Remembering Lehman Brothers and the Death Spiral Convertible Bonds
August 26, 2011
Who can forget Lehman Brothers? And who can fail to notice Nomura Securities these days, desperately trying to become like an American investment bank with its heavy emphasis on financial engineering and aggressive salesmanship but with excess baggage leftover from Lehman Brothers. A news item in one of the issues of this week’s Wall Street Journal made us remember Lehman Brothers and feel pity for Nomura Securities.
It also seems that Lehman Brothers had started writing its own obituary in early 2005.
One of the issues’ in this week's Wall Street Journal reported that a new product called the "Double Decker Funds" has been introduced in Japan. The low interest rate environment in Japan that has prevailed for almost two decades has every now and then turned the country into a financial derivatives laboratory. Investors have incessantly searched for financial products which would produce high yield. It seems that the latest craze is the "double decker" funds, which combine high return assets with high yielding currencies. But whether it is the double decker funds or the power reverse dual currency notes (PRDC), over the years most of the transactions concerning the exotic financial derivatives in Japan have been rather benign. However, there have been a few instances when innovation, combined with greed and malevolence on the part of the sell side investment banks and the corporate executives, have produced highly toxic financial products.
One such highly toxic and controversial financial product was the "death spiral" convertible bond, a product, more or less, banned in the United States for some time now. Death spiral convertible bonds are technically known as floating rate convertible bonds where the conversion price is kept floating. A floating rate convertible bond, a.k.a. a death spiral convertible bond, converts into the common shares of the underlying company at a deep discount to the share price that exists at the time of the issuance and at a fixed dollar amount rather than a fixed number of shares
Nomura Securities first introduced the death spiral convertible bonds in Japan in 2003, though Nomura used a rather innocuous name of Multiple Private Offerings (MPOs) to brand these securities. Investors would have been impervious to the pernicious nature of these financial derivatives had the events of February 2005, which in a large measure upset the equilibrium of corporate Japan, not put the spotlight on these securities. TakafumiHorie, a 32 year, young and brash entrepreneur who owned the budding internet service provider, Livedoor, acquired 35% stake in Nippon Broadcasting system (NBS). Horie’s ultimate objective was the control of Fuji Television, one of the largest TV networks in Japan. NBS owned 22.5% of Fuji’s shares. What really surprised everybody about this deal was that Livedoor, with revenue of $200 million and a market capitalization of $2 billion was able to raise $800 million needed for the acquisition and that too in such a short span of time. Enter, Lehman Brothers, enter the death spiral convertibles.Lehman Brothers gave $800 million to Livedoor and bought death spiral convertible bonds, with zero coupon and warrants attached to them, from the company in lieu of those funds. Even though there was an "initial conversion price" of Yen 450 the term sheet for this convertible bond had a clause that once the bond is issued, this initial conversion price of the bond shall be modified the next trading day after every Friday (known as the "decision date") to an amount equal to 90% of the trading-volume-weighted-average price of the company’s common shares during the three consecutive trading days preceding the "decision date" which will then become the "modified conversion price". Of course, there was a floor for the conversion price; it was Yen 157. The initial conversion price itself was at a very steep discount to what Livedoor’s stock was trading at in February 2005. On top of that, the way the bonds were priced, there was every incentive by the holder of these bonds to keep shorting the stock so that modified conversion price fell more and more towards the minimum, where for the fixed dollar amount, the holder of the bonds would get more and more common shares of the company.
Livedoor would eventually be delisted from the Tokyo Stock Exchange a year later and the stock price would fall to Yen 94. Horie would go to jail and Fuji TV would be shaken up to its bone. That sordid saga is well known and well documented in the financial press.
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