Profiting from Mortality Death bonds may be the most macabre investment scheme ever devised by Wall Street In May, as the subprime mortgage market was cracking, many of the biggest players in finance gathered at a conference in New York to talk about the next exotic investment coming down the pike: death bonds. When the event was held two years ago, just 250 people showed up. This time, nearly 600 descended on the Sheraton Hotel & Towers for the three-day confab, including delegations from Bear Stearns (BSC ), Deutsche Bank (DB ), Lehman Brothers (LEH ), Merrill Lynch (MER ), UBS (UBS ), Wachovia (WB ), Wells Fargo (WFC ), and other big firms. They flocked to seminars with titles such as "Legislative Review," milled about the exhibition hall picking up the usual conference swag, and buzzed at luncheons and a Carnegie Hall gala about the big push into the market being made by Cantor Fitzgerald, a major bond-trading shop. With all the happy banter, you wouldn't have known they were there to learn about new and imaginative ways to profit from people dying. Slide Show >>Death bond is shorthand for a gentler term the industry prefers: life settlement-backed security. Whatever the name, it's as macabre an investing concept as Wall Street has ever cooked up. Some 90 million Americans own life insurance, but many of them find the premiums too expensive; others would simply prefer to cash in early. "Life settlements" are arrangements that offer people the chance to sell their policies to investors, who keep paying the premiums until the sellers die and then collect the payout. For the investors it's a ghoulish actuarial gamble: The quicker the death, the more profit is reaped. Most of the transactions are done by small local firms called life settlement providers, which in the past have typically sold the policies to hedge funds. Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors. If the market develops as Wall Street expects, ordinary mutual funds will soon be able to get in on the action, too. BUT THE INVESTMENT BANKS are wading into murky waters. The life settlements industry increasingly finds itself in the grip of dubious characters devising audacious and in some cases illegal schemes to make money. Many are targeting elderly people with deceptive sales pitches—so many that the National Association of Securities Dealers has issued a warning about abusive practices. Others are promising investors unrealistic returns or misleading them about the risks. Some are doing both. That didn't discourage the high-powered guests at the New York conference, though. As they tossed back cocktails and dined on pan-seared filet mignon, they enthused about the market's possibilities. "Wall Street firms are here because they know this is an asset class that isn't going away," says David C. Dorr, president and CEO of Life-Exchange Inc. (LFXG ), an electronic platform for trading life settlements. "There's big potential." The truth is, at this early stage, there's no way of knowing how popular death bonds might become. Wall Street's innovation machine has turned out both huge hits and big flops over the years. But the growth of the underlying market for life settlements has been torrid so far. In 2005 about $10 billion worth were transacted, according to Sanford C. Bernstein & Co. (AB ), up from virtually nothing in 2001. Industry analysts say this number rose to $15 billion in 2006, and could double this year, to $30 billion. Over the next few decades, as the ranks of retirees swell, Bernstein predicts that the face value of life settlement deals will top $160 billion a year in today's dollars. Death bonds will never approach the size of the mortgage market, which saw $1.9 trillion of securities issued last year. But if Wall Street achieves its goal of turning most of the life settlements created each year into death bonds, the market could rival the size of today's junk-bond market, where issuance totaled $128 billion in 2006, up from $56 billion in 1996, according to market watcher Dealogic. Investment banks have already drawn up their sales pitches to well-heeled institutional customers. Firms say death bonds should return around 8% a year, right between the expected returns of stocks and Treasury bonds. Moreover, they're "uncorrelated assets," meaning their performance isn't tied to what's happening in other markets. After all, death rates don't rise or fall based on what's happening to commodities, say. Uncorrelated assets like these are highly prized in an increasingly connected global financial system. It all sounds great, except that many of the life settlements that Wall Street firms are buying fall into categories ranging from sketchy to toxic. "They are creating a very risky product," says Janet Tavakoli, a Chicago financial consultant who specializes in advising clients on asset-backed investments. "They may be planning to sell them to sophisticated investors, but they could be roping in people who don't appreciate the risk." Many life settlement providers, for example, are trying to lure people who don't even hold insurance. In this tail-wagging-the-dog scenario, speculators take out policies on the individuals' behalf, pay them something up front, cover the premiums, and then wait for the people to die so they can collect. At the most outlandish extreme, one outfit devised a plan involving the population of the Federation of St. Kitts and Nevis in the Caribbean. Investors, meanwhile, have been burned by operators who have misrepresented the profit potential on deals. Two men now awaiting trial in California hatched an allegedly fraudulent scheme aimed at the entire congregation of a black church in South Central Los Angeles. They promised investors 25% annual returns because African Americans die earlier than other racial groups—an ugly pitch that prosecutors say overstated the upside potential. Even some of the biggest life settlement firms operate under a cloud. Philadelphia's Coventry First, for example, faces civil charges from the New York Attorney General's office and is in danger of being barred from doing business in Florida. It denies any wrongdoing. The eight-year-old industry certainly has an ignominious history. It grew from the shards of the so-called viaticals business, which imploded in the late 1990s amid allegations of fraudulent dealings with AIDS patients and other terminally ill people. The word viatical comes from viaticum, a religious term for the communion given to a person near death. As AIDS spread during the 1980s, patients turned to the viatical settlements market to unlock insurance money to pay for care. But advances in medicine in the 1990s extended patients' lives, making viaticals less profitable for the buyers. At the same time, the industry was rife with abusive sales practices that drew the attention of prosecutors. By 1999, business had all but dried up. Surprisingly little has changed in the latest iteration. Only 26 states require professional licensing for life settlement brokers; elsewhere, anyone can hang a shingle. The market is especially popular among former stockbrokers, mortgage brokers, insurance agents, and lawyers. But all sorts of people from small-time movie producers to dentists are setting up shop. There's nothing inherently wrong with life settlements. In fact, for people who need quick cash or want to supplement their retirement nest eggs, the market can be a boon. Without it, a person looking to unload a policy would have only one choice: to sell it back to the insurer for the so-called cash surrender value, a fraction of the face value. "No one is forcing anyone to sell insurance policies," says Meir Eliav, president of Legacy Benefits Corp., a New York life settlements provider that was involved in one of the first death bond deals in the U.S., a $70 million offering in 2004. "This is a terrific option for the consumer." Wall Street's intense interest says much about the world of high—and low—finance in 2007. In earlier eras, big firms' success or failure rested mainly on their ability to turn long-term client relationships into full-service operations—advising corporate clients on potential acquisitions, managing investments, and arranging financing. But Wall Street has been overtaken by securities trading and the endless creation of financial products, such as asset-backed bonds, collateralized debt obligations, credit default swaps, and other exotica. Cast in that light, Wall Street's move into death bonds seems almost inevitable. Goldman Sachs (GS ) and the other firms consider these instruments the next stage in a trend that started with mortgage-backed securities in the 1970s and has since expanded to include everything from credit-card receivables to intellectual property. The term of art is "securitization," and it has become a multitrillion-dollar business. The mechanics are straightforward: Assets are pooled together and then sold off in the form of bonds or pieces of bonds. By collecting many different assets, the risk is dispersed: Even if a few don't pay off, the rest will. At least that's the theory. ALREADY THERE'S a bustling market in Germany and London for unrated death bonds—that is, ones that aren't graded by big ratings agencies such as Moody's Investors Service (MCO ) or Standard & Poor's (which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP )). So far there have been only two small rated deals in the U.S. But given how aggressively the banks are stockpiling life settlements, most market watchers expect big, rated deals to become commonplace soon, at which point mutual funds can dive in. "The product just lends itself to securitizations, like what has been done with mortgage-backed securities," says Philippe Hatstadt, who heads the new "longevity derivatives" group at Bear Stearns & Co (BSC ). Cantor Fitzgerald, one of Wall Street's savviest bond-trading shops, is rolling out an electronic trading platform for life settlements and, ultimately, death bonds. The LexNet platform has been in the works for more than a year and is a major priority inside Cantor, say insiders. But the push into increasingly complicated securitizations carries with it ever greater risk. That's what Wall Street is dealing with now as bonds backed by pools of subprime mortgages blow up left and right. A surge in defaults on these riskiest of loans is battering the hedge funds that invested—and the banks that arranged, packaged, and sold them. In June, two Bear Stearns hedge funds that bet on bonds backed by subprime loans collapsed, sparking panic on Wall Street about the health of other risky investments. Tavakoli says the same kinds of missteps are bound to happen with death bonds. But Wall Street is good at justifying its moves into new lines of business, however iffy they might seem, notes Kenneth C. Froewiss, a professor of finance at New York University's Stern School of Business and a former JPMorgan Chase & Co. (JPM ) investment banker: "At the end of the day, what Wall Street does best is figuring out what investors might want and structuring products to meet those needs." And its own needs. That's not to say it isn't aware of appearances. Wall Street is doing its best both to polish the life settlement industry's image and to downplay its own direct involvement. The New York conference was put on by the Life Insurance Settlement Assn. (LISA), an organization of market players that began as the Viatical Association of America in 1994, changed its name to the Viatical & Life Settlement Assn. in 2000, and then dropped the "viatical" altogether three years ago. In an attempt to put even more distance between Wall Street and the old viatical crowd, six investment houses, including Bear Stearns, Credit Suisse (CS ), Goldman Sachs (GS ), and UBS, in March formed a trade group called the Institutional Life Markets Assn. to lobby for "best practices" and "appropriate regulation." Until some degree of legitimacy is in place, firms will keep as low a profile as possible. Goldman Sachs, for example, came close last year to acquiring San Diego's Life Settlement Solutions Inc., a large provider, but backed out at the last minute, according to people familiar with the potential deal. Instead, Goldman, which declined to comment for this story, is quietly building up its own subsidiary under the nondescript name Eastport Capital. That unit sent four representatives to the LISA conference. It's no wonder that Wall Street is simultaneously attracted and cautious. The alchemy going on in the finance labs is real, but the market for life settlements is deeply troubled. There's a persistent problem with brokers offering lowball prices and failing to disclose transaction costs. The marketing to investors has often been suspect, too. In late 2005, for instance, the big accounting firm KPMG sent a cease-and-desist notice to Keydata Investment Services Ltd., a London firm that was using KPMG's name in its marketing material for unrated death bonds without permission. A Keydata official didn't return phone calls seeking comment. A KPMG spokesman says: "We do not endorse or recommend these products." IMPROPER MARKETING is just one of the things that got two California men into trouble. Next March, Curtis D. Somoza and Robert A. Coberly are scheduled to go on trial in federal court in Los Angeles on charges that they bilked dozens of investors out of tens of millions of dollars in a scheme involving an African American church group in Los Angeles called the Personal Involvement Center. The men, whose lawyers declined to comment, raised $69 million for an investment trust called Persistence Capital, which arranged to buy policies from Transamerica Corp. on the lives of some 2,000 members of the inner-city church. The deal was structured so that Persistence would pay for the premiums, while the $275,000 death benefit on each policy would be split three ways: $15,000 to the deceased person's family to cover burial costs, $20,000 to the church group, and the remaining $240,000 to the trust. The trust's haul would go toward paying the premiums on the remaining policies and providing payouts to investors. Somoza and Coberly pitched the deal to the Reverend J. Benjamin Hardwick as an opportunity for the 75-year-old pastor to get a modest death benefit for his mostly poor members and raise funds for the group's charitable works. Somoza and Co-berly sold it to investors as a way to score a high annual return of 25% because the church group's members "were predominantly African Americans and had a higher mortality rate than the average population," according to the indictment. Prosecutors say the pitch reflected inflated return assumptions. Hardwick didn't return several phone calls seeking comment. Soon after the deal was set up, say prosecutors, Coberly and Somoza began looting the trust to buy mansions and sports cars. In September, 2005, a year after Persistence bought the policies from Transamerica, it was forced into bankruptcy by investors demanding their money back. Trying to salvage the scheme, Coberly and Somoza shopped the policies to other investors but could find no buyers. They were arrested in May, 2006, and charged with 27 counts of securities and wire fraud. Coventry First has also been accused of wrongdoing. Last October Eliot Spitzer, in one of his final acts as New York's attorney general, charged the firm with cheating elderly insurance holders. In a civil suit in New York State Court, the now-governor accused Coventry, which buys life settlements and resells them, of making "dozens" of secret payments to brokers as a reward for not seeking competing bids. (The investigation is now overseen by Attorney General Andrew Cuomo.) Coventry CEO Alan Buerger says the lawsuit was based on "a handful of out-of-context e-mails." True or not, the allegations against Coventry sent a shock wave through the life settlement business. Most damagingly, they torpedoed a planned $300 million death bond offering from a partnership formed by Coventry and Ritchie Capital, a hedge fund. The deal, which was to be underwritten by Lehman Brothers Inc (LEH )., would have been backed by a pool of life insurance policies with a face value of $1.16 billion, by far the largest U.S. death bond offering to date. What's alarming is how far the deal had progressed before blowing up. Investors were cued up and ready to buy. On Oct. 10, 2006, Moody's (MCO ) even tagged the senior notes, which had a face value of $166 million, with a rating of A3, an investment-grade status that would have allowed ordinary mutual funds to pile in. Then the Coventry suit was filed, and Moody's quickly withdrew its rating, citing the "uncertainty surrounding the transaction." Michael N. Adler, a Moody's spokesman, says the firm wasn't aware Coventry was under investigation when it issued the rating. The 10-page report that accompanied the rating is no longer available to the public. In the report, obtained by BusinessWeek, Moody's said it believed that Coventry's "due diligence was adequate for the rating being requested." Jay Eisbruck, a Moody's managing director, stresses that "this is an asset class that we are very careful about." What especially worries regulators are so-called stranger- initiated deals, in which an investor persuades people to take an expensive policy and lends them money for the premium. In the boldest example yet, an investor group pitched a bank on a deal involving all 45,000 residents of St. Kitts and Nevis. The promoters claimed the islands' government was on board. But the deal got a cool reception from Wall Street bankers, who all stress that they perform ample due diligence before buying policies. A government finance official said he had never heard of such a deal. Yet hedge funds and other finance firms have been diving into other stranger-initiated deals in the past two years, wooing seniors into taking out policies by offering cruises and other gifts. Industry sources estimate that $10 billion to $20 billion in such policies have been created since 2004. Some state insurance commissioners have joined with insurers in calling for a crackdown. Amazingly, such problems have merely delayed the emergence of death bonds, not derailed it. G. Andrew Karolyi, a finance professor at Ohio State University's Fischer College of Business who specializes in international markets, says Wall Street's interest is predictable given the "demographic bubble" of aging baby boomers, many of whom will be looking to cash in insurance policies. "For investment banks," he says, "all of this sounds like an opportunity to make money." Tavakoli, the securitization consultant, is more blunt. The idea of death bonds, she says, "creeps me out."   Create Date : 15 ¾ÄȨԡÒ¹ 2550     0 comment Last Update : 15 ¾ÄȨԡÒ¹ 2550 17:30:03 ¹.     Counter : 354 Pageviews.   Share Tweet

IPOs: How to Kick the Tires Interesting topic from Businessweek June 28, 2007, 12:01AM EST Not all initial public offerings are created equal. Here's what investors should look for when buying newly issued shares by David Bogoslaw It's been less than a week since the Blackstone Group's (BX) much-vaunted initial public offering, and other private equity firms are eyeing a foray into the public market, starting with the Carlyle Group. Should investors respond to this trend with eagerness or wariness? While an IPO allows investors to participate in what's usually a hot sector, a healthy dose of skepticism is always advisable when considering buying a newly issued stock. First of all, there's nothing accidental about the timing of an IPO. As investment guru Burton Malkiel says in A Random Walk Down Wall Street, an IPO is usually scheduled by a company's managers to coincide with a prosperity peak for the company, or with the height of investor enthusiasm for a current fad. Healthy skepticism Some experts recommend that you wait until after the so-called lockup period, or the first six months of trading, has passed. This allows you to see how well the stock holds up to additional selling pressure, or to take advantage of a price decline. The Blackstone IPO, which was valued at $33.6 billion, was touted as the biggest IPO of the past five years. Ten times oversubscribed, the shares opened at $31 last Friday and had risen 13% by the market close that day. By Tuesday, however, the price was down to $30.75. It isn't hard to see why private equity firms have become the talk of the market when you consider the rise in demand for financial services and the economic strength that industry has demonstrated in recent years. Private equity accounted for 48% of merger-and-acquisition value and 20% of volume during the first five months of 2007, vs. 32% and 17%, respectively, for all of 2006, according to Thomson Financial. But not everyone is buying the hype, with skeptics citing inflated prices and the absence of a track record of trading publicly. Variable Quality If IPOs are pricing fairly strongly lately, it's because the IPO market takes its cue from the broader market, where valuations have increased over the past year. Given the greater cyclicality of the IPO market vs. the broader market, it's likely that if there's a slowdown in the broader market, we'll see a more dramatic drop in IPO issuance, says Michael Hoder, a stock analyst at Morningstar Funds (MORN). And investors would be missing some good opportunities if they think it's wiser to stay away from IPOs in a weak market cycle, according to Paul Bard, vice-president of research at Renaissance Capital in Greenwich, Conn. When the overall market is weak, only companies that have strong fundamentals get pushed through, often at very attractive prices. Conversely, when the IPO market gets hectic, deal quality tends to diminish, as at the height of the tech bubble in 1999. Seeing the market's willingness to absorb IPOs, banks are happy to oblige by pushing even lower-quality stocks into the public sphere, says Bard. In any market, investors looking to buy shares of newly public companies should do their homework. This week, Five for the Money takes a look at five things investors should look for when considering an IPO. 1. Company Fundamentals Don't let the lack of transparency and hype around hot sectors cloud your vision. As with any company, its financial track record, competitive position in its industry, business model, and earnings power will tell you most of what is worth knowing. After the quality of a company's management team, its market opportunity and products are the key factors to look at, according to Bob Davis, managing general partner at Highland Capital Partners, a venture capital firm. "We like to see a market we believe is expanding and a market we believe is huge with a capital H," Davis says. He'd rather pick a company with a small share of a $5 billion market than one that has the dominant position in a $50 million market. For Bard at Renaissance, it's not only how ample the market opportunity is but whether a company is able to grow faster than the market. "If you can find both those things, those are the two key ingredients for driving strong earnings growth," he says. Davis, who was the first CEO of Lycos and now specializes in digital media and Internet companies, says it's important to thoroughly analyze the subsegments within such a broadly defined industry as digital media so as to fully appreciate what a company actually does and who its competitors are. He asks lots of questions. For example, if a company is the dominant player in a market, what are the barriers to entry for newcomers? If there's another entrenched competitor, does that company have more capital, more time, more resources, more relationships, more intellectual property, or a better team that will put your company at a disadvantage? In looking at products, he asks "What is the satisfaction that I'm delivering to a customer, that says either 'I'm going to solve your problem or make you feel pretty good about something'?" Having products that give a customer a reason to want to do business with or switch to a provider is critical, he says. 2. Valuation Renaissance Capital, which does extensive research on IPOs, says its analysts use a variety of metrics to compare newly public firms with the most comparable publicly traded peers. These metrics include price-to-sales, price-to-earnings, and enterprise value-to-cash flow, using the midpoint of the proposed offer's price range. Similarly, Renaissance measures the trading performance of the new company's peers relative to the market, using it as a proxy for the expected trading of the new company's stock. In weighing the potential value of a company, Morningstar doesn't believe in relying on comparable multiples within the same industry, as many analysts do. Instead, "we build a discounted-cash-flow model based on what we think its competitive position is," says Hodel. "We don't take a favorable view of an IPO just because it's in a hot sector. We take a look at it for its own merits." In the absence of public filings of financial results and analysts' coverage, investors' best bet is to check the S-1, the registration statement companies are required to file with the Securities & Exchange Commission prior to an IPO. An S-1 typically includes a preliminary prospectus, income statement, and balance sheet, plus various sections that highlight potential risks and intended use of proceeds from an IPO. 3. Corporate Governance In looking at how closely the interests of the company's managers and the board of directors are aligned with the interests of new public shareholders, Renaissance considers insiders' stock holdings, any conflicts of interests, and the number of independent directors on the board. An insider on a board often gets paid an exorbitant fee. If a board member has "a relationship with the company through affiliates, then they're not independent and we're not certain they're going to do what's best for investors," says Bard at Renaissance. Insider transactions with an affiliate that may not have been done on an arm's-length basis, such as with a supplier, also set off alarms. How eager insiders are to sell their shares may also send a warning. If the preliminary prospectus says that founders and officers are selling 30% or more of the number of shares being offered, it could signal a rush for the exits, says author Tom Taulli in his book, Investing in IPOs, Version 2.0. 4. Motivation Hodel says he likes to see a company with a motivation to do an IPO for reasons other than the strength of recent valuations. "If it's just a cash-out for insiders, that's a bad sign." A good example is MasterCard (MA), which went public in May, 2006. Some of the banks that owned MasterCard saw a public offering as a way to take some of the litigation risk associated with antitrust lawsuits off themselves. "Our analyst looked at the company and determined that the litigation risk was more a matter of perception, that it wasn't as big a deal, as some people thought," says Hodel. The MasterCard example also highlights the need to peer below the surface of typical market concerns. For example, any mention of litigation risk in a company's S-1 is generally treated as a red flag that shouts "Beware" to would-be investors. Stated risks should be weighed in the context of how big an impediment to growth they may be. If the worries that a risk gives rise to aren't warranted, it can just as easily be an opportunity. 5. Underwriters Investors would be wise to scrutinize not only the company offering the shares but also the financial institution underwriting the deal. The first question is how confident the underwriter is that there's enough demand for all the shares being offered. If a bank offers shares on a firm commitment basis, it's a sign of confidence in the quality of the stock, while offering to sell shares on a best-efforts basis shows some trepidation. The size and reputation of the underwriter can also send a signal to investors: "The general rule of thumb is either to stay away from or take a closer look at companies being underwritten by third-tier underwriters that don't typically do IPOs," says Bard. "They don't have as long a track record, but also the companies they're taking public are less-seasoned companies." One trait that distinguishes the so-called top-tier banks from others is their relationships with the largest institutional investors, such as major mutual fund companies. By using a top-tier underwriter, a company has a better chance of placing its shares with the most reputable institutional investors. But even the best-regarded underwriters do their share of less-than-stellar deals, Bard warns. Certain underwriters have more expertise in particular sectors, perhaps because they have a trustworthy analyst covering a given industry. Morgan Stanley (MS) and Goldman Sachs (GS) are known for their skill with technology companies, which can serve as a kind of stamp of approval, Bard says. An IPO may look good on the surface, but the involvement of a second- or third-tier underwriter can make investors suspicious and can cause some of the top institutional investors to hold off and question why a more respected bank isn't managing the IPO, he says. But a less-well-known underwriter doesn't always mean there's reason for concern. A small shop may have specific knowledge of an industry that makes it more qualified to handle the IPO than a bigger firm. Morningstar is beginning to take a closer look at the shareholders behind IPOs as another way of gauging a company's underlying value, Hodel explains. "This is going to be especially important as more private equity firms come public," he predicts. "We're getting a sense of who the better private equity or venture capital firms are [in terms of] how well they pick their investments, how they value them, how disciplined they are in what they pay for them, how well they operate them after taking control of them." Bogoslaw is a reporter for BusinessWeek's Investing channel.   Create Date : 15 ¾ÄȨԡÒ¹ 2550     0 comment Last Update : 15 ¾ÄȨԡÒ¹ 2550 15:51:29 ¹.     Counter : 184 Pageviews.   Share Tweet