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Financial

Market Bubbleology Revisted

11:40 AM -- Did you see the front page of the Wall Street Journal today? If you did, you noticed the big headline about the shady ways in which Lehman Brothers and other U.S. investment banks have helped clients sidestep taxes on dividends?

Here's the simple explanation: The two firms essentially perform a "stock swap." The investment bank buys stock from a hedge fund. While holding the stock, the bank makes payments to the hedge fund equivalent to the dividends earned and appreciation in the stock's value. In return, the hedge fund makes payments to the bank in the form of a benchmark interest rate.

The hedge fund is now earning tax free dividends on the stock because it technically no longer owns it. Meanwhile, the investment bank that does own the stock, and therefore must pay tax on the dividends, offsets the tax payments by expensing the very swap payments it made to the hedge fund. This swap has helped hedge funds avoid payment of $1 billion in taxes. According to the article:

    The government's question: Are the trades executed for any purpose other than to sidestep the dividend tax?


This question sounds eerily similar to the questions being asked of telecom carriers in 2001 during the bursting of the bubble. You may recall that carriers would perform similar "swaps" when Carrier A and Carrier B would sell each other a similar amount of capacity on their networks. The move would have no economic impact on their business but would boost revenues. The SEC asked the same question then: Were the swaps performed for legitimate business reasons or were they for the sole purpose of reporting misleading revenues?

Swaps were OK as long as they were reported separately from the company's regular balance sheet. But this was not always practiced. Joe Nacchio, the former CEO of Qwest Communications International Inc. (NYSE: Q), reported swaps like this in 2001 while his company's inflated stock was in a free fall.

That was 2001's bubble. Today's housing and financial services bubble now seems to have similar ingredients to the one this industry is all too familiar with.

— Raymond McConville, Reporter, Light Reading

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paolo.franzoi 12/5/2012 | 3:02:36 PM
re: Market Bubbleology Revisted
Scott,

I would say there is 1 HUGE difference.

Outside of our little Telecom world, people's stock portfolios, and this website, I think the Telecom bust has been ignored by the public at large.

I look on your pages about Western Electric (aka Lucent aka part of ALU) and the troubles it has had over the past nearly 10 years. That formerly proud institution has become a corpse (as I posted in another thread).

I disagree with his conclusions, but I agree with rjmcmahon that the industry is still sick. If you look at Q2 results, it is not getting better. Please stop pointing at Enterprise Players (see Cisco) as a counterexample.

We are in a time of massive disruption and have been for a long time. It is possible that 10 years from now, Verizon and AT&T will die under their own weight.

The world flies on oblivious. Once people get their money back out of real estate (like they got it out of tech), the story will fade. People and industries will have been wrecked. The world will go on.

Your right, there is a sucker born every minute.

seven
Scott Raynovich 12/5/2012 | 3:02:36 PM
re: Market Bubbleology Revisted It's mind-boggling to me how many parallels to the tech/telecom implosion in 200s are emerging in the current credit crisis/housing bubble implosion:

1) Swap shenanigans -- Somewhat like you just mentioned, but the concept of "swapping" seems to be a catch-all for Wall Street's version of three-card monte. Swaps have migrated from telecom to the mortgage business. You can exchange any kind of asset for any sort of paper derivative these days. The only problem? It's really hard to figure out whether these pieces of paper have any value -- just like telecom IRUs.

2) Ratings Conflict -- Moodys, S&P, and Fitch were rating up a storm on mortgage bonds and "CDOs" (collateralized debt obligations) during the mortgage boom. Isn't it funny how so many of these pieces of paper made "investment grade" -- when all they were were bundles of crappy-ass loans? It's obvious that it was in the interest for the ratings agencies to pump these things up: the better these bonds looked -- the more business for the ratings agencies! Isn't this a bit like the telecom sell-side analysts embracing stocks for banking business?

http://www.boston.com/business...

3) Special Purpose Entities (SPEs) and off-balance sheet transactions. Our investment professions must of the memories of cockroaches. SPEs and off-balance sheet transactions are what allowed Enron to perpetrate fraud by hiding its debt off the balance sheet. Yes, Enron. Now, apparently many GLOBAL BANKS were doing the same thing. Yikes! Of course, there is not a direct correlation between SPEs and fraud, but it certainly makes it easier to hide things. Is it really a good idea for global banks to do deals with SPEs to hide liabilities off balance sheet? I don't think so.

4) Rah-Rah TV. CNBC and other outlets cheerleaded the housing bubble just as they did the tech boom. They did features on condo-flippers in Vegas -- does this remind anybody of the their breathless coverage of tech bulls and day traders? What'd the deal?

I guess that's what makes America beautiful -- a sucker is born every minute.
Scott Raynovich 12/5/2012 | 3:02:35 PM
re: Market Bubbleology Revisted Seven,

Well Verizon just rolled a truck to fix my FiOS service for the second time, so I see what you mean. That couldn't be profitable considering my total communications bill with them went DOWN while the services they are providing went UP.

As far as the industry, it will probably continue to be "restructured" over a number of years. How long will it take? Forever. Take a look at the auto industry -- the restructuring they started in the 1980s has never ended. A big part of the problem are large pension costs.

But let's look on the bright side of life -- nobody ever thought ringtones would make so much money

Raymond McConville 12/5/2012 | 3:02:34 PM
re: Market Bubbleology Revisted That truck roll to your house was particularly expensive for Verizon since here in the Northeast, the technicians are all union workers.

Hard to envision them crumbling under their own weight though. After all, we'll always need to make phone calls. Then again, it's the wireless side of the telcos business that has been dragging the sleepy wireline giants through everything. At the very worst, it'd be a massive restructuring that resulted in these guys pretty much becoming exclusively wireless providers.

And as long as we're on the subject of the auto industry, Ford should do a similar restructuring. For all of the company's struggles, they still do one thing very well, and that is trucks. The F-150 remains the best selling car in the country. Not best selling truck, best selling car, period. What that company really should do is completely rebrand itself as a truck manufacturer and stop throwing their money away selling crappy Ford Fusions that nobody wants. Is anyone excited that the Taurus is coming back? Anyone?
paolo.franzoi 12/5/2012 | 3:02:34 PM
re: Market Bubbleology Revisted
Raymond,

Now that I have a UMA phone - I am not sure that I need the PSTN. I agree with your comment about restructuring, the question is who will have the guts to do it.

Scott,

The difference is (and if I use Raymond's Auto Industry analogy) that the Telephone Companies are monopoly utilities that are being forced into a competitive market. We see how well that worked for Western Electric. I see the leadership of Verizon and AT&T as less disastrous than that of Lucent. But they have a long way to go to rebuild their companies into something where they deliver something is willing to pay a lot of margin for.

seven
optiplayer 12/5/2012 | 3:02:33 PM
re: Market Bubbleology Revisted Scott,

One more similarlity building on your #4 the cult of personality that developed in the telecom bubble (Ebbers, Nacchio, Huber, etc.) compared to hedge and PE funds today (Lampert, Shwartzman, etc.). Granted, many of these managers have delivered outstanding results for their investors for years but the way they are obsessively worshipped on CNBC is stomach-churning.
deauxfaux 12/5/2012 | 3:02:24 PM
re: Market Bubbleology Revisted 1) Tax free exchanges are in common use everywhere; the central tenant is the idea that property of near identical value changes hands, so that there is no taxable event. The most common form of asset sale is the triangular exchange; where stock or cash in one company is put into newco, which then buys the assets of the target.

2) Revenue swaps don't involve the exchange of real property and are a totally different thing.
Scott Raynovich 12/5/2012 | 3:02:24 PM
re: Market Bubbleology Revisted Spoken like a true bubbleologist. I say in general terms, all swaps are the same -- you are moving something somewhere else so as to hide something. Why not just call it what it is?

In a tax swap, you are hiding a tax liability. In an IRU swap, you are hiding a fixed cost and masking it as revenue (Like Worldcom)

In a credit-default swap, you are hedging the risk of your high-risk asset (trying to hide the risk)

In a SPE (special purpose entity), you are shifting assets (swapping) off-balance sheet to hide debt.

Increasingly, in our rocket-science finance world, people are trying to hide stuff.




-------------------

1) Tax free exchanges are in common use >everywhere; the central tenant is the idea that >property of near identical value changes hands, so that there is no taxable event. The most common form of asset sale is the triangular exchange; where stock or cash

2) Revenue swaps don't involve the exchange of real property and are a totally different thing.
Stevery 12/5/2012 | 3:02:24 PM
re: Market Bubbleology Revisted Tax free exchanges are in common use everywhere; the central tenant is the idea that property of near identical value changes hands,

Sadly, the IRS refuses to recognize that my exchange of intellectual property for equally valuable green-paper property is a tax-free event.
voyce_overipee1 12/5/2012 | 3:02:23 PM
re: Market Bubbleology Revisted Now that I have a UMA phone - I am not sure that I need the PSTN. I agree with your comment about restructuring, the question is who will have the guts to do it.

If you have a UMA phone, you are on the PSTN. You're not directly on the TDM infrastructure in terms of POTS, but your call is controlled by the same PSTN carriers, and is part of the public switched telephone system, just a bit further away physically. Cell phones are also part of the PSTN, for all intents and purposes.
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