Last week, telecommunications giant WorldCom, the parent company of MCI, announced a rate increase that will affect 20 million customers worldwide. MCI just finished a campaign offering cut-rate long distance service to new customers, so why raise rates so quickly?
The answer is because WorldCom is in financial trouble; moreover, that trouble could be on the same scale as the Enron collapse.
On April 29th, the CEO of WorldCom, Bernard Ebbers, resigned. His company, which made 75 acquisitions in 19 years (including MCI and CompuServe), has run up a staggering $29 billion in debt. Its stock price, which reached a high of $64.50 in June of 1999, is now at about $2.35 per share. In February, WorldCom cut its revenue projections and announced a $15 to $20 billion write-down related to “goodwill”–the amount WorldCom paid for acquisitions over and above what the acquired companies were really worth. Then in mid-April, WorldCom stunned Wall Street by announcing a further cut of its revenue projections by $1 billion.
That’s not all. WorldCom is currently under investigation by the Securities and Exchange Commission, which is looking at how WorldCom booked its income. It seems the company went down the Enron path, declaring income it never collected, booking inflated sales commissions, and counting as income customer bills that were uncollectable. There are also questions about how it classified assets of companies it purchased.
Believe it or not, that’s the good news. The bad news is that WorldCom’s debt was recently downgraded, sending the price of its bonds into a tailspin. What makes this a crisis on the level of Enron is that WorldCom is the seventh largest corporate bond issuer in the US.
What, exactly, does that mean? Well, when the stock market tanked in early 2000, many investors moved their money from stocks into bonds, seeking a safe haven from market volatility. Bonds have long been seen as stable, safe investments, particularly for elderly investors who can’t risk seeing the value of their investments fall while they’re close to or in retirement.
In general, bonds are safe. But bonds come in many different flavors. There are municipal bonds, which are issued by state and local governments, school districts, ports, public utilities, and other local governmental authorities. “Munis,” as they’re called, are backed by the finances of the local governments that issue them (and ultimately backed by taxpayers). There are federal government bonds, too, which are called “Treasury Bonds,” “Treasury Notes,” or “Treasury Bills” (or, more simply, “T-Bills” or “Treasuries”). Treasuries are backed by the federal government (and ultimately taxpayers).
There are bonds issued by semi-private agencies like the mortgage bonds issued by Fannie Mae and Freddie Mac, which operate with some taxpayer funding, but are run like private companies.
And, finally, there are bonds issued by private companies, called “corporate bonds.” Corporate bonds come in different flavors, too. Some are “investment grade,” meaning the issuing corporation is considered financially sound and fully able to pay the interest on the bonds and, at maturity, pay back the principal, with little risk of default. Other corporate bonds are “junk bonds,” issued by companies that are struggling to make ends meet and need some cash to get the company back on track. With junk bonds, the risk is high that the company will miss interest payments or eventually default on paying back the principal at maturity.
Why, you might ask, would anyone buy corporate bonds–particularly junk bonds–when they can buy Munis or Treasuries? The answer is simply this: the higher the risk of default, the higher the rate of return on the bonds. Munis generally pay the lowest rate of interest to the investor, usually between 2-6%. Treasuries pay a little more, but corporate bonds pay much, much higher rates–above 10% annual interest on many junk bonds.
Bonds are also traded on a market, just like stocks. Once a bond is purchased, it can be sold to another investor. Its price can vary, depending on how solid and safe the investment is. For corporate bonds, the price depends on how strong the issuing company’s financials are. Ratings agencies, like Moody’s Investors Service and Standard & Poors, have the task of keeping track of bonds issued by various companies. They issue ratings for corporate bonds based on the issuing company’s financial stability.
Now, “investment grade” is the highest rating for corporate bonds. WorldCom’s bonds used to be rated investment grade, and so investors all over the world, particularly large institutional investors like mutual funds, company retirement funds, state-owned retirement plans, banks, and insurance companies all owned pieces of WorldCom’s debt. Those institutional investors represent thousands of individuals who invested in mutual bond funds, including retired folks living on company pensions, school teachers, fire fighters, government employees, Mom ‘n’ Pops with their IRA accounts, and many, many people who just set aside $20 or $30 out of each paycheck to go into the company 401(k). Two of the largest owners of WorldCom bonds are the California Public Employees’ Retirement System and the Vanguard Group.
When WorldCom’s debt was downgraded on April 25th, the price of its bonds fell rapidly. At the end of the week, on April 30, WorldCom bonds were trading at 46 cents on the dollar, which put them firmly in the junk bond category.
This is perhaps the largest bond collapse in history. Investors have lost almost $6 billion in less than a year. And the effect has rippled out through the corporate bond market, dragging down the price of all investment grade corporate bonds, as institutional investors have been forced to sell bonds of other companies in an attempt to make up for their WorldCom losses.
How could WorldCom, a company that was in financial trouble, issue bonds that were rated investment grade quality? Because WorldCom, like Enron, Xerox, QWest, Global Crossing, and other companies, didn’t play by the rules (those few that still exist). It hid its problems by issuing “proforma” financial statements and not adhering to government-mandated accounting standards, so ratings agencies were fooled. The ratings agencies themselves are private companies, not governmental entities, so there are no rigorous standards that they have to adhere to while evaluating the balance sheets of companies like WorldCom. And because there are so many companies that issue bonds, it’s a big job to evaluate them all aggressively on a continuing basis. Certainly the lack of government-mandated regulations, standards, rules, and enforcement of the few rules that exist all contributed to the problem.
In short, in a largely deregulated market, the WorldCom bond collapse has proved that there are no safe havens for investors.