September 2000 Newsletter
Issue Nine, Volume One

WHERE HAVE THEY ALL GONE?

By Mike Gasior

I know that life is constantly changing and that nothing ever really does stay the same. Seasons change. Friends come and go. Technology shifts. Never mind the constant ebb and flow of the participants in the business world. Companies hit the scene like a ball of fire and can disappear in a flaming crash or without a trace. It is almost hard to remember W.T. Grant anymore. Or American Motors Corporation. Woolworth's isn't even that far back in our rear view mirror and we have conveniently forgotten them. Their marketshare was quickly absorbed by their competitors and consumers were largely unaffected by their disappearance. I worry and wonder if the same will hold up to be true of the changes in the world's financial industry.

"OH YES......I REMEMBER IT WELL"

All too frequently I seem to take on an "old farty" kind of aura when truthfully I don't consider myself all that old. Hell, I know who Eminem is as well as Carson Dailey and I've even seen an episode or two of Dawson's Creek. Why don't you consider the following list and ask yourself what ALL of them shared in common as recently as 12 years ago:

--Aubrey G. Lanston --Bankers Trust --Chase Manhattan Bank --Citibank --Dean Witter Reynolds --Donaldson, Lufkin & Jennrette --Drexel Burnham Lambert --E.F. Hutton --First Boston --Irving Securities --Kidder Peabody --Manufacturers Hanover --Morgan Stanley --Paine Webber --Shearson --Smith Barney --Solomon Brothers --UBS Securities

So did you figure it out? All of them were "stand alone" Primary Government Securities Dealers not long ago. The list, which is far from ALL of the dealers of the day, numbers a total of 18 companies. I put the list together from my own personal memory.

When I went through the list and thought about how many Primary Dealers were left of the 18, the number I arrived at was 4. After some of them merged together (Citibank, Shearson, E.F. Hutton, Solomon Brothers and Smith Barney into one entity today), or ceased their Primary Dealer status (Aubrey G. Lanston), or just plain ceased to exist (Drexel), we are left with a very different landscape.

SO WHAT?

As I read more of the details surrounding the Chase Manhattan Bank/J.P. Morgan merger the other day, I was struck by how much has changed on Wall Street. Nevermind the interesting and contentious relationship between the two powerful families associated with the organizations (the Rockefellers with Chase and the Morgans with J.P. Morgan) and their history during the last century. I just couldn't help but wonder how this most recent merger might affect my clients and the bond markets as a whole.

As recently as 1988 there were 46 companies who did business as Primary Dealers in Government Securities. That number is shortly going to drop to 27 once UBS finishes their acquisition of Paine Webber and the Chase/Morgan merger is final. My overall assessment is that this whole trend might be worrisome.

WELCOME TO THE BOND MARKET

People seem to forget sometimes that the bond markets operate in a much different manner than the stock markets. In the past decade every Tom, Dick and Harry has set themselves up as brokers willing to stand between you, if you want to buy some stock, and someone else who wants to sell some. Volume has exploded and commissions, along with profit margins, have reached razor thin levels.

But please remind yourself how the bond markets operate; they are, and remain, an over-the- counter market in the classic and traditional sense. This means when I call Merrill to buy or sell some Treasury, corporate or muni bonds I am going to be either buying them out of, or selling them into, Merrill's own inventory of those securities. There is no bond "exchange" where brokers match up the orders of buyers and sellers and take a commission for doing it. All that is needed is a broker willing to be the "other party" to the transaction.

In this past 10 years there has also been an explosion in the variety of mortgage backed, asset backed, CMO and other securities which are increasingly complex and esoteric; but these also trade in an over-the-counter manner. I'm amazed how quickly we have forgotten the financial debacle of late 1994. Alan Greenspan was ratcheting up interest rates, mortgage backed securities durations were extending, their prices were plummeting, and it seemed every insurance company and pension fund suddenly wanted to lighten their load with regard to these products. Well remember what I said: if you want to sell these securities you need to find a broker/dealer who is willing to buy them from you and put them into their own inventory. And how do you think the brokers were doing on their OWN positions at that time? You can be assured that they were getting their asses shot off as well as their customers and weren't all that hungry to be buying even more of these things from you in the panic of that year.

Do any of you remember who was by far the largest broker in the mortgage backed market at that time? Actually bigger than numbers two and three combined actually? It was Kidder Peabody. And what happened to them right in the middle of all this panic? They disappeared from the face of the earth. Sure, you'll want to tell me that they were actually absorbed into Paine Webber, but the combined operation never rivaled Kidder's dominance of that market again. Lots and lots of money was lost and the markets became quiet once again. But the parade of powerful bond houses ceasing to exist continued. Going back to my days as a broker these bond houses were almost like royalty and spoke of in reverential kinds of ways: Solomon......Kidder......Bankers Trust. Now all of them are either effectively out of the bond business or just plain gone. p>SO WHERE DOES THIS LEAVE THE US?

It's a simple fact that the more participants a market has, the more efficient it will be, liquidity is better and pricing more competitive. I hate to point out the obvious, but going from 46 to 27 Primary Dealers in 12 years certainly can't be a "good thing" for the bond market. Even organizations with active bond desks are not taking the same size positions as they used to, nor are they trading as actively for their own proprietary accounts.

You can't blame the management of these firms for this changing attitude. We have to allocate a decent amount of risk capital to this operation and then, down the road, show shareholders the benefit and profit that taking this risk provided. But people still remember the Solomon Brothers Treasury auction fiasco. They also remember Kidder Peabody going down in a thud thanks to the ridiculous Joe Jett scandal. And finally, if Long Term Capital Management can fold up like a cheap suitcase with 34 PHD's on staff along with 2 Nobel Prize winners, do you think that we could convince our management that WE have all sorts of safety nets in place and that it can't happen to us?? Doubtful.

Right now this whole reduction of possible bond dealers has had little effect on the market. The markets have been reasonably quiet and there have been no tremendously unsettling movements in interest rates. It is possible that no obvious correlation will be seen for a long time to come, but there is the basis of my worry. No one needs to worry when markets are working smoothly. EVERYONE needs them to work smoothly when there is a crisis. Calling the 1994 market situation a "crisis" might really be pushing my luck, but things went pretty poorly for lots and lots of investors. And even since then the number of large bond dealers has been dramatically reduced.

THE SUMMARY

The types of fixed income investments available to investors becomes more complicated every day.

These securities all sell over-the-counter.

Will there be a broker there ready to buy it back from you should there come a day you'd like to sell it?

Will you be looking to sell at a time when things are great in the markets, or a time when things are in turmoil?

Can you bet your organizations future on the previous answers?

My thought is that this whole change has skewed the playing field more in the direction of the broker/dealers and if a crisis were to erupt, investors could be badly hurt. I also think it might give continued impetus to the movement to create more electronic markets for bonds; as there has already been movements in this regard in the past few years. So the summary of this whole discussion is simply this: caveat emptor. When you buy any of these products you must always keep in mind the possibility that there might not be a ready buyer to take it off your hands when you decide to sell it.

ON ANOTHER NOTE

Priceline.com announced that their earnings were going to disappoint analyst's expectations this week and their stock dropped by 40%. Apple Computer made a similar announcement and their stock dropped by 50%. Even Intel got drilled recently. I guess we are living in an age where expectations are running VERY high and many, many companies have learned the hard way that you had better not disappointment Wall Street.

Not that anyone gives a damn about my thoughts, but I truly feel Apple had turned the corner in the past couple of years and their new product introductions have been interesting and timely. I can't say for a second that I would go buy a single share of their stock, but long-term I have to think they're going to at least stay in business and be fine. Their niche remains solidly intact irregardless of any occasional earnings disappointments. But that's what they will remain for the foreseeable future; a niche player.

Priceline.com on the other hand is over. For whatever reason, as I sat and listened to the news of their revenue disappointment, it hit me like a lightning bolt that their whole business plan is stupid and won't survive long term. As soon as the airlines, hotels, supermarkets, and whoever else, figures out how to replace them with their own bidding systems they will. The airlines are already onto this with the introduction of a site of their own. So there's my feeble opinion. Priceline.com is done. Put a fork in them.

BERMUDA ONE LAST TIME

The Bermuda program running November 27th through December 1st has been a terrific success and I look forward to seeing those of you who have registered. A meeting was held in my office yesterday to discuss the very limited room left for most of the days. If you had been planning to attend, please give my office a call at (860) 347-6568 and ask about availability. Many of the programs have 5 seats or fewer available at this point.

You can also register at the website:

http://www.afs-seminars.com

Copyright 2000, Michael Gasior. All Rights Reserved.

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