Legal but Absurd: Borrow a Billion and Report a Profit
Jesus, Earlie. What's the world coming to? Now the geniuses on Wall Street have concocted a way to issue debt and report additional *income* now without having to record any expense associated with the liability side of selling a call option on the company stock. Unbelievable. Just unbelievable. Our economic system is going to hell in the proverbial handbasket. What legacy are these criminals leaving...
nytimes.com
August 8, 2003
FLOYD NORRIS
Legal but Absurd: Borrow a Billion and Report a Profit
It sounds like a debtor's dream. The lender pays interest to the borrower, and the borrower reports a profit.
STMicroelectronics, a European semiconductor maker, raised $1.2 billion last week by selling a new convertible bond with an interest rate that was half a percentage point below zero. For every dollar a buyer invested, the company promised to pay back 95 cents in 10 years.
That makes sense to the financial engineers who design convertibles. The idea is that a buyer of a convertible bond is buying three things. First is the bond, with whatever the normal interest rate on that company's bond would be. Second is a 10-year call option to buy the underlying stock. And third is a put on the bond, giving the buyer the right to sell the bond back early to the company, an escape mechanism if the stock falls far enough to make the conversion feature seem hopelessly out of the money.
Investors who bought the bonds were persuaded that the options were worth more than the interest that would normally be paid if the bond lacked such options. A result was the negative interest rate.
Whether the investment is a good one remains to be seen, of course. The exercise price for the conversion is $33.43, a 55 percent premium to where the share price stood when the deal was sold and 62 percent above yesterday's close of $20.61. A bond buyer would seem to be showing hope for a big gain in the stock, while demanding protection from the possibility of a substantial price decline.
That may not be as contradictory as it seems, because STMicro is a typical technology stock. It went to the moon in 2000, peaking at $73.88, and fell to $11 last fall. Optimists have reason to be wary.
But the important point may be that the embedded call option has similarities to the typical employee stock option. The option lasts 10 years, although the buyer can cancel it by redeeming the bond after 3, 5 or 7 years. The option cannot be separated from the bond and sold separately. Similarly, employees cannot sell their options, and can cancel them early by quitting.
None of that prevented the market from valuing the option. The arithmetic indicates that the option was valued at 10 percent of the price of the bond.
STMicro's fellow technology companies might want to ponder that fact. For in the current debate about whether to force companies to treat stock options as an expense, they have argued that such options cannot be valued. As the Securities Industry Association put it, existing valuation models "do not provide reliable estimates for options of one or more years in duration." The association complained that the valuation depended on estimates of future volatility, and said such estimates were often wrong.
True enough. But that did not stop STMicro from accepting a market price for a very similar option embedded in its bond. Nor does uncertainty about valuation keep it, or any other member of the Securities Industry Association, from issuing millions of options to officers and employees.
Had STMicro reported the value of those options as an expense last year, its reported profits would have fallen 47 percent. The company said the only official who could discuss such issues was on vacation and unreachable.
Issuing this bond will raise reported profits a bit. The company will report interest income, not expense.
There is a pattern here. Because accounting rules let companies ignore the value of options, the companies can obscure the cost of compensating employees and even claim a profit from borrowing money. That such accounting is legal does not stop it from being absurd.
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