The Great Deformation (97 page)

If deregulation meant a permanent increase in TXU's profit margins, of course, the heady February 2007 LBO valuation of its current cash flow might have made sense. The underlying reality, however, was that the price of wholesale electric power in Texas at the moment had been inflated by a humongous natural gas price bubble which flared-up in the wake of Hurricane Katrina's August 2005 disruption of offshore gas production.

Natural gas prices had soared to the unheard of range of $10 and $15 per thousand cubic feet (Mcf), compared to a band of $2–$5 per Mcf that had prevailed for years. So TXU's fulsome cash flow was running on the after-burners, as it were, of one of the greatest commodity bubbles of recent times.

At the same time that TXU was booking revenues of 13.7 cents per Kwh based on natural gas prices, the fuels cost at its base-load nuke plants was 0.4 cents per kWh and just 1.2 cents in its lignite coal plants. Thus, at the coincident peaks of the Greenspan credit bubble and the natural gas price bubble in February 2007, TXU was selling electric power at 12X and 36X the cost of its lignite- and uranium-based power, respectively.

These markups were off-the-charts crazy. Even after absorption of modest fixed operating costs (labor and maintenance) at its power plants and
corporate overhead, the profits were staggering. It was only a matter of time, therefore, until the natural gas bubble ruptured and TXU's power margins came crashing back to earth.

HOW THE FED HELPED BUSHWHACK TXU

As it happened, the Fed's rock-bottom interest rates were contagious and fueled a boom in debt-financed gas drilling that soon caused supplies to soar and natural gas prices to plummet. In this manner, the power plant “fuels arb” was flattened and with it the company's financial results. The Fed thus unintentionally bushwhacked the largest LBO in history. So doing, it demonstrated just how badly the nation's central bank had mangled the free market.

When Bernanke slashed interest rates to nearly zero, it triggered a Wall Street scramble for “yield” products to peddle to desperate investors—at the very time that the natural gas patch was swarming with drillers willing to issue just such high yielding securities. The natural gas price bubble had encouraged a drilling boom based on horizontal wells and chemical flooding of gas reservoirs. This “fracking” process can liberate prodigious amounts of natural gas that otherwise would remain trapped in low-porosity shale reservoirs, but it also slurps capital in vast amounts: fracked wells generate bountiful gas output during their first few months of production but then peter out rapidly. Thus, the whole secret of the so-called fracking revolution was to drill, drill, and keep drilling.

The tens of billions of fresh cash required for the shale-fracking play was not a problem for the fast-money dealers of Wall Street, who had just the answer: namely, high-yielding natural gas investments called VPPs (volume production payments). These were another form of opaque off-balance sheet debt. In this case investors provided up-front funding for gas wells in return for a fat yield and a collateral claim on the gas.

Accordingly, a flood of Wall Street money found its way to red-hot shale gas drillers like XTO, which was soon swallowed whole by ExxonMobil, and to the kingpin of the shale-fracking play, Chesapeake Energy. Its balance sheet grew explosively between 2003 and 2011, with proven reserves rising from 2 trillion cubic feet to 20 trillion and total assets climbing from $4 billion to $40 billion.

It was virtually limitless Wall Street drilling money that accounted for this pell-mell expansion. During this same eight-year period, Chesapeake's outstanding level of “high yield” borrowings—bonds, preferreds, and VPPs—soared from $2 billion to $21 billion. In this respect, Chesapeake was only the most visible practitioner of what was an industry-wide stampede to “borrow and drill.”

This debt-driven explosion of reserves, production, and injected storage eventually left giant drillers like Chesapeake gasping for solvency; massive new gas supplies caused prices to steadily weaken and then crash. By the spring of 2012, natural gas was trading at a price so devastatingly low ($2.50 per Mcf) that even the monster of the gas patch, ExxonMobil, cried uncle. “We are losing our shirts” complained its CEO, Rex Tillerson.

With little prospect that natural gas will revive anytime soon, TXU's revenues and operating income will remain in the sub-basement. The $36 billion of LBO debt raised at the top of the Greenspan bubble is therefore almost certain to default owing, ironically, to the aftershocks of the even larger debt bubble which fueled the fracking binge.

The larger point is that artificially cheap debt causes profound distortions, dislocations, and malinvestments as it wends its way through the real economy. In this case underpriced debt fostered a giant, uneconomic LBO and also massive overinvestment in natural gas fracking. When the collision of the two finally brings about the thundering collapse of the largest LBO in history, there should be no doubt that it was fostered by the foolish money printers in the Eccles Building and the LBO funds who took the bait.

WHY DEBT ZOMBIES REMAIN:

GOLDMAN AND TPG'S THIRTY-WEEK RAID ON ALLTEL

The massive debt created by the giant LBOs of 2006–2008 has stuck to the ribs of the US economy ever since. This is true even in the $28 billion Alltel buyout, where the private equity sponsors of the deal, Goldman Sachs and TPG, were able to harvest a $1.3 billion profit without breaking a sweat during their thirty-week stint as at-risk owners. But the $24 billion of debt used to fund the LBO didn't go away when the sponsors collected their quickie winnings. It was just shuffled along to the buyer, Verizon, where it was added to its existing debt of $42 billion.

The Alltel LBO thus functioned as a financial laundry. The company's debt was raised from $2 billion to $24 billion and an equal amount of cash was paid out to its public shareholders and speculators. Then, after only a few months in the garb of an LBO, its heavily mortgaged assets were passed on to a new corporate owner.

The Alltel LBO was thus recorded as a roaring success because its sponsors made a 50 percent annualized return. Yet that was possible only because the next owner—a lumbering quasi-public utility that has been destroying shareholder value for a decade—kissed the buyout shops with a modest premium on their small equity investment, and then carried the whole mountain of LBO debt forward on its own balance sheet.

This preposterous debt shuffle could not have occurred on the free market because Verizon's purchase price at 19X operating income was ludicrous. This was especially so since the Alltel wireless business was overwhelmingly a “contiguous” rather than an “in-market” acquisition, meaning that there were virtually no cost savings.

The real synergy, in fact, was purely financial. Verizon's after-tax cost of debt was only 3.7 percent, meaning that its debt financing cost on the $28 billion purchase price was just $1.0 billion annually. Since Alltel's $1.5 billion of operating income substantially exceeded this figure, the acquisition computed out to be “accretive.”

Plain and simple, the deal was driven by state policy—the tax deductibility of debt capital and the radical financial repression policies of the Fed. Undoubtedly, the monetary politburo had visions that its ultra-low interest rate régime would spur investment in plant and equipment or IT system upgrades. In fact, it was supplying high octane fuel for financial engineering—a signal to corporate executives to grow their asset base the easy way—that is, on the floor of the New York Stock Exchange.

The proud new owner of Alltel's $24 billion of LBO debt, however, was actually a poster boy for failed financial engineering. For more than a decade Verizon's serial M&A had caused the scope of its operations to continuously swell, even as its earnings had gone steadily south, falling from $2.70 per share in 2004 to less than $0.90 in recent years. Despite the capital intensive nature of telecom, Verizon had skimped on CapEx, causing the inflation-adjusted value of its plant and equipment to shrink by about 25 percent over 2002–2011. Yet the decade-long M&A spree of executives obsessed by merger mania and pumping their stock price caused its nominal asset base to grow by $60 billion, or 35 percent.

So the smoking gun wasn't hard to find: nearly 90 percent of that asset gain was due to a doubling of its goodwill—that is, M&A deal premiums. Indeed, Verizon's goodwill now totals more than $100 billion and represents nearly 45 percent of its asset base.

Such massive goodwill, alas, is a telltale sign of a debt-ridden deal machine of the type fostered by the Fed's bubble finance. The startling fact, therefore, is that the nation's largest telecom services vendor has a tangible net worth of negative $17 billion. Its deal-making executives have been destroying value for more than a decade, aided and abetted by central bank money printers.

HOW KKR STRIPPED THE BEDS IN AMERICA'S LARGEST HOSPITAL CHAIN WITH SOME HELP FROM BUBBLES BEN

The November 2006 HCA buyout was notable for its then-record breaking
$33 billion size and its exceedingly thrifty approach to the equity account. KKR and its partners put up only $3.9 billion of fresh equity, or about 12 percent, of the capitalization of this monster deal. Funding the $28 billion debt balance required a veritable Noah's ark of every kind of debt known to Wall Street, including revolvers, term loans, junk bonds, foreign loans, and even a far-out instrument called “second-lien toggle notes.”

At first glance, HCA's 160-unit hospital system might appear to be exactly the wrong candidate for massive permanent leverage. After all, the HCA system obtained 45 percent of its revenues from Medicare and Medicaid, government programs which have long been on the fiscal ragged edge and which are increasingly subject to indeterminate and unpredictable regulatory and reimbursement risk.

Yet the stunningly aggressive manner in which KKR and Bain have literally plundered cash from HCA since the mega-buyout implies just the opposite. After loading HCA with $28 billion of debt to fund the original buyout, KKR and Bain have since extracted dividends and stock buybacks amounting to another $7 billion. These massive payouts to the sponsors have absorbed every dime of available cash and borrowing capacity at HCA. In fact, during the four years ending in fiscal 2011 the company generated just $5 billion of income from operations net of capital spending and investing activities, meaning that the dividends and buybacks amounted to an incredible 140 percent of HCA's free cash flow.

By every traditional rule of leveraged buyouts, all of that free cash flow should have been allocated to paying down debt, so that the company could have edged out of harm's way. In fact, HCA's debt mountain had not been reduced by a net dime after four years, and it was a preposterously overleveraged deal in the first place.

Perhaps the most telling evidence of the latter point came from the company's own CEO, Jack Bovender. When asked what had been the biggest shock which came out of the LBO, he replied, “Honestly, the fact that you could borrow $28 billion.”

KKR had been able to borrow $28 billion because the second junk loan bubble was red hot at the time of the original deal, but after collapsing into the depths in 2009 it had made a roaring comeback just in time to fund the HCA dividends in 2010. Indeed, Bernanke's maniacal money printing after the Lehman event had catalyzed a virtual stampede back into the very same risk-asset classes which had been reduced to smoldering ruins during the financial crisis.

In fact, junk bonds had undergone their third miraculous rebirth since the age of bubble finance began in 1987. Once again, it was speculator driven money flows into the junk bond asset class that levitated prices, not
the credit facts on the ground. Most leveraged issuers were still limping operationally and had neither paid down significant debts nor had any prospects of doing so.

Nevertheless, the Fed so juiced the carry trade with free “funding currency” that astute speculators now anticipated a rising junk bond market. This trend, in turn, would permit troubled LBO borrowers to refinance or otherwise “extend and pretend,” and thereby sharply reduce the realized rate of defaults and make existing junk bonds far more attractive. Accordingly, by November 2010 junk bond prices were up a stunning 85 percent from their post-Lehman lows.

Hedge fund speculators were now essentially operating in the third degree of Keynes' beauty contest (see
chapter 23
). Punters were buying ugly credits hand over fist because they anticipated that other punters would find these credits considerably more attractive, once their struggling borrowers had kicked their current balloon of maturing obligations down the Fed-sponsored road of perpetual refinance.

Not surprisingly, 2010 and 2011 became record years for junk bond issuance, notwithstanding an economy that was still furtively laboring to “recover” and, according to the leading Keynesian shaman, Larry Summers, had not yet obtained “escape velocity.” Nonetheless, $500 billion of junk bonds were issued in those two years—65 percent more than during the previous peak of 2006–2007 when the mega-LBOs had been spawned.

In the context of the 2010–2011 junk bond boom, the leveraged dividend recap made a reappearance like clockwork. Thus, in November 2010 KKR and Bain announced they would pay themselves a $2 billion dividend and that it would be financed with a new issue of junk bonds to be piled on top of HCA's $28 billion of debt.

Moreover, this was actually their third dividend payday of the year. The first two payouts had been even more egregious: the private equity sponsors borrowed $1.75 billion in February 2010 from HCA's bank revolver to pay themselves a dividend and then, unbelievably, banged the revolver again in May for another $500 million dividend.