Second Short Quiz Suggested Answers

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johnkarls
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Joined: Fri Jun 29, 2007 8:43 pm

Second Short Quiz Suggested Answers

Post by johnkarls »

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Introductory Note =

The First Short Quiz focused, inter alia, on the fact that, in general, commercial banks do NOT make loans to American business and they do NOT make mortgage loans to American homeowners (as distinguished from originating mortgage loans which they immediately sell to Fannie Mae, Freddie Mac and/or the U.S. Federal Reserve and then collect fees for servicing those loans).

The final Q&A of the First Short Quiz alluded to the fact that commercial banks have concentrated for many decades on making credit-card loans to American taxpayers at exorbitant interest rates.

[In this regard, it should be noted that commercial banks do not even make many auto loans because the auto companies have long since established their own finance subs as a way of competing with each other.]

However, commercial banks as a class have also invested a substantial portion of their FDIC-insured deposits in high-risk high-return assets.

Most recently, this took the form of investing in high-risk high-return sub-prime mortgage pools which were created by investment banks such as Goldman Sachs and marketed to commercial banks as well as institutional investors such as pension funds and university-endowment funds. [And whose value was insured by AIG which disingenuously called the insurance policies Credit-Default Swaps in a successful attempt to fool the N.Y. State Insurance Regulators into believing the CDS’s were not merely plain-old garden-variety insurance contracts -- NB: AIG’s tom-foolery didn’t fool Goldman Sachs which required the AIG parent company to guarantee those insurance contracts since they were being written by relatively-infinitesimal AIG Financial Products Inc. which was NOT maintaining any insurance reserves to cover losses (the guarantees by the AIG parent company meant that the insurance reserves on the CDS insurance contracts took the form of the value of AIG’s three huge and hugely-profitable main subsidiaries, which is why the entire AIG group had to be bailed out by the U.S. Government, rather than simply letting AIG Financial Products Inc. go through bankruptcy)].

In order to disabuse the reader of these quizzes of the notion that sub-prime mortgages were only a one-time temptation to the commercial banks which have now learned their lesson, the following questions examine the high-return high-risk investments comprising a substantial portion of the assets of the commercial banks during the two decades before sub-prime mortgages came along!!!

[In other words, there will always be a new Serpent in the Garden of Eden, so an appreciation that the Sub-Prime-Mortgage Serpent was NOT the first Serpent is worthwhile to gain an appreciation that there will always be more Serpents of an infinite variety that will come along!!!]


Question 1

What made Rudy Giuliani famous?

Answer 1

In the 1980’s and 1990’s, Limited Buy Out (“LBO”) Funds became famous for acquiring control of companies (primarily public companies via tender offers for the publicly-held stock at a premium over current market value).

LBO Funds were able to turn a quick profit because (1) they were replacing non-deductible dividends paid by the target company with deductible interest expense paid on the debt used to eliminate most of the stock on which the dividends had been paid; and (2) at least in the case of prudent LBO Funds, they were armed with a strategy that had been brought to them by their “buy out partner” (which, typically, was an important member of the target’s management team and sometimes was the CEO her/himself), such as closing an unprofitable facility or unprofitable line of business, or raiding the target’s OVER-funded pension plan (pension plans in the stock market’s “salad days” when the market, to a great extent, was riding high because of LBO’s, were typically OVER-funded).

Because so many of the strategies employed by LBO Funds during the short period they owned the target before re-selling it at an astronomical profit involved screwing the employees (please “pardon my French”) such as throwing them out of work or raiding their pension plans, there was a public perception that LBO Funds were reprehensible.

This, despite the fact that the investors in the LBO Funds were primarily university endowment funds and pension funds.

Rudy Giuliani tapped into the public dislike for LBO Funds!!!

By attacking the Junk Bond King!!!

By way of background, Junk Bonds were what put the Leverage into Leveraged Buy Outs.

A theretofore typical company might have debt of less than 50% of its assets and shareholders’ equity of more than 50% of its assets.

Such an UN-leveraged company was an FJT = Fat Juicy Target!!!

An LBO Fund might buy the stock of the FJT with less than 10% of its own money, with the remainder of the Tender Offer for the Publicly-Held Stock provided by high-yield high-return debt (aka Junk Bonds).

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A mathematical illustration???

The publicly-held stock of FJT is worth $10 Billion (aka its Market Capitalization or Market Cap).

FJT’s assets are worth $20 Billion, but it already has $10 Billion of debt.

LBO Fund offers $12 Billion to the public shareholders, a majority of whom accept. The remainder are immediately squeezed out (which is legally permissible in most states, particularly Delaware where virtually all publicly-held companies are incorporated).

How did the LBO Fund raise the $12 Billion to pay for the stock???

By borrowing, say, $11 Billion in the form of high-yield high-risk (because it will be subordinated to the existing $10 Billion debt of FJT) Junk Bonds.

The remaining $1 Billion (5% of the total assets of FJT) would come from the university endowment funds and pension funds that are the investors in the LBO Fund.

If, within a year or so, the LBO Fund is able to increase the value of FJT’s assets by eliminating its U.S. corporate income tax (by, as previously mentioned, substituting deductible interest for non-deductible dividends) and its in-the-bag strategy (such as closing an unprofitable line of business or raiding FJT’s pension plan) by, say, a mere 30% from $20 Billion to $26 Billion* then the value of the shares have increased from the $1 Billion purchase price to $7 Billion = a 600% profit on the investment for the year or so that FJT has been held.

[* For accounting/financial techies, the increase would comprise almost solely an increase in “Goodwill.”]

That is the power of leverage!!!

*****
Who was the Junk Bond King???

The inventor of Junk Bonds and the investment banker who arranged the lion’s share of the Junk Bonds employed by the LBO’s of the 1980’s and 1990’s???

Michael Milken.

And how did Rudy Giuliani “Get Shorty”???

[Full disclosure = That is a reference to a famous movie; Yours Truly has no idea how tall Michael Milken actually is.]

Giuliani prosecuted him on relatively-insignificant charges of stock fraud and insider trading!!! The way Al Capone was finally brought down on charges of income-tax fraud!!! (Rather than for all of Capone’s murders, etc.)

And the reason for singling out Michael Milken from among the zillions of targets who might also have been prosecuted for stock fraud and insider trading was the fact that he was the Junk Bond King!!!

And it should be noted that being the Junk Bond King could easily have been accomplished without engaging in any alleged stock fraud or alleged insider trading!!! BECAUSE THERE WAS NOTHING ILLEGAL ABOUT JUNK BONDS!!! (Unlike Al Capone's really-objectionable activities which were actually illegal and essential to his success as a mob boss!!!)

*****
And why did this make Rudy Giuliani famous???

He “cut off at the knees” Michael Milken by threatening his investment bank, Drexel Burnham Lambert, with a RICO investigation/prosecution unless they severed ties with Milken.

This would, as a practical matter, render Michael Milken financially incapable of defending himself!!!

Why did Drexel immediately sever ties with Milken???

Because a RICO investigation/prosecution would, as a practical matter, put Drexel Burnham Lambert out of business.

Why was this so controversial???

Because The Racketeer Influenced and Corrupt Organizations Act ("RICO") had been enacted in 1970 to combat Organized Crime with virtually-unlimited powers granted to prosecutors that were not only unprecedented but of highly-controversial constitutional validity.

RICO had never before been used to summarily execute a normal highly-respected corporation and summarily render a normal business person unable to defend himself.

Question 2

Who was Michael Milken?

Answer 2

Please see Q&A-1.

Question 3

What were Junk Bonds?

Answer 3

Please see Q&A-1.

Question 4

How did Junk Bonds fuel the Limited Buy-Outs (LBO’s) of the 1980’s and 1990’s?

Answer 4

Please see Q&A-1.

Question 5

What is Mezzanine Debt?

Answer 5

Mezzanine Debt is another name for Junk Bonds.

Question 6

Who invested in the Mezzanine Debt?

Answer 6

Virtually all Mezzanine Debt was provided by commercial banks.

Though some “pedestrian” investment funds formed to provide university endowment funds and pension funds with a bit less risk for a portion of their investment portfolios, invested in Mezzanine Debt.

Question 7

Why were LBO’s, by and large, so profitable?

Answer 7

Please see Q&A-1.

Question 8

What were some of the unfortunate side effects of LBO’s?

Answer 8

As mentioned in Q&A-1, LBO’s were almost a sure-fire winner for the university endowment funds and pension funds for two reasons, the second of which was a strategy which quite often was closing an unprofitable line of business or raiding a company pension plan.

Now would be a good time to answer Q-10.

Because LBO Funds should NOT be confused with Venture Capital Funds --

As described in Q&A-1, an LBO Fund takes control of an existing corporation and makes it more profitable by (1) eliminating its corporate income tax and, typically (2) employing one other strategy such as closing an unprofitable line of business or raiding a company pension plan.

In contrast, a Venture Capital Fund is what the name suggests.

It finances start-ups.

Though nobody should think for a moment that the cost of capital provided by Venture Capital Funds (usually in the form of equity rather than debt) isn’t also incredibly high because a high percentage of new ventures fail.

Question 9

When Mitt Romney tried to defend his record at Bain Capital, what types of companies did he cite?

Answer 9

Bain Capital was, if not unique, extremely unusual because it combined LBO investments with venture-capital investments.

The political attacks leveled against Mitt Romney during his 2012 Presidential Campaign were leveled against Bain Capital’s LBO investments.

Mitt Romney’s responses invariably cited the job-creation of Bain Capital’s successful Venture-Capital investments.

Question 10

What is the difference between LBO’s and venture capital?

Answer 10

Please see Q&A-8.

Question 11

Were the commercial banks really undertaking substantial risk in buying the Mezzanine Debt (aka Junk Bonds) of the LBO’s?

Answer 11

Not really.

Because it’s hard for an LBO to misfire during the year or so it takes to (1) eliminate the FJT’s corporate income tax, and (2) implement the second strategy of, for example, closing an unprofitable line of business or raiding the company pension plan -- whose success is also virtually guaranteed.

Question 12

Was it the Mezzanine Debt (aka Junk Bonds) that made the Levereaged Buy Outs leveraged?

Answer 12

Of course!!!

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