Back in February 2001, Deutsche Bank was very bearish on a major US telecommunications
company. In a credit review, the bank’s analyst said that "per concerns/trends
summarized above, [the company] will be downgraded,"adding that "we
seek a cap at the current level. Risk appetite reduced."
Three months later, Deutsche Bank was very bullish on a major US telecommunications
company. It was lead manager on a record-breaking $12 billion bond deal, talking
up the credit in markets around the world. If you were to ask Deutsche Bank
whether risk appetite for this credit was a good idea, they would respond with
a resounding yes.
You can see this punchline coming a mile off. That’s right, we’re talking about
the same company here: WorldCom. If you were cynical, you might even say that
Deutsche Bank had a double interest in selling WorldCom’s nuclear-waste bonds
to as many investors as possible: not only did its fees go up as the deal got
bigger, but its own loans to the company, which matured long before the bonds
did, would be easily refinanced with the fresh billions pouring in from unsuspecting
And it’s not just Deutsche Bank, either: JP Morgan, Citigroup and Bank of America
are all in substantially the same boat, according to a New York Times article
today. So, should you ever trust them again when they try to sell you bonds
from major borrowers like WorldCom or Argentina? Unfortunately, you have very
little choice. Since the repeal of the Glass-Steagall Act, all the major bond
underwriters (the investment banks, as were) are also major lenders (the commercial
banks, as were). Citibank merged with Salomon Brothers, Chase bought JP Morgan,
Deutsche Bank bought Bankers Trust.
Chances are, then, that if you’re buying a bond from a broker-dealer, that
institution probably also has a lending relationship with the issuer. In fact,
the securities houses are very proud of this fact: they call it "one-stop
shopping" or the suchlike, and quite openly buy bond mandates with large
loans. In the case of WorldCom, an $800 million loan commitment from Citigroup
directly resulted in a lead-manager position on the bond issue and a $20 million
fee. Quid pro quo.
Meanwhile, Citigroup will have been regaling WorldCom with its prowess at "distribution".
Since they bought Smith Barney, they will have said, they have access to an
enormous number of stockbrokers who could deliver the retail investors
that WorldCom desperately needed in order to diversify its investor base.
Once more in English? Basically, we’ve got millions of suckers who’ll put their
money wherever we tell them to. These aren’t sophisticated institutional investors
who do their own credit analysis before buying a bond, they’re little guys with
savings accounts who trust their broker to ensure that their fixed-income investments
are relatively safe. (If they wanted risk, they’d be buying stocks.) Meanwhile,
as the new guys are coming in, the bank itself is getting out.
With regard to emerging-market sovereign debt in particular, I’ve made
the case (PDF file) that retail investors (that’s you and me) should simply
not be allowed to buy individual bond issues: if they want exposure to the asset
class, they should buy mutual or index funds instead. I’m hesitant to extend
that case to domestic bond issues like that of WorldCom, but most of the arguments
In any case, this should be a lesson to any individual investors out there:
yes, you should always have a certain amount of your portfolio in fixed income.
But picking bonds is not like picking stocks: you’re extremely unlikely to outperform
the pros, even if you get lucky. And, as we’ve learned again today, you’d be
foolish to trust your broker. So buy funds instead.