Sunday, September 26, 2010


In the August 24 issue, I discussed the history, business climate, and the events that led to Microsoft’s (MSFT) offer to buy Yahoo Inc. (YHOO) in early 2008. In this issue, I plan to briefly discuss the implications of the deal if it had gone through, and what the effects on both companies and the industry would have been.

To begin, many question marks exist concerning the feasibility of the deal. In early 2008, the economy was just beginning to feel the effects of what would become the credit crisis and recession. In late January 2008, MSFT made an initial offer of $31 per share to YHOO management. As I highlighted last time, it was a good opportunity for stockholders that had seen Google (GOOG), Research in Motion, Apple and Amazon soar while YHOO got left behind during the 2000s to cut their losses and walk away. For that reason, many investors, institutions, and hedge funds were pushing for the deal to be consummated. In a clear sign of this, activist investor Carl Icahn took a stake in YHOO and a seat on its board to push for the deal in May, 2008. As far as investors were concerned, there should have been very few hurdles to the deal’s consummation. Obviously, the mandate of any company’s management is to maximize the stock price. YHOO’s management was already engaged in turnaround initiatives, and continually pushed for a better deal because they felt success was just on the horizon. Their overly optimistic projections for the next few years after 2008 were clearly unrealistic, and their unwillingness to bend to MSFT’s advances and the prodding of their own shareholders would prove to be the undoing of the deal.

Looking at the tech industry landscape at the time, an irony of the deal falling through lies in the fact that Microsoft was one of the only, if not the only, suitable partners for Yahoo. To begin, due to the sheer size/market capitalization, there are very few companies within the Internet sector that would have been large enough to acquire Yahoo. Looking at the larger group of companies under the Technology category, if a company such as Hewlett-Packard or Intel was looking to diversify into the internet services sector (an unlikely proposition), then the list can be expanded a bit. Looking at only those firms that were already in the Internet sector, however, MSFT was likely the only one with the financial resources to buy YHOO without using a huge amount of debt, and a small enough Internet search presence that its acquisition of YHOO would not raise the ire of antitrust regulators. As mentioned last time, after the initial YHOO/MSFT proposition fell through, YHOO tried to outsource its search operation to GOOG, immediately triggering the watchful eye of the Justice Department.

Throughout early 2008 and in the two years since, some commentators have suggested that other suitors could have come from private equity and the buyout sector. At the time, this was also an unlikely occurrence. First, in 2008, the LBO sector had just been through a second period of glory, the first of which came during the mid to late 1980s. By early 2008, the broader economy was just beginning to feel the strain from what would become the credit crisis. However, LBO deal volume was already falling as investment banks were already cutting back on lending to their Financial Sponsors clients. That raises the question of whether an LBO could have even been pulled off from the lender’s perspective. Second, from the buy-side perspective, the numbers simply do not add up. Obviously, the private equity firms that would have been able to pull this off either by themselves or as part of a consortium (Blackstone, Texas Pacific, KKR, etc.) are sophisticated investors. Working within reasonable projections for purchase price, debt, and leverage, the prospective returns would likely have not been high enough. With the amount of debt that would have been necessary, YHOO’s cash flow and EBITDA could not have been leveraged enough to make the deal work. Of course, unrealistic projections are not unfamiliar in this case, with YHOO’s management putting forth overly optimistic scenarios at the time of MSFT’s proposition. Either way, in the end the fact that private equity did not get involved could have been due to either the increasing lack of credit, or the conscious decision of such investors to not get involved.

As mentioned, YHOO management was forecasting an overly optimistic scenario going forward due to their still-in-progress turnaround effort that they hoped would come about as a result of these “Panama” initiatives. Their projections were above and beyond what many analysts at the time were projecting. MSFT was well aware of this, and with any merger, this could have led to internal frictions during the integration process. In this case, there may very well have been a higher amount of friction due to the aforementioned factors and another big question mark: the integration of the two companies.

The integration process, if undertaken, would have been very difficult for many reasons. First, the integration of two companies of YHOO and MSFT’s size is a tremendous undertaking. MSFT has nearly 90,000 employees, and YHOO has thousands as well. As is the case with most mergers, there would have been many redundancies on all levels of the company. Second, the integration of the companies’ technologies would have been quite tedious. The “different technologies” were not limited to their Internet search divisions, but everything from advertising systems to HR. This is one point of integration in which the challenges were much deeper than may have initially appeared on the surface.

In addition to the challenges of integration that are seen in any merger, the companies involved here are vastly different in terms of firm culture. Despite the fact that both MSFT and YHOO are relatively young within the grand scheme of the American business landscape (35 and 16 years old, respectively), within the world of computer and Internet technology, this age gap is huge -- MSFT is like a senior citizen while YHOO is middle-aged. As such, both companies have different primary businesses and came of age in very different eras, which translates into a vast difference in corporate culture. While MSFT’s culture is more traditional and formal, YHOO, coming of age during the late 1990s tech boom, embodies the dot-com, Bay Area culture of casual everything from dress codes to intra-office relations. This vast gap would have been very difficult to close during the integration period, and it could have caused difficulties after integration was complete.

Finally, the post-merger company likely would have not affected the overall Internet search landscape very much. Google is still the unquestioned leader in the Internet search category with over 70% of the market. Many commentators have pointed out that MSFT’s Bing will have over 30% of the market once the integration of their search engines is complete. While Bing was gradually eating away at Google’s market share for much of the past year after its initial release, recent figures suggest this may be coming to an end. Either way, it has not made a great difference. For example, I have yet to hear someone say, “I Binged it,” and I’m sure we’ve all said or hear others regularly say, “I Googled it.” As it stands now, MSFT and YHOO’s market share is about 30% and declining. In the event of a full merger, the integration challenges could very well have accelerated that decline.

As of now, it appears that a merger of MSFT and YHOO would not have been a tremendous success for either party, YHOO in particular. For YHOO, while the outcome was not applauded by shareholders at first, the ultimate outsourcing of YHOO search to MSFT’s Bing is a long-term positive for the company. The current search outsourcing deal enables YHOO to focus on its core competencies, while grabbing a healthy percentage of the revenues from MSFT’s Bing search engine. Since YHOO’s stock price declined in 2008 and has remained largely stagnant since, the ultimate outcome of the new arrangement could be a major factor in a future renaissance in the stock price, if other factors come together to make the company successful once again.

Finally, one thing that the deal definitely would not have affected is the M&A market for small tech companies. The large cash reserves of MSFT, YHOO, and GOOG (with MSFT being the only one of the three that pays a dividend), enable all three to be active buyers of small tech companies. A merger between MSFT and YHOO would not have changed that. If anything, it would have made GOOG a bit more aggressive in acquiring small tech firms. The robustness of M&A within the technology sector is perhaps most evident to its being at the forefront of innovation and the evolution of technology as an increasingly important sector of the American economy.

Respectfully Yours,
Matthew R. Green

September 27, 2010

Tuesday, August 24, 2010

Issue XX - Microsoft/Yahoo

Dear Readers,

One of the major business storylines throughout the first half of 2008 was the possibility of Microsoft Corp. (MSFT) acquiring Yahoo Inc (YHOO). The deal had been in the works for several months before the formal offer was announced on January 31, 2008. After the initial offer, several rounds of negotiations commenced, ending in the early summer and eventually fading away from the news as the faltering economy overtook the headlines. I have spent the past month studying the circumstances surrounding the merger. The questions I sought to answer were simple. First, what were the causes, and motivations, behind this proposition? Second, could it have been consummated, and if so, would it have worked? My findings are contained in this two-part newsletter (Part 2 will come out next week).

The origins of MSFT and YHOO’s courtship, as is the case with most mergers, were not due to events solely involving the two companies. In particular, it was due to the new behemoth in all areas of the internet business during this decade: Google (GOOG). YHOO had spent the first ten years of its existence as one of the companies on the forefront of wide-scale internet use. As a result, even with the emergence of GOOG this decade, YHOO still enjoyed the luxury of a broader, more widespread audience. For example, despite the emergence of university and workplace-based e-mail systems after 1998-2000, and the debut of GOOG’s Gmail, millions of individuals still use their original e-mail address after all these years.

GOOG was established by Larry Page and Sergey Brin in 1998. Unlike early sites such as YHOO and, which sought to be hubs of everyone’s internet activity, GOOG was originally conceived as a superior search engine, and has grown out of that in the years since. By the middle of the 2000s, GOOG had emerged in less than five years to dominate the online search market. It had its initial public offering in 2004, and by 2005 the company was diversifying into e-mail, maps, and many other businesses. By 2006, GOOG’s share of the search market was well over 60% and growing. (For an idea of how fast this was happening, GOOG’s market share in search was reaching above 70% by the time MSFT made its bid for YHOO.)

YHOO management was aware of these problems long before the unsolicited offer was announced in January 2008. In 2006, reports surfaced of growing tensions within YHOO about the company’s direction and strategy. A prominent YHOO manager, Brad Garlinghouse, issued an internal memo that has become known as the “peanut butter manifesto,” available here. It was leaked to the press in the middle of November of that year. The point of the metaphor was that YHOO had become spread too thin, like peanut butter on a sandwich. In other words, it was engaged in many different sectors of the internet business, and not doing any of them particularly well. Garlinghouse's recommendation was to hunker down, eliminate the many redundancies at the company, and focus on the few core sectors in which it could do well.

Similar dilemmas have been seen countless times in American business history. A quick example: Procter & Gamble (PG). Having long been one of the most comprehensive consumer-products companies, by the mid-to-late 1990s the strategy of the company’s management was increasingly skewed toward growth via innovation and introducing new brands. While a few of these brands were hits and are company staples today (e.g., Swiffer), the failure of a number of new brands and the slowing of the economy combined to produce an earnings miss in February 2000. As PG was one of the first companies to miss earnings during the early 2000s slowdown, the market was not expecting it, and the stock was cut in half in a matter of weeks. After a change in management, new CEO A.G. Lafley refocused the company’s strategy on what had long been its core businesses of personal care and household cleaning items. High-growth sectors like hair coloring and shaving were also included in this strategy, thereby leading to the acquisition of Gillette in January 2005, among others. Historic, yet stagnant brands (e.g. Folgers Coffee, a $1 billion brand that was profitable but low-growth), were spun off or sold. Like PG, GOOG has achieved success by focusing on its core business of internet search. Recognizing this, Garlinghouse put forth his vision for YHOO.

In the search advertising market, the business model is simpler than it may initially seem. Briefly, when an ad gets clicked, GOOG, MSFT, YHOO, or whichever other search engine displays the ad gets paid, and the advertiser gets a potential customer. While this might not seem like much at first glance, millions of clicks add up. Since Americans are spending more time online every year, the potential market is worth billions and growing exponentially. By 2007, GOOG dominated this market with 70% market share, while YHOO and MSFT were fighting over the scraps at 18% and 9%, respectively.

With regard to search advertising, the main issue for YHOO was that while it had a larger audience amongst its many features due to its legacy as one of the oldest internet firms, it did not effectively monetize its search engine. This was, of course, GOOG’s forte. While YHOO was a very proud brand with a long-established brand name, the fact that GOOG was conceived and focused on search and monetizing that business is what made the difference. In short, YHOO had the audience, but GOOG did a better job making money in their core business. Therefore, in late 2006 YHOO management began to explore ways to combine YHOO’s superior audience with GOOG-style monetization. The success of MSFT’s Bing search engine thus far is evidence that a better-executed initiative at YHOO may have been successful. Bing will have nearly 30% of the market when fully integrated, although long-term growth concerns are currently surfacing.

To highlight the wide difference in monetization success, at the time of MSFT’s offer, analysts estimated that GOOG got approximately 20 cents for each click, compared to less than a dime at YHOO. As mentioned, YHOO’s management was well aware of this and launched several initiatives throughout 2007 to improve this; the most prominent became known as the “Panama Project” with tepid results. While YHOO made progress with regard to monetizing the searches, GOOG’s market share continued to increase throughout the year, effectively nullifying the gains in monetization.

Meanwhile, 800 miles north of Silicon Valley in Redmond, MSFT management was debating about how to best increase the market share of their services. Knowing of YHOO’s internal squabbles, and knowing that YHOO had a large, broad audience that they did not have on the internet, MSFT saw the potential synergies in doing a deal. Therefore, while YHOO was making its efforts to improve its search monetization throughout 2007, MSFT began making subtle hints in the press and opened up formal discussions with YHOO. MSFT’s management team recognized that YHOO had many areas of redundancy and felt they could better diagnose and solve YHOO’s underlying issues.
At the time, many questioned why MSFT would want to expand into the internet when its specialty is software. Simply, any well-seasoned businessman knows that you can’t rest on your laurels; you need to be expanding, improving, or both. In the 2000s, MSFT had expanded into video games (Xbox), and a larger internet presence was a natural next step via an internal initiative to overhaul their properties or an acquisition. Seeing YHOO in a vulnerable position beginning in mid-2006 made this more of a possibility.

Thus, on January 31, 2008, MSFT made an offer of $31 per share for YHOO. Less than two weeks later, YHOO rejected the offer, saying that it substantially undervalued the company. In early March, formal talks took place between the two companies’ leaders, followed by similar summits over the next two months. In May, YHOO co-founders Jerry Yang and David Filo rebuffed MSFT CEO Steve Ballmer’s raised offer of $33, announcing their price as $37 per share. At this point, Ballmer publicly announced that he had “had enough” with YHOO. Several weeks later, YHOO retracted and reopened the ongoing discussions, now willing to sell for $33 or $34 per share. After a few more meetings, YHOO cut off talks and signed an agreement with GOOG.

Not surprisingly, there was intense media interest in the prospects of the deal from the very beginning. Since GOOG already held more than 70% of the search advertising market, antitrust concerns made for the fact that MSFT was one of the only, if not the only, viable suitors. $45 billion deals are few in number to begin with, and on a worldwide basis the proposed YHOO/MSFT merger would have been one of the 30 biggest deals of all time. After the deal collapsed, YHOO tried to outsource its search engine to GOOG. The Department of Justice immediately stepped in and voiced its concerns, because GOOG would have had more than 90% market share in the sector. Among these regulatory concerns and an increasing divide over pricing between YHOO and GOOG, the deal was called off in late 2008. MSFT and YHOO re-initiated talks, and in 2009 YHOO outsourced its search engine to MSFT’s new Bing search platform, which is the current arrangement today.

Leading those opposed to the deal were, not surprisingly, those who built the company and the board of directors. Many commentators at the time pointed out the fact that YHOO was still a company run by its founders who were extremely proud of their brand. Jerry Yang was still CEO, and co-founder David Filo was still involved with company management as well. They had already initiated their turnaround strategy, and were confident that it would work. Their optimism can be seen in their overly optimistic projections for the company going forward from early 2008. Clearly, Yang and the rest of the management team were determined to see through their own redemption with the YHOO shareholders. When this did not come to pass, Yang stepped down as CEO in
the wake of the tumult to be replaced in January 2009 by Carol Bartz.

In conclusion, with an offer of $31 per share, MSFT could make its offer appear to be a very good deal to shareholders and not overpay for YHOO, if at all. As mentioned, YHOO’s board was well aware of this and did not want to sell out so easily. However, the lesson here is what ultimately matters is the opinion of shareholders. By early 2008, the Panama initiatives had yet to bear fruit, and shareholders were not yet confident in YHOO management’s turnaround strategy. Additionally, 2006 and 2007 had been especially brutal on the share price, at a time that the “Four Horsemen” tech stocks of Amazon (AMZN), Research in Motion (RIMM), Apple (AAPL), and GOOG were leading the market upward (See Charts 1 and 2). This was fresh on the minds of YHOO shareholders in January 2008, as the market was still relatively high at the time and their stock had lots of ground to make up. For this reason, the initial refusal of YHOO management to accept the deal and subsequent dragging out of the negotiations did not bode well for the deal from the outset.

Next week, I will be running through what a combined MSFT/YHOO would have looked like and what challenges would have existed for the company’s integration.

Respectfully Yours,

Matthew R. Green

August 24, 2010

Chart 1: YHOO Share Price 2004-Present

Chart 2: YHOO (Blue) compared to AMZN, RIMM, GOOG and AAPL 2004-Present

Monday, July 19, 2010

Issue XVIII - For-Profit Education

Dear Readers,

As the job market has gotten tighter and more competitive over the past decade, it has become well known that a high school diploma or GED is no longer sufficient to provide a secure future. Consequently, one of the largest growth sectors this decade has been the for-profit education sector. A few of the biggest publicly-traded providers of for profit-education are Apollo Group (University of Phoenix, APOL), DeVry Inc. (DeVry College, DV), and Corinthian Colleges (Everest University, COCO). These schools claim that due to their setup as for-profit institutions, they are able to systematically make teaching more efficient and more responsive to the needs of adult learners.

Recent developments, along with higher unemployment, have shed light on the practices of these institutions. Stories range from inadequate career training to degrees of limited value because they are from non-accredited programs (although the school itself may be accredited) to countless students who are unable to find jobs while being saddled with debt. As these problems have surfaced, concerns about the business model of these institutions have been voiced by everyone from investors to the Department of Education. The problems, however, are much deeper. Unbeknownst to many outside the realm of education, US taxpayers may be on the hook for these students’ debts if they default on their loans. With these problems and the increasing possibility of more regulation, the stocks of publicly-traded for-profit colleges have dropped in recent months. Although the plight of many for-profit alumni is a story in and of itself, I will be focusing on the financial side of this business and the outlook regarding the for-profit business model.

Due to continuing high unemployment and the rising cost of private colleges and even state universities, community colleges across the nation have been filling up in record numbers. Therefore, a sector that had primarily been “open enrollment” is suddenly more selective. For those who are left out, many have chosen to enter the realm of for-profit education. Advertisements for these colleges are everywhere, as are their campuses, despite the fact that many of their degrees can be earned online. The ads inspire visions of an education sufficient to achieve a stable, even prestigious, career.

A major point of attraction to many working adults, the for-profit's target demographic, is convenience. For example, classes often begin each month as opposed to the perceived constraint of the semester system. Additionally, prospective students are offered easy access to loans. The reason it is so easy to obtain financing is because the schools aggressively encourage students to take them out, often utilizing high-pressure sales tactics to maintain enrollment through granting loans. The root of the concern among most observers is that the constant need to increase enrollment (translation: profits) is resulting in the overall commercialization or “McDonaldization” of the educational experience.

In May, hedge fund manager Steve Eisman made a presentation at the Ira Sohn Research Conference in which he characterized the for-profit sector as a group of “marketing machines with the purpose of sucking up government funds disguised as universities.” This came as a surprise, considering that many others at the conference, such as John Paulson and Stephen Mandel of Lone Pine Capital, are long-term investors in the sector. Thus, a clear dichotomy exists between investors' opinions about the sector, its growth prospects, and its business model. It’s not surprising that most investors are long. Since Apollo Group (APOL), the parent company of the University of Phoenix, went public in 1994, it has produced a nearly 4,000% return for investors. However, it is currently down 50% since peaking in April 2004. By any measure, that is a remarkable run. However, as Eisen put forth in his presentation, a look at the company’s business model reveals eerie parallels to the housing crisis that rocked the economy several years ago, and from which we have not recovered.

One of the root causes of the housing crisis was the fact that mortgage originators were paid based on the volume of loans that they provided to the big banks, regardless of how those loans performed down the road. In the same way, for-profit school admissions counselors are paid based on the number of students that they “close.” In the May 4, 2010 edition of PBS’s Frontline, former University of Phoenix admissions counselors reflected on the high-pressure sales tactics they were required to use to get students to sign off on loans needed for enrollment. One counselor, who wished not to be named, reflected on closing individuals who were clearly not prepared to do college-level work. Despite having basic admissions standards (e.g. a high school diploma or GED), the lack of preparation of many students leads to a much higher dropout rate at the for-profits, and this drives defaults higher as these dropouts are stuck with the debt.

It’s no surprise that the for-profits engage in these practices. Just as the housing market needed people to continue taking out mortgages to keep growing, for-profit education needs to keep growing to satisfy the growth expectations of investors. Another reason the loans are so aggressively pushed is not solely because of the need for volume, but because Federal Pell grants and Stafford loans are the lifeblood of many for-profit institutions. The schools, like the mortgage originators, get paid and then have no further liability. The students are stuck with the loan, and the taxpayers with the bill if they default. While there is currently no financial penalty for the schools if their students are unable to attain what is increasingly being referred to as “gainful employment” after graduation, changes could be on the horizon.

What for-profit schools don’t have is the luxury of no financial penalty if student enrollment drops. Thus far, consistently increasing enrollment has not been an insurmountable problem for them. However, one of two scenarios could trigger a downward spiral for the for-profits. First, if the employment situation improves markedly, then enrollment will drop. Second, and more likely in the short-term, for-profits will be in trouble if Congress limits their access to student loans. According to the US Department of Education, in the 2008-09 school year, nearly 24% of federal Pell grants financed students at for-profit schools. This is nearly double the percentage of a decade ago.

In addition, Federal Stafford loans to for-profit institutions jumped from under $5 billion in 2000 to $26.5 billion last year. At some for-profits, this accounts for nearly 80% of their overall revenue. According to the College Board, community college students made up only 10% of the total Stafford loan volume in 2007-08, and usually take out less than $10,000 per student. In the case of for-profit colleges, that number was 88%, and nearly 20% of students graduate with at least $30,000 in debt. These borrowing rates reflect the higher costs and lack of financial aid associated with for-profit colleges, where tuition costs are typically higher than at public or non-profit colleges. If the government limits for-profits' access to students loans in any small way, then the schools' ability to churn out loan volume will be cut. Without this ability, enrollment at the for-profits will inevitably drop precipitously, and so will their earnings. With a disproportionate amount of federal loan money currently going toward for-profit schools that offer educations of questionable value, it is time to take a serious look at whether for-profit colleges in their current form are good for America. Eisen noted in his presentation that the taxpayers could be on the hook for $275 billion in for-profit student loan defaults over the next decade if current trends continue unabated. Considering the government's large current deficits, a comprehensive review would be prudent.

Although congressional scrutiny of the for-profits has increased over the past several years, such inquiry is not new. The first hearings on this topic were spearheaded by Georgia Senator Sam Nunn in early 1990. An excerpt from the 1990 hearing could very easily have come from the congressional hearings this year. Nunn said,

"Unwary Americans are being lured into so-called educational schools by sophisticated sales pitches that offer promises of bright futures, high paying jobs and Federal loans for financing. In fact, the students often end up with little or no training, no job and a large bill to repay the student loan. In some cases the students recognize the training is useless and they withdraw midway and end up liable for the entire loan while the school operators pocket a handsome profit. As a result, the student is worse off than ever, often defaults on the loan, and the American taxpayer ultimately picks up the tab.”

In more recent Congressional hearings, lobbyists for the industry have testified that the rate of default for students that graduate from these institutions is no different than graduates from community and public colleges. However, the manner in which the data is measured renders these readings nearly meaningless. Under current laws, the official measurement of educational loan risk used by the US government is the “cohort-default rate.” Published by the Dept. of Education, the rate measures the percentage of borrowers who default in the first two years of repayment. While this is used to penalize underperforming colleges, defaults outside of the two-year window are not taken into account.

Therefore, only a portion of the loans that eventually default are measured. As any lender knows, it usually takes more than two years for a borrower to default. Using the housing crisis as a comparison, even the worst subprime loans that were made during the housing bubble took 18-24 months to default. Even after the expiration of so-called introductory “teaser” rates, many buyers pushed back default as long as possible. Therefore, you can expect the for-profit lobbying camp to fight any proposed changes in measuring default rates so as to mask the true default rate of their group.

According to data from the Dept. of Education, 11.9% of federal loan recipients who attended for-profit colleges have defaulted on their loans within two years. This compares to 6.2% among recipients who attended public colleges, and 4.1% who attended private colleges. When the time frame is extended beyond the two-year cohort period, the for-profit figure jumps to 21.2% of federal loan recipients. This trend continues as the years pass. For-profit colleges made up 16% of all federal Stafford Loans issued from 1995 to 2007. However, they made up 34% of the defaults over the same period. Compare that to public and private four-year colleges, with rates of 15.1% and 13.6%, respectively.

A for-profit lobbyist at the 2010 congressional hearing was quoted as saying that it would be “unfair” for the government to penalize them for serving a riskier sector of the population. That is akin to mortgage lenders saying that it would be unfair to penalize them for originating the “liar” and “ninja” (no jobs, no income) home loans to a risky sector of the population that clearly did not have the ability to pay them back. For-profit institutions clearly want to maintain their image of providing a necessary service to working class students, despite providing a substandard level of instruction and then expecting them to pay back debts which they cannot handle with the jobs they end up getting.

Yet, Congress is more likely to take the case of predatory student lending much more seriously than some might think because student loan debt cannot be discarded under current bankruptcy law. Unlike an underwater mortgage, students can’t just walk away from them. If they default, they are disqualified from further federal aid, thus becoming ineligible for further education. Additionally, they may have their tax refunds and wages seized by the government. Their negative credit makes it harder to obtain housing, cars, etc. When they can get a loan/consolidation, they pay higher interest rates. This situation is happening with alarming frequency as the job market has tightened.

Less than two years removed from the failure of Lehman Brothers and the subsequent bailout, the US taxpayer could potentially be on the hook for another few hundred billion dollars if alumni of for-profit institutions continue to default and Congress passes a relief bill. As this debate has hit the news over the past few months, the stocks of Apollo Group, DeVry University, and Corinthian Colleges have plummeted in the range of 30-50%. It should be noted that these stocks were top performers throughout 2008, when they were viewed as beneficiaries of the recession which has sent many back to school. The more Congress scrutinizes these companies’ business models and practices, the more likely it is that their stocks will continue to go down. As we know from oil and financials in 2008, when a sector is targeted by a group of short sellers, it can go down swiftly and relentlessly, regardless of how far below equity or enterprise value the resultant stock valuations might be.

The current situation was not always the norm with for-profits, even at the Apollo Group’s University of Phoenix. When my family lived in Arizona in the 1980s, my mother taught nursing at the University of Phoenix before it began its massive national expansion. Even though it was a for-profit institution, it had not yet McDonaldized college education via watered-down online coursework, short term schedules, and convenient, office-like campuses. Back then, it was similar to a normal community college experience, offering day or evening classes. Students were given a great amount of individual attention and adhered to a normal two-term and/or summer semester. However, after Apollo Group went public and the focus shifted to profit growth, it was akin to a successful small-town business expanding and in the process losing focus on its core mission. Therefore, Congress should view its mission as focusing on measures that make sure the level of instruction is sufficient, and to prevent the objective of these colleges from simply expanding enrollment to ensure profit growth.

America's leaders have pledged for America have the highest percentage of college graduates in the world by 2020. As the world economy changes and US-based jobs become more knowledge-oriented, a college education is all but mandatory for individual success. Despite their problems, for-profit institutions are likely not going away. After all, since community colleges have been unable to accommodate the demand for spots, for-profit institutions are picking up the slack, as they are able to expand capacity more quickly. That said, in their current form their business model is unsustainable and arguably not beneficial for America. We the People and Congress need to recognize them for what they currently are: for-profit corporations. A for-profit’s board of directors has a fiduciary obligation to the shareholders, not to the students or alumni. They will stay for-profit, but we need to make sure the pursuit of profit does not overtake their stated mission to educate Americans for the future.

Respectfully yours,
Matthew R. Green
July 19, 2010

Monday, July 5, 2010

Issue XVII - Municipal Finances

Dear Readers,

As renewed uneasiness about the economy creeps into the public consciousness, one subject of rising concern among economists and government officials alike is the public finances of all levels of government. The range of specific concerns is vast, from underfunded state pension funds to the increasingly precarious task of financing municipalities by issuing bonds. With the increased scrutiny, many questions have been raised about the viability of local and state debt, and rightfully so, as municipal and state bonds are investments to which a great portion of the investing public has direct or indirect exposure. In a few recent issues, I have focused on the situation in Europe, which is potentially a harbinger for what could eventually happen in the US. This issue focuses on municipal governments, whose problems seem to get progressively more unflattering with each new story that makes the news. With the current legal framework regarding local and state bankruptcies, this situation is potentially another problem where the strains will work their way up to the states, and eventually the federal government will be forced to take on the burden.

While it is making its way to the forefront of the public consciousness, the fact of the matter is that municipalities declaring bankruptcy is nothing new. What is different this time, and at the heart of many concerns, is the sheer number of municipalities that are potentially facing bankruptcy. While Chapter 9 filings are much less common than personal and corporate bankruptcies and the ramifications are not as severe as one might think, what carries severe consequences is the possibility of many happening at once. The US Bankruptcy Code for municipalities, collectively known as Chapter 9, ensures that the repercussions are not immediate in nature.

Prior to the 1930s, there was very little in terms of legal infrastructure designed to address municipal bankruptcies. Once the US entered the throes of the Depression, a growing number of municipalities across the nation (particularly in the Dust Bowl, which suffered from crop loss and the subsequent exodus of population) became unable to pay their workers and outstanding debts. To remedy this, laws were altered within the US Bankruptcy Code beginning in 1934-35. Because the 10th Amendment of the US Constitution places limits on the influence the federal government can exert upon the states, Chapter 9 filings are by and large local issues and are resolved on that level. The Chapter 9 process involves several steps. First, a municipality must go to their state for approval (this process varies by state). Second, the municipality generally must prove itself to be insolvent, unable to meet present and/or future obligations. Finally, it must make a good faith effort to negotiate with its creditors before filing. As is the case with corporate bankruptcies, it is often in the creditors’ best interest to do this as well, since they could both potentially lose more in a bankruptcy.

The primary duty of the judge in a Chapter 9 filing is to ensure a municipality is eligible to file, and then place a stamp of approval on its plan for paying off the debt. Judges cannot force a municipality to liquidate assets to pay its creditors. Slate magazine, while reporting on San Diego’s financial debacle in 2005, quoted a lawyer who worked on Miami’s 1996 Chapter 9 filing as saying, “They can’t come and pick up the fire engine(s).” Furthermore, unlike a personal or business bankruptcy, a Chapter 9 filing is not made with the intention of ridding a municipality of its debt. Instead, its purpose is to allow reorganization by assisting a municipality in terminating unsustainable contracts and to ease the process of raising lower-interest financing. For this reason, the city does not need approval of the judge to borrow money and/or engage in other financial transactions, which would be necessary in a corporate or personal bankruptcy.

As is the case with personal and corporate bankruptcy, the causes are predictable and often years, if not decades, in the making. Faced with falling revenue from the loss of an industry or population, a city begins to operate with a deficit, and more often than not gets in the habit of it. This is not a bad thing in and of itself, as utilizing debt markets allows a city to sustain its credit. While this is commonplace in the short-term, during economic downturns it is a situation that can quickly turn ugly, particularly if a government has not planned accordingly.

As mentioned, while municipal bankruptcies occur much less frequently than personal or corporate bankruptcies, they are never out of the question. During the 20th century, there were over 400 municipal bankruptcies in the US, including the near-filings of a few major cities. One of the reasons Chapter 9 is not frequently used is that for politicians, the ends often do not justify the means. In other words, many municipalities that could potentially benefit from Chapter 9 might be hesitant to file because the process would involve tax increases and unpopular service cuts. Thus, the risk of political fallout is extremely high. As is well-known and remembered, in 1975 New York City came close to filing for Chapter 9. This is most remembered by New Yorkers for the cuts in the police force and sanitation departments, and also for the famous New York Post headline covering President Ford’s reluctance to bail out the city: “Ford to City - Drop Dead.” However, at the time it was actually quite difficult for a large city to meet the eligibility requirements for Chapter 9. In response, Congress altered the Chapter 9 bankruptcy codes in early 1976, making it easier for large cities to utilize Chapter 9. A few years later, in 1978, Cleveland defaulted on a few short-term loans, but through the valiant work of their city council managed to push through an 11th hour increase in the city’s income tax to avoid Chapter 9.

Today, California has been attracting attention as one of the hubs of public finance debacles on both the local and state level. Besides the well-publicized state budget problems, the Golden State has a long recent history of financial problems on the local level. The 1976 revisions in the Chapter 9 code are what enabled Orange County to file for bankruptcy in 1994. One of the county’s investment managers had parked its pension funds in derivatives that went sour, causing a sudden $2 billion loss. Even while the real estate market in Southern California was flying high in 2005, candidates campaigning for mayor in San Diego openly talked about filing for bankruptcy to close a swelling pension deficit. Four years later, they haven’t closed the gap. After teetering precariously on the edge of Chapter 9 for the last few years, recent news stories have reported that grand jury investigations into the city’s finances found that San Diego regularly skipped payments destined for the pension fund, while continuing to raise the pensions and benefits of public employees. Each year, avoiding Chapter 9 in San Diego has become a more arduous task, yet politicians seem to be playing the classic game of kick the can down the road.

Another California city brought to its knees by public pensions was the Northern California city of Vallejo in 2008. In this case, it was rather simple, brought about via high fixed costs in employee salaries and pension expenses. This reflects a greater problem throughout California and much of the United States. Due to the fact that California is generally a desirable place to live, the cost of living is high. As a result, public employee unions, which especially in Northern California have the ears of left-leaning politicians, have repeatedly secured lucrative contracts for their members, often in the form of campaign promises. Over the next few years, look for Chapter 9 to be used more often by municipalities across the nation to force renegotiations on public employees.

Obviously, this problem isn’t solely caused by generous contracts for public employees, nor is it confined to California. Along with the recent troubles in California, cities such as Harrisburg, Detroit, Phoenix, Cleveland, and even New York City are struggling to balance their budgets, and will likely witness budget standoffs on a yearly basis until the US experiences a sustained economic recovery. In response to the problems at local levels, states are emerging as the ones who seem willing to initiate cuts. The problems, as is the case on the municipal level, range from the usual suspects of underfunded pensions to outdated governmental structures and bureaucracies. Time magazine recently reported on the efforts of Nebraska state senator Rich Pahls to merge many of his state’s 93 counties. Similar programs in England during the 1960s and 1970s brought about today’s system of counties, while the old borders became “historic” counties. In Nebraska, this means forcing consolidation of road services, vehicle registration, and law enforcement, eliminating many local government jobs in the process. Pahl’s efforts have been quashed thus far, in part because “it seemed too frank an acknowledgement of the passing of small-town America.” With 16 of Nebraska’s counties having less than 20,000 residents, with a handful under 2,000, such measures will no doubt be necessary in the coming years.

Pensions, just as they are on a local level, are increasingly being revealed as dead weight that needs to be reduced in the new economic climate. For years, politicians have wooed public employee unions’ votes via promises of pension raises and benefit security, assuming the funds would always be there. In a tabloid mecca like New York City, there has been no shortage of stories covering relatively lavish retirements for selected public employees. The New York Times recently reported that nearly 3,700 retired New York State public employees earn more than $100,000 a year in pension payments, many who are barely in their 50s. Other such tales have made the news all over the nation recently. It is reflective of a growing public divide between public and private employees and the fact that public employees have found themselves living in parallel, yet separate, economic realities over the past decade. It is unfortunate to potentially need to cut the benefits of those who protect our property and teach our children. However, the fact is that during the past decade private sector employees, particularly in the auto, airline and a slew of other industries, have experienced constant downsizing, stagnant or decreasing wages, and are paying more for health care. Traditional pensions are a thing of the past for the private sector, now almost solely confined to the tax-supported public sector. Private sector employees fund their own retirement via 401(k)s and other such plans, which are subject to the oscillations of the economy. On top of that, public sector workers have always enjoyed a higher level of job security, which is one reason that it has always been a big deal when these sectors have experienced cuts.

As the economy remains uneasy, there is no doubt in my mind that a number of cities will end up filing for Chapter 9 as local and state budgets continue to deteriorate. However, this is unlikely to create a state of anarchy, although there will no doubt be a public outcry by any number of affected parties. With the way such occurrences have played out in the past, business will go on as usual for everyone except those who hold large portfolios of municipal bonds, and of course municipal employees. For practical reasons, when a city declares Chapter 9, it is able to continue its operations. The bigger problem with a Chapter 9 bankruptcy lies in store for a city’s creditors. Municipal bonds, due to their tax advantages, have long been a preferred investment for institutions all the way down to individual investors. While a Chapter 9 filing does not free a city from its debt obligations, it can be a mechanism through which municipal bonds can be terminated before their maturity. The last time so many municipalities had problems at once was, not surprisingly, the Great Depression. Considering that we have just experienced the worst economic downturn since the Great Depression, and municipalities across the country are currently reporting financial troubles, it is reasonable to surmise that municipalities are not out of the woods.

The day of reckoning is closest for municipalities, simply because the ramifications of an individual Chapter 9 filing are much less than a state becoming insolvent. Thus far, states have shown a better ability to push back their problems, while the municipalities deal with them first. Unless a true economic recovery takes hold, things will continue to make their way up the totem pole. A rash of local bankruptcies would place added pressure on states like California to fix the problems on the state level, and do it quickly. However, if that doesn’t happen, the problem would then be passed to the federal level. In the same way that when mortgage originators went bankrupt, next in line were banks that bought the soured loans and repackaged them. When the banks had trouble, eventually the government had to bail them out, adding to its own debt. The public finance debacle could shape up in a similar way. While I am not a doomsayer with regard to the possibility of high inflation from the debasement of our currency, if the government ends up bailing out the states in one way or another, the chances of higher inflation will immediately increase. This provides a reason to hope that governments on the local and state level, employees and elected officials alike, can get their act together. Just as the private sector has been forced to cut and hunker down, all levels of government also need to learn to live with the new realities.

Respectfully yours,
Matthew R. Green
July 5, 2010

Wednesday, June 30, 2010

Seasonality of Silver Data 1984-2009

Bear with me here, as I can't import an Excel Spreadsheet directly.

All prices are The London Fix Silver/oz. in USD.
Open and Closing Dates are the First and Last trading days of each respective month.
1984 1985 1986 1987 1988 1989 1990
May Open $8.93 $6.15 $5.11 $7.94 $6.36 $5.65 $4.95
May Close $9.12 $6.09 $5.20 $7.69 $6.60 $5.22 $5.07
Difference $0.19 ($0.06) $0.09 ($0.25) $0.24 ($0.43) $0.12
June Close $8.39 $6.11 $5.05 $7.14 $6.65 $5.17 $4.84
Difference ($0.73) $0.02 ($0.15) ($0.55) $0.05 ($0.05) ($0.23)
July Close $7.11 $6.34 $5.05 $8.32 $6.80 $5.15 $4.85
Difference ($1.28) $0.23 $0.00 $1.18 $0.15 ($0.02) $0.01
Aug Close $7.45 $6.25 $5.17 $7.55 $6.46 $5.07 $4.83
Difference $0.34 ($0.09) $0.12 ($0.77) ($0.34) ($0.08) ($0.02)
Sept Close $7.44 $6.05 $5.52 $7.64 $6.17 $5.28 $4.79
Difference ($0.01) ($0.20) $0.35 $0.09 ($0.29) $0.21 ($0.04)

Gain/Loss ($1.49) ($0.10) $0.41 ($0.30) ($0.19) ($0.37) ($0.16)
% -16.69% -1.63% 8.02% -3.78% -2.99% -6.55% -3.23%

1991 1992 1993 1994 1995 1996 1997
$3.97 $4.01 $4.27 $5.29 5.7 5.33 4.68
$4.13 $4.06 $4.71 $5.50 5.3 5.34 4.86
$0.16 $0.05 $0.44 $0.21 ($0.40) $0.01 $0.18
$4.45 $4.03 $4.48 5.25 5.33 5.03 4.72
$0.32 ($0.03) ($0.23) ($0.25) $0.03 ($0.31) ($0.14)
$4.06 $3.95 $5.30 $5.29 5.1 5.11 4.38
($0.39) ($0.08) $0.82 $0.04 ($0.23) $0.08 ($0.34)
$3.81 $3.72 $4.84 $5.36 5.32 5.2 4.73
($0.25) ($0.23) ($0.46) $0.07 $0.22 $0.09 $0.35
$4.13 $3.77 $4.03 $5.62 5.53 4.88 5.17
$0.32 $0.05 ($0.81) $0.26 $0.21 ($0.32) $0.44

$0.16 ($0.24) ($0.24) $0.33 ($0.17) ($0.45) $0.49
4.03% -5.99% -5.62% 6.24% -2.98% -8.44% 10.47%

1998 1999 2000 2001 2002 2003 2004
6.17 5.33 5.01 4.34 4.54 4.66 6.1
4.97 4.94 4.9 4.43 5.05 4.56 6.17
($1.20) ($0.39) ($0.11) $0.09 $0.51 ($0.10) $0.07
5.36 5.22 5.02 4.34 4.87 4.51 5.91
$0.39 $0.28 $0.12 ($0.09) ($0.18) ($0.05) ($0.26)
5.53 5.45 4.95 4.22 4.66 5.08 6.32
$0.17 $0.23 ($0.07) ($0.12) ($0.21) $0.57 $0.41
4.79 5.08 4.91 4.2 4.57 5.11 6.74
($0.74) ($0.37) ($0.04) ($0.02) ($0.09) $0.03 $0.42
5.39 5.58 4.89 4.59 4.53 5.12 6.67
$0.60 $0.50 ($0.02) $0.39 ($0.04) $0.01 ($0.07)

($0.78) $0.25 ($0.12) $0.25 ($0.01) $0.46 $0.57
-12.64% 4.69% -2.40% 5.76% -0.22% 9.87% 9.34%

2005 2006 2007 2008 2009
6.85 13.92 13.45 16.64 12.15
7.13 12.9 13.25 16.85 15.52
$0.28 ($1.02) ($0.20) $0.21 $3.37
7.1 10.7 12.54 17.65 13.94
($0.03) ($2.20) ($0.71) $0.80 ($1.58)
7.15 11.34 12.93 17.48 13.63
$0.05 $0.64 $0.39 ($0.17) ($0.31)
6.74 12.6 11.95 13.76 14.54
($0.41) $1.26 ($0.98) ($3.72) $0.91
7.53 11.55 13.65 12.96 16.45
$0.79 ($1.05) $1.70 ($0.80) $1.91

$0.68 ($2.37) $0.20 ($3.68) $4.30
9.93% -17.03% 1.49% -22.12% 35.39%

Average Loss: -7.49% Median: -5.62%
Average Overall: -0.27%
Average Gain: 9.57% Median: 8.02%

Since 2003: Average Loss: -19.57%
Average Gain: 13.20% Median: 9.87%

Average Overall: 3.84%
w/o 2008/09: 2.72%

Monthly Performance:
1984 1985 1986 1987 1988
May %'s 2.13% -0.98% 1.76% -3.15% 3.77%
June %'s -8.00% 0.33% -2.88% -7.15% 0.76%
July %'s -15.26% 3.76% 0.00% 16.53% 2.26%
Aug %'s 4.78% -1.42% 2.38% -9.25% -5.00%
Sept. %'s -0.13% -3.20% 6.77% 1.19% -4.49%

1989 1990 1991 1992 1993 1994
-7.61% 2.42% 4.03% 1.25% 10.30% 3.97%
-0.96% -4.54% 7.75% -0.74% -4.88% -4.55%
-0.39% 0.21% -8.76% -1.99% 18.30% 0.76%
-1.55% -0.41% -6.16% -5.82% -8.68% 1.32%
4.14% -0.83% 8.40% 1.34% -16.74% 4.85%

1995 1996 1997 1998 1999 2000
-7.02% 0.19% 3.85% -19.45% -7.32% -2.20%
0.57% -5.81% -2.88% 7.85% 5.67% 2.45%
-4.32% 1.59% -7.20% 3.17% 4.41% -1.39%
4.31% 1.76% 7.99% -13.38% -6.79% -0.81%
3.95% -6.15% 9.30% 12.53% 9.84% -0.41%

2001 2002 2003 2004 2005 2006
2.07% 11.23% -2.15% 1.15% 4.09% -7.33%
-2.03% -3.56% -1.10% -4.21% -0.42% -17.05%
-2.76% -4.31% 12.64% 6.94% 0.70% 5.98%
-0.47% -1.93% 0.59% 6.65% -5.73% 11.11%
9.29% -0.88% 0.20% -1.04% 11.72% -8.33%

2007 2008 2009
-1.49% 1.26% 27.74%
-5.36% 4.75% -10.18%
3.11% -0.96% -2.22%
-7.58% -21.28% 6.68%
14.23% -5.81% 13.14%

Average: May %'s 0.87%
June %'s -2.16%
July %'s 1.18%
Aug %'s -1.87%
Sept. %'s 2.42%

Since 2003: May %'s 3.32%
June %'s -4.80%
July %'s 3.74%
Aug %'s -1.37%
Sept. %'s 3.44%

Up Down
May 62% 38%
June 31% 69%
July 58% 42%
August 38% 62%
Sept 58% 42%

Friday, June 18, 2010

Issue XVI - Mergers 2010

Dear Readers,

After Mergers and Acquisitions activity picked up in the second half of 2009, commentators, economists, and bankers alike were divided with regard to what 2010 held in store. The divide was vast, ranging from predictions of a “perfect storm” for M&A by Goldman Sachs to expectations of another downturn. While predictions of a robust comeback have yet to pass, after what has transpired the past few years M&A is doing better than expected. After a steep drop in 2008 and again in 2009, the value of overall deals has leveled out so far in 2010. When history is considered, even a breakeven year in the wake of such an economic contraction is something to feel good about. In the grand scheme of things, 2010 is currently on pace to transpire as a lukewarm year for M&A.

As I covered in January, M&A activity through the first half of 2009 was dominated by a few mega-healthcare deals (Wyeth/Pfizer and Schering/Merck), and a great percentage of investment banking revenue came via assignments to help companies of all sizes shore up their balance sheets. Activity on both the traditional M&A and Private Equity sides began to pick up at the end of the summer. The final three months of 2009 featured activity from industries across the board. Highlights included Exxon buying XTO energy, Warren Buffett buying Burlington Northern Santa Fe, and Comcast buying NBC Universal.

Looking back on M&A activity during the past three recessions, the cycle has been about two or three years from peak to nadir. This has been the trend regardless of the downturn’s severity. M&A experienced three down years during and after the 1990-91 recession, and two years after the 2001 dot-com bust. The latter was a particularly tough period, as bulge bracket firms were also reeling from the loss of revenue from underwriting tech IPO’s. Based on current numbers, this year could be shaping up to follow this pattern yet again. As of last week, total deal volume so far in 2010 is merely 1% off last year’s pace. After peaking in 2007, M&A saw year-over-year drops of 41% in 2008 and 22% in 2009, according to Bloomberg. While things are still touch and go, given the two-year cycle and this year’s pace, the M&A market appears to be holding up nicely while not getting ahead of itself.
Additionally, as we all know, the most recent recession has been deeper than the previous two in both its severity and longevity. According to data from the Bureau of Economic Analysis, the 1990 recession saw three consecutive quarters of negative GDP growth from Q3 1990 to Q1 1991. The 2001 recession saw two non-consecutive quarters of negative growth, in Q1 and Q3 of that year. Compare that to five out of six quarters of negative growth from Q1 2008 to Q2 2009, the one exception being Q2 2008 when the government’s stimulus checks helped out. ThomsonReuters columnist Rolfe Winkler wrote last week that, “considering the depth of the latest recession compared to the prior two, one might think dealmakers would still be in hibernation.” That said, it is all the more remarkable that M&A appears to be resilient, sticking to its two-to-three year cycle (refer to Chart 1).

Chart 1 – Annual M&A Volume 1988-2008

Partly in response to the pickup in late 2009, many were quick to predict that 2010 would be a robust year for M&A. A report endorsing this viewpoint was produced by Goldman Sachs in late 2009. Goldman’s view was based on the fact that companies have lots of cash on their balance sheets, with levels rising through and after the recession. In addition to rising cash levels (refer to Chart 2), the report pointed to the environment of low interest rates and the search for non-organic growth potentially leading to what was described as a “perfect storm for M&A.” Thus far, this has not come to pass. That is not to say that the report was completely inaccurate in its predictions, however. While the activity in late 2009 was promising, the momentum seems to have stalled somewhat in the first months of 2010. There are several reasons for this.

Chart 2 – Corporate Cash Balances September 2004 - 2009

First, the reduced activity during the first quarter of 2010 was partially the result of continued volatility in the equity markets. The Dow Jones Industrial Average ranged from just below 10,000 to above 11,200 within the first few months of the year. Heavy volatility is not conducive to M&A activity because buyers and sellers want to have a fairly stable equity environment before they act/make an offer. But that is not to say that big deals did not take place. Energy and Utilities led the way early in the year, with Schlumberger acquiring Smith International and FirstEnergy acquiring Allegheny Energy. As volatility lowered in April, activity saw an uptick, accelerating into May after the so called “flash crash” on May 6. Companies have taken advantage of the lower stock prices since then to make moves. A few all-cash examples of this include Hewlett-Packard’s acquisition of Palm on April 28 and SAP’s acquisition of Sybase on May 12.

Second, despite the largesse of cash on balance sheets, this in and of itself does not mean that companies will be going on buying sprees. While large cash positions increase the potential for activity, in the aftermath of 2008 companies have been treading carefully with regard to using cash for acquisitions, and especially for buybacks of stock. However, after going through an aggressive cost-cutting cycle through the recession, it is possible that companies will be looking in the near future for potential acquisitions where they can cut costs while creating growth, which is inherently difficult to do in a low-growth economy. A few recent examples are the aforementioned FirstEnergy/Allegheny Energy merger, the United/Continental merger, and Century Link’s acquisition of Qwest Communications. Although the latter transaction is all-stock, it is one of the best examples of a synergy-based deal so far this year. While both companies have been cutting costs, they are hoping the synergies from their merger, announced on April 26, will provide more than $500 million in new cost savings, according to ThomsonReuters.

Finally, another sector within M&A that could see a pickup in 2010 is one of its main engines: Private Equity. The reason is that not only do PE firms have lots of cash sitting on the sidelines, they are also potentially racing the clock with regard to investor’s funds. Private equity has largely been on the sidelines since 2007-08 due to the lack of credit, which provides the leverage needed to generate promised returns for investors. Obviously, this is a far cry from the over $1 trillion in buyout deals that were consummated in 2006-07 (refer to Chart 3). An editorial last week in Investor’s Business Daily reported that PE firms have $445 billion sitting on the sidelines that was raised during what is rapidly becoming known as the Second Golden Age of Private Equity (the first was during the 1980s). To have such a sum in one’s coffers doesn’t sound bad at all, but it’s more complicated than that. In short, when a PE firm raises a new fund, it usually has a pre-set time frame in which it can put those funds to work. Most funds have a five to seven year window in which they can legally invest capital, after which investors can start pulling their capital out to look for returns elsewhere. There is a popular saying within the industry that goes, “use it or lose it.”

Chart 3 – Total LBO Deal Volume 2006-2010

Indeed, there is a great amount of capital that will be lost if it is not put to work. Therefore, many firms may accept the reality of lower returns and start investing once again. Of course, this carries the risk that some bad deals may take place. That said, we have seen an uptick in PE deals so far in 2010 compared to 2009. A few of the bigger deals have included the acquisition of Interactive Data by Silver Lake Partners and Warburg Pincus, as well as the acquisition of Dyncorp by Cerberus Capital Management.

For the remainder of the year, there are two main factors that could set the tone for how the M&A sector plays out. First, as always, the equity markets. The events of May 6 sent the VIX to nearly 40, but it has since fallen back to the level it was at just before that day. However, with many market observers pointing to tepid economic data and expecting a pullback, this could change. Volatility could reassert itself, and that could potentially inhibit activity for the rest of the year. Second, as mentioned, private equity will have to continue negotiating with lenders to take advantage of the low-interest rate environment to make use of their investor’s funds. Their success or lack thereof in this will be a major determinant for M&A the rest of this year. Finally, another factor that could make a difference is the situation in the Gulf, which could lead to a few consolidations within the petroleum industry and the associated sectors. Already, the volume of M&A activity in the energy sector has doubled to date this year compared to the same time frame in 2009, according to ThomsonReuters. Total deal volume in the sector stands at $128.5 billion as of last week, compared to $57 billion in the same period in 2009, which also outpaces the volume of $122 billion during same period in 2007. With a robust second half, M&A in the energy sector could surpass the 2007 high-water mark.

In summary, it is reasonable at this time to assert that M&A will have a reasonably good year, possibly breaking the downtrend, but not great compared to some of the boom years. Deal volumes continue to recover and we continue to see companies across with board with cash-rich balance sheets, the same situation existing in private equity. Therefore, the real question should be how much potential activity is built up, and whether or not that potential can be unleashed within the current economic environment. The surest way for this to happen would be an improved economy that leads to increased lending by the banks. It adds a reason to hope the economic recovery continues through the remainder of the year.

Respectfully Yours,

Matthew R. Green

June 18, 2010

Friday, June 4, 2010

Issue XV - Correlations

Dear Readers,

Although many date the start of the current economic crisis to the July 2007 collapse of two Bear Stearns internal hedge funds that were heavily invested in fixed-income mortgage securities, to me, the first event that was a “snap out of it” moment came in late February 2007. On February 27 of that year, the Shanghai Composite Index fell 9% in one trading session. This would be followed shortly by the collapse of Irvine, California, based New Century Financial, the first major mortgage originator to fail.

In the wake of the events since, much has been written and said about what warning signs existed, if any, prior to the crash of the US housing market. Of the warning signs, most pundits have pointed to the overheated housing market and other symptoms of excess liquidity (i.e., banks lending for leveraged buyouts at 8-10 times cash flow, with relatively few covenants). From following and studying the precious metals market during the past few years, I have noticed that a few unusual correlations existed prior to the first signs of trouble in early 2007. I am seeking to take a look at what the big picture was, what available data indicated at the time, and what, if any, warning signs can be deduced.

By early 2007, everything from equities to real estate was up. This occurrence can be attributed to several things. First and foremost, the capital unleashed by Greenspan’s interest rate cuts needed to find a home somewhere. That alone contributed to all asset classes being pushed up. Second, China’s role in the global economy contributed to subdued US inflation, rather than the level of inflation that might have been expected due to then-historically low interest rates. Finally, the modern measure of volatility, the VIX, was at all-time lows. This did not allow for proper risk management, allowing dangerous levels of leverage to be built up. As such, all asset classes were held up, and this paved the way for a swift decline when it all ended.

A mass of liquidity was unleashed in the early 2000s by central banks around the world, led by Greenspan’s Fed. This was due to the economic slowdown in 2000-2002 and the shock of 9/11. This global flood of capital saturated everything from emerging markets to equities around the world, but especially the US housing market. By early 2007, while banks were still making lots of money, uncertainty was creeping into the economy from the stalled housing market. No one was really sure what the effects would be, and around this time economists increasingly found themselves at odds with each other with respect to their predictions. However, there was a feeling that at the very least, the Federal Reserve would be able to engineer a soft landing for the economy, as Greenspan had been credited with doing five years earlier. For the time being, an air of euphoria prevailed in late 2006 and into 2007.

This giddiness was not only caused by the billions that had been made in real estate, but across all markets. The correlations that existed in late 2006 were unlike any that had ever been seen before. Gold, equities, and bonds, government and corporate, were all up. Such an across-the-board correlation, particularly between US government debt and gold, is rare. Gold finished 2006 up at a then-eye-popping $637 per ounce, up more than 20% for the year. The S&P 500 was up 14% on the year, rising after two relatively tepid years in 2004 and 2005, when it was largely range-bound. Finally, US government bond futures finished the year up 6%. As such, yields between the 5, 10 and 30-year bonds had not only risen but converged as well.

While the full faith and credit of the United States government was alive and well, an increase in gold implies uncertainty in the monetary system and, more often, the perception that inflation is going to rise. After all, inflation was significantly up in 2006 and 2007. The rise of emerging markets, such as Brazil, China, and India, and the resulting increases in demand for oil and food staples had helped to steadily push inflation up during the 2000s. However, in that case fixed-income investments would not be expected to do as well. The inverse correlation between Uncle Sam’s debt and gold was mentioned by a few commentators at that time. Dennis Gartman, the Virginia-based economic commentator and author of The Gartman Letter, wrote in December 2006 that, “one would expect gold and the debt market to move in contravention, for strong gold means rising inflation which is, of course, an anathema to debt investments. The only reason we can ascertain to push both higher is weakening economic environs, deflation and serious economic dislocations” (refer to Charts 1 and 2).

Chart 1 – Price of Gold, January-December 2006

Chart 2 – US Government Debt Yields, 2000-2010

In addition to contributing to the increases in the price of commodities, China’s role in the global economy allowed interest rates to stay low without immediately generating inflation due to the lower prices for its goods. It also contributed to lower rates and the property boom by, as I have previously written about, a voracious appetite for US debt. By early 2007, as Greenspan was enjoying the close of his first year of retirement, he was the most celebrated central banker in history (in all reality his legacy will be as such, no matter how much we know that he made mistakes). What was the perhaps the first tremor of what would become the Great Recession arrived in late February while Greenspan was addressing a large European fixed income conference in London. There, he advised the attendees that there was a chance the US could fall into recession in late 2007. The next day, a tremor came out of China that reverberated around the world.

On February 27, it became known that the Chinese government was creating a task force to explore ways to curb speculation on the Shanghai Composite Index (SSE). Investors panicked at the prospect of the Chinese government suddenly curbing their access to its capital markets. The SSE, which had doubled in 2006, fell by 9% in one trading session, to 4000. Suddenly, the markets were on edge. Although the SSE recovered along with US and European markets to post all-time highs in October 2007, it served to illustrate the newfound importance of China, even at a time when its importance was not completely understood by those who had the most at stake.

The rise of China and its role as a factory for the world created economic conditions that served to mask the true situation. This had many ripple effects on the global economy, some more obvious than others. The “money loop” that was established enabled goods to be produced at lower prices, contributing to subdued inflation at the point of sale in the US and Europe. Another effect was that the resultant, ballooning trade deficit left the Chinese flush with cash. As was the case with the US, this capital had to find a home somewhere. The Chinese ramped up their buying of treasuries throughout the 2000s. Indeed, it was one reason that US government debt prices went up with the market in 2006. China’s purchases of US government debt increased from $72 billion in 2000 to $420 billion in 2007. China bought other, higher-yielding debt implicitly guaranteed by the US government (translation: Fannie Mae and Freddie Mac debt) in large numbers, further contributing to the property bubble. Of course, to political leaders in the US and Europe, this was a win-win situation. Subdued inflation was a key ingredient in maintaining economic stability despite low interest rates. The juiced housing market created construction and real estate jobs (these sectors created over 1/3 of the new jobs created from 2003-06, according to official Dept. of Labor data). In this manner, China’s role of helping to pay for the American Dream was crucial to keeping the American machine running, which in turn had to run in order to keep China’s factory machine running, and so on.

By early 2007, economists and central banks across the globe found themselves increasingly divided about the future prospects for the US economy. Residential real estate prices across the nation had stopped appreciating or were in swift decline, particularly on the coasts and across the Sun Belt. At the same time, as we know, there was still plenty to smile about. One month before the first signs of trouble, the mood was jovial at the 2007 World Economic Forum in Davos, Switzerland. As mentioned, prices for most assets were still at relative highs, and there was emerging talk of a secular “Great Moderation” among a growing cadre of academics. One central tenet of this theory was that modern banking systems and risk management had brought volatility to new, permanent lows. Thus, the implication was that we were in an age of lessened, if any, financial shocks. Since the early 1990s, the primary measure of volatility has been the VIX index. In late 2006, the VIX was at multi-decade lows.

The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index. Briefly, it has been disseminated since 1993, and is constructed by formulas that measure the fluctuations of S&P 500 futures activity. Although there are now derivatives that trade based on its fluctuations, the VIX itself is not backed by anything. It is solely for the purpose of measuring volatility in the market. The VIX measured in the 40’s after the tech bubble burst, and fell steadily from the upper 20’s in 2001-02 before dropping below 10 for the first time in late 2006 (refer to Chart 3). The driving up of asset prices across the board had led to lower profits and returns on investment. However, this also served to drive down volatility. Although I have generally disagreed with Nouriel Roubini’s economic predictions since the beginning of 2009, his initial prediction about the US real estate market and the derivative-led shock waves across the banking system proved to be spot-on. While he was predicting the ripple effects of the real estate downturn, he was also noting that the excess of liquidity was resulting in diminished returns as well as less volatility. In turn, this caused rates of leverage to grow at alarming rates (after all, traders thrive on volatility, no matter which way the market goes). At Davos in January 2007, while part of a panel discussion, Roubini prophetically noted that, due to leverage more than anything, “the risk of something systemic happening is rising.”

Chart 3 VIX Index 1993-Present

By late 2006, nearly every widely-used measure of market risk did not point to heightened volatility in 2007, let alone a sharp downturn, and much less than what would eventually transpire. One of the reasons that I point to the SSE fall in February 2007 is that on that day, the VIX posted its largest one-day jump ever up to that point, and this sent global markets ineluctably on the path to heightened volatility that would define the next two years. Prior to that day, however, volatility was low across the global markets, and yields continued to flatten across the atlas of credit. Money managers found themselves needing to take on more risk to achieve the returns demanded by clients, or to merely replicate/exceed past performance.

Lower volatility, to a trader, meant it was theoretically safer to take risk. That directly translated into more leverage. In particular, a key driver of the hedge fund industry’s growth from 2000-2007 was the fact that many institutional investors had fallen behind when the tech bubble burst. This was particularly true within the realm of pension funds. To get back on track, more robust returns were sought. Hedge funds, ready to use leverage via the environment of readily available credit, were the perfect candidates to accept this assignment. Money managers would lose clients if returns were not high enough to meet or exceed investor expectations, so the vast majority of them used leverage. The first hedge fund tremor came five months before February 2007, in September 2006. A trader at Amaranth Advisors, one of the many hedge funds that opened up in Greenwich, CT, in the 2000s, had wagered with 9-1 leverage that the value of the March and April 2007 natural gas futures contracts would converge. When the spreads instead widened, Amaranth was forced to liquidate after losing more than $5 billion in one week.

According to Michael Lewis’s Bloomberg column from January 11, 2007, the Amaranth debacle was the most widely-read story on Bloomberg since 9/11 when it broke on Monday, September 18, 2006. Additionally, several of the follow-up stories were in that year’s Top 20. That speaks volumes about what Wall Street was concerned about in the months that led up to February 2007. Besides the obvious reasons (cutthroat competition, firms wanting to know who the winners in the trade were, wanting to know who would buy the portfolio, etc.) it is also indicative of what may have been shared concerns. What I mean is that other Wall Streeters appear to have been concerned about the use of leverage and risk. They could conceive of their own firms having the same problems. However, the conclusion by way of the prevailing market measurements at the time was that all was well. Indeed, in spite of Amaranth, the VIX continued to fall for several more months afterward.

In the end, this lack of preparedness for the events of 2007-2009 was an issue of unprecedented historical market correlations brought on by the excess of liquidity. Because it had never happened on a global scale, and therefore had no historical precedent, the effects and outcomes were nearly impossible to predict. Therefore, it should serve as a reminder that this was not completely a matter of the financial and political crème de la crème being asleep at the wheel, as countless pundits have asserted in the three years since.

Respectfully Yours,

Matthew R. Green

June 4, 2010

Friday, May 21, 2010

Issue XIV - Currencies

Dear Readers,

All the news coming out of Europe has made for an interesting week in the markets, particularly the currency markets. The Euro has continued to plunge against the Dollar and other currencies on concerns ranging from doubts about whether the bailout of Greece will work to speculation about the future viability of the Euro. As I wrote in February, while I believe the Dollar is continuing to climb into overvalued territory, volatility and/or upward pressure will likely continue until a) the focal point of currency crises shifts to the US, or b) the crisis is resolved in a manner about which the market is confident. Neither of these has happened. As the situation plays out, I view the skeptics who doubt the Euro’s viability as misguided. A breakup of the Euro, particularly a disorganized piece-by-piece dismantling, is counterproductive and would only harm the EU as a whole. Second, the Euro’s plunge against other world currencies could trigger currency crises in other heavily indebted countries outside the Eurozone, such as Japan.

The volatile action of the Euro, accelerating during the past two weeks, is symptomatic of trading action that is less fundamentally driven than it is by news and gut instinct. As I write this, markets are being battered by Germany’s announcement that it will ban naked short-selling of shares of its top financial institutions and also of its bonds. Similar measures were put into place in the US during the fall of 2008 by the SEC in an attempt to bolster the battered shares of financial services companies. With these measures coming from a country that is looked upon as arguably the most fiscally sound in the entire EU, the ramifications have shaken the market. As a result, on Tuesday night the Dollar Index shot over 87, but retraced sharply back during the past few days. Such action also suggests large, concentrated short positions in the Euro by large trading desks all the way to small hedge funds. The sharp reversal could be indicative of a one-sided market that is ripe for a correction.

That said, the Euro is looking more oversold right now than at any point since 2007, and the Dollar is consequently looking more overbought than at any point within that time frame. Some commentators have suggested this action indicates that the market is beginning to price in the possibility of a Euro breakup and/or demise, or a correction to a permanently lower exchange rate with the dollar (refer to Charts 1 and 2). Both measures are in extreme territory, and the sustainability is questionable. However, the volatility and resultant irrationality will no doubt continue as long as such crises keep popping up.

Chart 1 – Euro Index May 2007 - Present

Chart 2 – US Dollar Index May 2007 - Present

Another story affecting the market has been the emerging speculation that Greece could be forced out of the European Union. I have serious doubts about this possibility. First, there is no established process in the EU’s protocol for the removal of a member nation. Moreover, any attempt to do so would be seriously disruptive, not to mention counterproductive. At a time when Rome is burning, so to speak, more disruption is the last thing that Europe needs. As such, I would interpret such speculation for what it is: mere speculation. Second, taking apart the European Monetary Union will inevitably be more difficult than putting it together. Marc Chandler, global head of currency strategy at Brown Brothers Harriman, stated this week that, “As there is no mechanism for this, we are dubious about the veracity. There is unlikely to be much of a consensus for this move.” The latter part of the statement touches on the bigger, real problem of the European situation. The problem is not confined to Greece, and expelling financially rogue members from the EU is not a long-term solution to the problem.

The real issue of a Greek ouster would be the implications for the rest of the little PIIGS. Portugal, Italy, Ireland, and Spain should be shaking at the possibility of a Greek ouster from the monetary union, as such would set a precedent for the same to happen to them. Therefore, there should be serious doubts that eliminating Greece would be conducive to the long-term viability of either Greece or the EU. If forced to exit, Greece will simply devalue its new currency, immediately resulting in inflation. In that case, there has been talk of reintroducing the drachma (Greece’s pre-Euro currency). This would entail a currency reintroduction with the specific intent to devalue. Greece would immediately see higher interest rates and thus a steeper wall to climb out of the current recession.

It is counterproductive from the EU’s perspective as well, since, as mentioned, getting rid of Greece would not put its problems behind it but merely shift the focus to the other, fiscally weaker members. The fundamental problem that enabled the PIIGS to dig these massive fiscal holes is that the Eurozone policymakers did not prepare a comprehensive fiscal overlay to support and enforce deficit/debt standards within what became a low interest rate monetary union; unfortunately, this union included some members who clearly did not deserve such low rates. The long-term goal of European policymakers is, obviously, maintaining the union. A mere decade into its existence, removal of any members would further undermine what is already being referred to by some as a “failed experiment.” Many commentators have mentioned that a swift breakup of the Euro would enable the indebted nations to devalue, inflate, and get on with their lives, while removing the burden from the more fiscally sound states. If this was viewed as the best solution, Greece would be close to or out the door already. But it is not. Since monetary union is the long-term goal, front and center on the solution-creating agenda should be the future enforcement of fiscal standards. While a mechanism for removal of fiscal outliers may not come to pass, at the very least rigid enforcement of fiscal standards will.

Having observed the various ways that financial contagion and systemic risk have manifested in the past few years, surmising potential effects of the events in Europe is prudent. Taking a look at the global macro picture, the next currency domino to fall could be Japan. The reasons stem from the potential effects on trade and the export-heavy Japanese economy. More importantly, the reason lies in the exporters that Japan directly competes against, Germany and the United States. One commentator pointed out this week that “exports from [Japan and Germany] are in direct competition on many aspects. In terms of products, both are strong in auto and precision equipment. In terms of export countries, both heavily rely on the US and China.” More importantly, Japan finds its currency rising against the Euro, and it comes at a time when Japan’s two largest export destinations, the US and China, are still mired with stagnant economic growth and/or the prospect of a double-dip recession. Indeed, the EUR/JPY exchange rate has fallen more than 35% since 2008 (refer to Chart 3). Germany’s largest export destinations have always been its neighbors in continental Europe. With the belt-tightening austerity measures in Greece and similar burdens likely to be placed by upon the other little PIIGS, Germany may need to look elsewhere to push its export sector, and its economic recovery, forward. As such, a lower Euro is a welcome prospect to the Germans. Therefore, I would look closely at the possibility of Germany and Japan seeing increased competition with each other, and the possibility of continued malaise in the Japanese export sector triggering a currency crisis.

Chart 3 – Euro/Yen Exchange May 2007 – Present

Not surprisingly, China has recently surpassed the US as the top export destination for Japanese goods. Although China’s long-term growth fundamentals are solid, in the short term many investors are wary, and rightfully so, about China’s need to put a damper on inflation and an overheating real estate market. With a second leg of the recession looking certain for Europe and still very possible in the US, Japan’s exports will likely be under pressure for some time. Therefore, the last thing Japan needs is increased competition with other exporters.

Obviously, the main reason why I focus on Japan is their 200% debt/GDP ratio. This is nothing new, having built up gradually over the past 20 years. However, one of the main reasons that a major currency crisis has not come to pass is because of Japan’s culture, “collectivist,” as one commentator aptly put it. In other words, Japanese citizens are more willing than one would think to pour their life savings into helping the government if it was in trouble. Combine that with a high domestic savings rate, and the result is that Japanese citizens and corporations own well over 80% of Japanese Government Bonds (JGB’s). The collectivist bent of the population and domestic savings rate are not going away. At the same time, a population that is ready and willing to help can only delay a crisis to an extent. Without resiliency in the export sector, the task will become much more difficult.

In conclusion, the situation in Europe will provide for an interesting narrative in the weeks and months to come. The possibility of a Euro breakup, while unlikely, has been exposed and is clearly being taken seriously by the market. Yet, if the focus of the crisis were to shift to elsewhere, perhaps to Japan, the Euro might suddenly rebound. Right now, one might wonder why the Euro was ever priced at 1.50 US Dollars given what is now known, but this and the current movements should not be taken as a sign the US Dollar is any safer in the long term. Fiat currencies around the world will face a serious test of their viability over the next two decades. The pace at which these tests will occur is yet to be determined, but will no doubt be heavily influenced by decisions made now and in the next few years.

Respectfully Yours,

Matthew R. Green

May 21, 2010

Friday, May 7, 2010

Issue XIII - Airlines

Dear Readers,

On Sunday evening, United Airlines and Continental Airlines announced that they would merge their operations. This follows in the footsteps of another combination of major carriers, Delta Air Lines’ acquisition of Northwest Airlines in October 2008. Over the past decade, we have seen four major US airlines (TWA, America West, Northwest, and Continental) swallowed up by, or merged with, one of their peers. The remaining “legacy” airlines are the “Big Three” of Delta, United, and American, along with a few smaller legacy carriers such as US Airways and Alaska Airlines. The trend of consolidation within the US airline industry stems from the governmental deregulation of the airline industry in 1978. In the post-deregulation era, three trends have defined the evolution of the airline industry. First, a largely unionized workforce and high cost structure prior to deregulation meant that downward pressure was inevitably placed on employee wages and benefits in the post-deregulation era. Second, new low-fare airlines with business models built around lower cost structures emerged and to this day continue to take away significant market share from the legacy airlines. Finally, competition and the subsequent need to expand led the better-positioned airlines to acquire or merge with the weaker ones, thus leaving only a fraction of the original legacy airlines in business today. With the latest round of consolidation, we have reached a point where future mergers will likely be multinational due to antitrust concerns. Equally likely is the prospect that legacy airlines will attempt to take over low-fare carriers in order to retain them as low-cost subsidiaries, but reorganize the competition in their own favor.

As the railroad industry suffered from rapidly declining traffic in the 1960s, air travel was on the rise, even though it was still a relative luxury for most Americans. Additionally, air transport was a highly regulated industry. The structure was rigid, highly inefficient, and fares were high. The government’s Civil Aeronautics Board (CAB) regulated routes, pricing, and maintained high barriers to entry for newcomers. Even the existing airlines often had to wait years to get new routes approved. One of the most famous stories involved Western Airlines waiting over a decade for approval to fly to Hawaii. It got it in 1969, after years of red tape and attorneys’ fees. Nevertheless, the industry was profitable and airline employees enjoyed relatively high salaries and benefits, made possible in part by the unionization of the workforce. With the CAB virtually ensuring profits, the companies could afford the high salaries, and the system was allowed to work in favor of the carriers and their employees.

It is a harsh reality that all forms of mass transportation are only marginally profitable at best. This is true across the industry, whether it is trucking, shipping, or rail. The airline industry was reminded of this when the 1973 oil crisis forced the airlines to raise fares, which the CAB readily approved. Despite this, the subsequent recession and declining passenger traffic caused the airlines to experience losses. With the massive 1970 Penn Central Railroad bankruptcy a recent memory, (Penn Central was the product of the 1968 merger of the Pennsylvania and New York Central Railroads, a necessity due to the desperate railroad situation), voices in Congress began to express concern that the same thing could happen to the airlines. Subsequently, hearings on airline deregulation began in 1975, spearheaded by Ted Kennedy. In 1977, President Carter appointed Cornell University economist Alfred Kahn as Chairman of the CAB. This was a notable because, as a marginal-cost economist, Kahn was known as an academic who favored deregulation regardless of the industry in question. As congressional hearings continued, the airlines, who favored the rigid system despite its flaws, began to lobby against the proposed legislation. Kahn envisioned an industry with lots of midsize carriers in competition with each other, where reduced profits brought about by competition would largely be balanced out by an increase in passenger numbers resulting from lower fares. Many industry veterans knew better. American Airlines’ Robert Crandall, who would later be known as one of the fiercest post-deregulation CEO’s, stood up in one congressional hearing and chastised the committee that “you’re going to ruin this industry!” Nonetheless, the bill found little resistance in Congress, and President Carter signed the bill into law on October 24, 1978.

While deregulation was necessary to open up air travel to the masses, there were several factors that Kahn and the other deregulators did not address. The most important factor was one for which the airlines found themselves completely unprepared prior to deregulation: highly unionized workforces made it difficult to adjust cost structures without tense labor relations and costly strikes. Not surprisingly, the 1980s brought about harsh realities for many airline employees. The post-deregulation environment immediately exerted downward pressure on the generous wages and benefits of airline employees, a process that continues to this day. Frank Lorenzo, a Queens, NY native, established himself as arguably the most prominent airline executive during the 1980s by building Texas Air into a holding company that would later purchase Continental, PeopleExpress, New York Air, and the once-mighty Eastern, all the while establishing himself as a vicious cost-cutter.

In 1983, Continental declared bankruptcy, and Lorenzo used the courts to force necessary cuts on the unions, emerging shortly thereafter as a lower-overhead, profitable carrier. After former astronaut-turned executive Frank Borman sold Eastern Airlines to Lorenzo in 1986, constant labor struggles ensued. Eventually, a six-month machinists strike in 1989 led Eastern to declare bankruptcy. During this time, Lorenzo was quoted as saying “I'm not paid to be a candy ass; I'm paid to go and get the job done.” By 1990, Lorenzo was a poster boy for the airline industry’s lousy labor relations. That year, he left Texas Air/Continental upon its second bankruptcy filing. His aggressive actions throughout the decade indicate that Lorenzo arguably knew better than any other airline executive what was necessary for the industry’s long-term financial health. Despite this, his tactics poisoned labor relations and made it harder for future airline executives to make necessary cuts due to the lingering atmosphere of distrust. An airline tycoon had become a pariah in just a few short years. His tarnished legacy was apparent in 1994, when Federico Pena’s Department of Transportation rejected an application to launch a new airline from an investor group that included Lorenzo, partially on the grounds that he was involved.

Throughout the rest of the 1990s, a good economy resulted in prosperity for the legacy carriers. However, well-publicized labor struggles remained. With low fuel prices aiding to produce several years of billion dollar-plus profits, the unions, particularly the Air Line Pilots Association (ALPA), began to demand more lucrative contracts. American’s CEO Bob Crandall needed President Clinton’s help to avert a 1997 pilot strike, which Clinton did by invoking the Railway Labor Act (amended to include airlines in the 1930s). The next year, Northwest was forced to impose a lockout on its pilots for two weeks. As the airlines’ profits remained steady into 1999 and 2000, ALPA members significantly lifted their demands. United’s pilots in particular demanded that their pay levels return to pre-deregulation levels, adjusted for inflation.

At the turn of the century, United was indeed flying high, confirming its slogan at the time, “United: Rising.” On the strength of its West Coast network, United rode the tech bubble to profitability. SFO briefly became the sixth-busiest airport in the world, providing United with a great amount of premium and business fares. Frustrated, United’s pilots took action by refusing to fly overtime. United was forced to cancel major portions of its summer schedule and largely acquiesced to its pilot’s demands later that year. Delta’s pilots used this as leverage to do the same in 2001, just months prior to 9/11. In a clear illustration of the union’s unwillingness to accept lower wages, despite the industry bleeding red ink after 9/11, Delta’s pilots refused to accept concessions until 2004, when oil prices began to strain the carrier’s finances.

After three decades of wage and benefit cuts, the legacy airlines remain union-heavy. However, the airlines have experienced the toughest decade in their history in the aftermath of 9/11 and with higher fuel prices. This has forced the unions to accept more flexible cost structures. The list of bankruptcies is extensive. US Airways went through bankruptcy twice, in 2002 and 2004. American narrowly averted bankruptcy in 2003 by winning large wage concessions. United was in bankruptcy from 2002 to 2006, and Delta and Northwest filed Chapter 11 on the same day in 2005. With the bankruptcies of this decade more drawn out than in the past, the airlines have been able to adjust their cost structures downward like never before. This offers hope that the airlines will be able to cope with the possibility of higher oil prices and industry difficulties in the future. Unfortunately, it took 30 years and a revolving door history of bankruptcy for unions and airlines alike to accept the new realities.

The lower barriers to entry post-deregulation led to the other two secular industry trends: the rise of low-fare airlines, and the commencement of a Darwinian race to survive among the legacy carriers. First, a look at the history of deregulation start-ups and a new breed: low fare carriers.

Immediately after deregulation, new upstart passenger airlines began to take to the skies. Midway Airlines of Chicago was planned pending the legislation, and thus began operating in 1979 from its namesake airport. The new, competitive environment meant that passengers suddenly had a choice of which airline to fly, because multiple airlines were competing on the same routes. More importantly, the lack of CAB fare regulation meant that passengers usually flew with the carrier who offered the lowest fare. This was not lost on several entrepreneurs, in particular a man named Donald Calvin Burr. In the late 1970s, the Harvard-educated Don Burr was working for Texas Air under future union foe Frank Lorenzo. Seeing the potential for low-fare airlines, he resigned in 1980 and moved back to the Northeast, setting his sights on Newark Airport. A sleepy airport during much of the 1970s, Burr found that the Port Authority was willing to lease Newark’s deteriorating North Terminal at fire lease rates. He also found that there were many Boeing 737’s on the market that were old, but well-maintained and in good flying shape.

In 1981, Don Burr’s PeopleExpress took to the skies out of Newark, forever changing the industry by redefining the concept of low-fare and no-frills service. The only thing included in the fare was the transportation. To check a bag or to get a snack or beverage on board involved an extra charge – “added value” - as Burr put it. To better utilize flight attendants, the company collected fares on board, and never had a toll-free phone reservation line, preferring local toll numbers for each of its destinations. The no-frills experience and low cost structure enabled Burr to profitably offer lower fares than his competitors. Passengers did not mind the no frills experience, and PeopleExpress grew exponentially as the public embraced low fares.

While PeopleExpress was synonymous with, and can be credited with catalyzing the growth of low-fare carriers in the 1980s, the art of running a low fare carrier was perfected by Dallas-based Southwest Airlines, which quietly rose to prominence throughout the 1980s and 1990s. After struggling as an upstart carrier in the early 1970s, Southwest introduced a new business plan emphasizing low costs. It employed a largely nonunion work force and initiated aggressive fuel hedging strategies, which both continue to be the foundation of its low cost structure today. Southwest was also on the cutting edge of utilizing its aircraft to the maximum by targeting short turnaround times, maintaining simplicity by only flying Boeing 737s, and focusing on point-to-point service rather than the hub-and-spoke system embraced by the legacy carriers in the 1980s. Southwest’s growing clout was apparent by 1993, when it opened shop on the East Coast. It began by initiating service to Baltimore, quickly followed by a large expansion to Florida, thus tapping the lucrative leisure market to and from the Sunshine State. New, upstart airlines continued to emulate the PeopleExpress/Southwest model, whether they started as small operations such as Valujet and AirTran, or large, well-capitalized startups such as JetBlue. By the 2000s these airlines were a prominent thorn in the side of the legacy carriers, further putting fare pressures on the large airlines and subsequently on the wages of the old-line employees.

Finally, the third secular trend of the past three decades has been the survival of the fittest. The original Big Three that emerged in the early 1990’s remain the dominant triumvirate to this day. First, a brief history on the mergers that led to this. After deregulation, many legacy carriers immediately began to struggle. Pan American World Airways, for decades America’s flag carrier to so many nations, found itself grossly unprepared for deregulation because of its lack of a domestic network to feed its flagship international operations. To remedy this, Pan Am purchased National Airlines in 1980. This was a harbinger of what would become the trend throughout the 1980s. After the industry was shocked by the sudden collapse of Braniff during the 1982 recession, the better-positioned airlines went on a buying spree. In order to acquire the “critical mass” to weather the new environment of cutthroat competition from deregulation upstarts and old foes alike, airlines began to purchase stakes in smaller airlines to establish feeder or “express” networks. Then, later in the decade, they began to acquire their competitors.

The industry experienced rapid consolidation in 1985 and 1986. Carl Icahn (then a famous corporate raider, different from his current practice of shareholder activism) purchased TWA in 1985, and immediately purchased St. Louis-based Ozark Airlines in 1986. That same year, Northwest Airlines purchased Minneapolis-based Republic Airlines. Pan Am’s marriage with National was not a happy one, and the struggling carrier sold its valuable transpacific routes and San Francisco hub to United in early 1986. Don Burr’s PeopleExpress, seeking to grow and gain a presence in the western US, purchased Denver-based Frontier Airlines in 1985. Unfortunately (and ironically with this week’s merger), Continental and United responded by initiating a bloodthirsty fare war in Denver. After a proposed sale to United fell through, the Frontier division of PeopleExpress was placed into bankruptcy in 1986. Burr was able to avert the bankruptcy of the entire company by selling to his old boss, Frank Lorenzo, in October of that year. Finally, 1986 ended with Delta doubling its size by purchasing Western Airlines, while American purchased AirCal.

By 1990, the “Big Three” of American, United, and Delta were more well-positioned than ever before to feed on the remains of other legacy carriers who continued to struggle. The Gulf War and subsequent oil spike proved to be the final nail in the coffin for several carriers. Eastern, having sold off major portions of its network and fleet, attempted to come back but ceased operations in February 1991. Midway, the original deregulation upstart carrier, attempted an ill-fated expansion at the same time fuel prices rose, and ceased operations in late 1991. Pan Am’s struggles continued to mount, accelerating after the Pan Am 103 terrorist attack in December 1988. After declaring bankruptcy in January 1991, Pan Am sold its crown jewel - its JFK hub and transatlantic routes, to Delta along with its Northeast Shuttle operation in exchange for cash and financial support. With that move, Delta became the world’s largest carrier overnight. Over the course of the year, Pan Am attempted to reorganize around its original Latin American routes and negotiated with Carl Icahn to merge with TWA. Sadly, before a merger could materialize, Delta cut off its support, and our nation’s most historic airline was forced to shut down in early December. American subsequently cemented its Latin American dominance by purchasing the Miami hub and Latin American routes. As mentioned earlier, the prosperous 1990’s led to a period of relative stability for the major carriers, but that all changed with 9/11.

Even before 9/11, United had entered into merger talks with US Airways, but due to antitrust concerns from John Ashcroft’s Justice Department, the plan was quashed mere weeks before 9/11. (Considering that both airlines declared bankruptcy in 2002, in United’s case lasting more than three years, the antitrust concerns were somewhat unwarranted given the subsequent events and the fact that much larger mergers have now taken place.) TWA, unable to regain its former glory, especially after the 1996 Flight 800 disaster, was purchased by American in 2001. The last remaining deregulation upstart survivor, America West, was bought by US Airways in 2005. The accelerating rise of oil prices after 2005 led to Delta purchasing Northwest in 2008, gaining a valuable transpacific network in the process. This in part necessitated the merger of United and Continental.

Concerning the future of the industry, it is necessary to look at the global picture. In Europe, the past decade has seen countries lose their historic flag carriers. Belgium’s Sabena went bankrupt in 2001. Some airlines have been bought and are now subsidiaries of others, but are kept as separate brands partially because of national identity and pride (the Netherland’s KLM is now owned by Air France). Others have gone bankrupt only to have their assets transferred by their creditors and re-launched under a new name for the sake of keeping a national flag carrier (Swissair, bankrupt in 2002, was reorganized by Credit Suisse and UBS as Swiss International Air Lines).

In the future, consolidation will likely become a global phenomenon. It is possible that we may see the airlines within alliances spearheaded by American, United, and Delta (Oneworld, Star Alliance and SkyTeam, respectively) begin to merge with each other. The fact that some countries can no longer support even one flag carrier in today’s economic environment supports the notion that the US was an anomaly with six to eight major carriers ten years ago. Without European-style government subsidizing of the airlines, it is likely that airline consolidation will continue in the US. The question is which strategy will the Big Three adopt? In the US, we have reached a point where future airline mergers may need to be multinational in order to avoid antitrust actions. If any of the Big Three announced merger plans with one another, antitrust concerns would immediately complicate the prospects of a deal. It will be interesting to see at what point, if any, the Justice Department steps in. Another possible step could be low-fare carriers being bought or merged with the legacy carriers. This would likely cause fares to rise, as less low-fare competition would make it easier for the Big Three to keep fares at more profitable levels.

Taking a final look at the big picture, airline deregulation in the US has more than fulfilled its main objective of making flying cheaper, and therefore more accessible to the general public. The winner has been the American consumer; the nominal price of an airline ticket is up just 45% since 1978. (By comparison, the price of many food staples is up over 100%, while a college education is up over 500%.) The losers have been those who invest in the airlines, and most of all the employees. Deregulation exposed the rigid union cost structure as inadequate for such competition and unpredictable cost fluctuations, particularly the price of oil. Bob Crandall summed up the post-deregulation industry when he said, “I've never invested in any airline. I'm an airline manager. And I always said to the employees of American, 'This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment.’” Indeed, since deregulation, over 150 airlines have gone bankrupt, the vast majority small startups that could never effectively compete with the large airlines, most folding within a few years. Those that still exist have to cope with cutthroat competition and the fact that the transportation industry, even in the good times, is only marginally profitable. Yet, we are able to get from city to city much cheaper than we were 30 years ago. In the end, it depends on one’s perspective, particularly the degree to which a traveler or employee may harbor nostalgia for the way the industry used to be.

Respectfully Yours,
Matthew R. Green
May 7, 2010