The Firm judges the Company as underleveraged. The more the leverage the more the tax advantage (Modigliani-Miller)

d. The Firm hopes it can find a lot of suckers that will help it take all the risk while accepting low returns.

Step 2: The Firm identifies a bank (or a syndicate) that will be willing to provide it a bridge loan. This loan is intended to help the Firm to pay for the purchase of ALL the Company shares until new suckers are found.

Step 3: Approach the Company’s management (and board) and convince them to approve of the takeover at a premium over current market price.

Step 4: Once agreement is reached, the Firm purchases all shares in the Company with money provided by the banks in Step 2.

Step 5: Once the Company is fully owned by the Firm, it issues a large amount of new debt. Because this debt comes on top of older, pre-LBO, debt it usually offer high interest and fall into the junk bond (=high yield bond = below-investment-grade bond) category.

Step 5: The Firm makes the Company pay most of the proceeds from the new bond issue in dividends to itself (the Firm)

Step 6: The Firm repays the bridge loan from the dividend money. In many cases the dividend amount exceeds the bridge loan amount. After paying the bridge loan, the private equity Firm already has some “free” money in its coffers.

Step 7: If the Company does well, the Firm can re-sell it (to another private buyer or even back to the public (reverse LBO!) and pocket the selling price (it doesn’t owe anything to the bondholder, the Company does).

If the Company does not do well, it can go bankrupt and taken over by the bondholders or even be liquidated. Although this may deprive the Firm from additional profits, it doesn’t suffer any out of pocket cash losses if this happens.

A few asides:

1. When the Company is made by the Firm issue additional debt, the situation of the original bondholders is worsened (say the interest coverage ratio of the firm goes down from 2 to 1). These original bonds lose value. Since this is all a zero-sum game, who is gaining this value? Answer: the Firm.

2. Issuing additional bonds is not the only way in which the deal can be financed. In recent years, leveraged loans (high-interest loans granted by banks) became popular. Not surprisingly, more than a few such loans became virtually worthless in recent months. The lending banks had to take a bath on this account as well.

Read the following article from yesterday’s WSJ (http://online.wsj.com/article/SB122091910239912651-email.html)

Think about the following: At what Step did this deal go wrong?

April 11, 2008

Please Read the Trillion Dollar Meltdown