Monday, May 10, 2010

Exodus: The Irony of Solvency Via Dilution Strategies

The question is whether an individual country that has mismanaged its affairs will precipitate an international financial crisis. Two myths have propagated the view that the question has an affirmative answer. One myth is that the individual country's loss of creditworthiness has a tequila effect. The supposed tequila effect is that other countries without the problems of the troubled country are unfairly tarnished as also subject to those problems. In this way, it is said, contagion spreads the crisis from its initial source to other innocent victims.

The second myth is that a bailout of the troubled country is essential. The rationale is again the idea of contagion. Failure to organize a bailout will create an international financial crisis by a domino effect. Rescuing the troubled country saves the rest of the world from unwarranted financial collapse. Anna Schwartz

Traders are like fishermen- they've got lots of stories about landing the big one. While I tend to use this blog more to share my stories of trades gone wrong- hoping, perhaps, others can learn vicariously from my (many) trading mistakes- today's story is of a trade that worked, and why the guiding theme might still be of use in the coming months.

Back in the first months of 2000, I, like Julian Robertson, couldn't believe my eyes as "Dot-Con" stock prices soared ever higher. The higher stock prices rose, the more dilute, debt ridden and unprofitable did the "Dot-Cons" become. Financial analysis of the internet "space" (perhaps referring to the quarterly report line meant for profits) concerned itself with demand, of issued securities, not of security issuers' products at a profitable price. The quantity and quality of "Dot-Con"- issued security supply was analyzed using the efficient market theory- market prices are rising, securities must be sound.

Willing to bet that such views wouldn't stand the test of time, I bought puts on a number of "Dot-Cons", usually without any problems. One day, in late February of 2000, I asked my broker for prices on EXDS (Exodus Communications) puts.

"My options guys think you're a fool to want to buy puts on this company. They have some call spread strategies that you'll like"

"Thank them for me, but I don't share their optimism on EXDS. Just get me those put prices."

Ten minutes later, he calls back.

"They really think you're making a mistake here, and don't want to sell you those puts."

"I think they're making a mistake here, one that might lead me to find another broker. Get me those prices."

Shortly thereafter, he calls back with the prices and we deal. Within two months, the stock price had dropped precipitously (I watched the April crash at Motown in Roppongi, Tokyo). I'd been buying puts on various internet stocks since late November 1999, in case you thought I was more prescient than the average bear.

Towards sumer's end in 2001 my broker called, informing me he was quitting to get a better job and we joked a bit about some of our dealings, including EXDS. Laughing, he tells me EXDS is trading at 50 cents. As our last trade together, I ask him to buy 100 shares of Exodus, and send me the certificate, which I framed.

The irony of the investment exodus from Exodus was just too rich to pass up. I plan on giving the framed certificate, along with a graph of the price, to my son as a warning.

"What magic lure did I use to land this big fish?," you might be wondering.

The "lure" I used to bag this fish comes from an apparently obscure (judging by the "dilute 'till ya' drop" rescue plans from both the Fed and ECB) view of securities' analysis which holds: 1) the present value of any security can be estimated by calculating the net present value of associated cash flow 2) other things equal, dilutive issuance of a security reduces its value by spreading that cash flow over a larger number of claims (unless, as was the case with EXDS, cash flow is negative, thus dilution actually increases per share value by dividing the loss among increased claims).

I think this same "lure" will help me bag even bigger fish, like Euro and the US$ securities. After all, both the Fed and ECB are adopting policies straight from the "Dot-Cons", hoping to dilute their way to solvency.

To be fair, they, like the "Dot-Cons" are actually buying time with the dilution. Ironically, they are likely to find, as the "Dot-Cons" did before them, the more time purchased in this way, the less one gets in the end. One good dilution deserves another, it seems.

Yet, depending on the rescue's goal, the purchased time might be sufficient. Anna Schwartz, in the paper quoted above, wondered about the goal of the 1995 Mexican bail-out:

For whose benefit was the Mexican rescue arranged? Is there any doubt that the loan package was designed to pay dollars to Americans and other nationals who invested in Tesobonos and Cetes and dollar-denominated loans to Mexican nonfinancial firms? Is that the reason emergency loans are needed? To eliminate risk from investment in high-yielding foreign assets?

The question seem just as valid today:

For whose benefit was the European rescue arranged? Is there any doubt that the loan package was designed to pay Euros to Americans and other nationals who loaned money to PIGS? Is that the reason emergency loans are needed? To eliminate risk from investment in high-yielding foreign assets?

Of course, risk is never eliminated by such actions, it is merely transferred. As noted above, however, when distributing a loss, dilution is a plus in that the per unit distribution declines. Perhaps this explains the Euro (and related market) rebound.

Alternatively, the rebound might simply be a case of Pavlov's Investors, who, like those of a decade ago, have been conditioned to buy every dilution. Of course, Pavlov's Dogs eventually stopped salivating when the food no longer followed the metronome.

My advice- don't be a dog.

I'm sure Big Financial firms are already planning their own exodus from these soon to be declining securities (and quite pleased about today's reaction), whether it's via a hedge, outright sales, or (more likely) by swapping their bad debt for sounder securities with the appropriate Central Bank (if such can then be found in sufficient quantity).  The only solvency saved by these bail-outs is that of those running for the exits.

Sometime in the not too distant future, the following will provide a template for another author to discuss an exodus from sovereign debt, instead of internet shares:

In March 2000 when Exodus Communications announced its fourth stock split in 14 months Internet companies couldn't print shares fast enough.

Mere announcements of splits were magic. Their power to propel stocks was equal to the incantations of analyst Merlins. In the poof of a press release, employee stock options soared in value, issues of new stock and convertible bonds commanded higher prices, and the ability to make acquisitions was amplified.

Stock splits became part of the Internet business model. During the period of its splitting frenzy, Exodus (nasdaq: EXDS - news - people ) issued $1.1 billion of convertible bonds and announced nine acquisitions totaling $2.5 billion.

Today, those splits are like a cherry bomb garnish in a cocktail of imploding business demand and crushing debt.

As Anna Schwartz put it: The way to ensure global financial stability is for each global financial institution to monitor and control risk in managing its own internal affairs.

What a novel idea.