Watch Out for Irrational Exuberance

Veterans of the telecom industry have lived through financial bubbles before. That is what happens when greed overcomes rational fears about over-investment.

As much as internet service, data transport providers and, in some cases, data center operators, must grapple with ever-increasing demand, those industries also have seen bouts of over-investment in capacity. Think about long-haul fiber transport in the late 1990s or excessive prices paid to acquire 3G spectrum in Europe. 

Excessive optimism led to mispricing of assets, over-investment, questionable growth metrics and outright fraud. Not to mention use of leverage. 

Asset-backed bonds played a role in the telecom collapse of 2001. During the late 1990s, there was a frenzy of investment in the telecommunications industry. Many telecom companies borrowed heavily to finance their expansion, and they often used asset-backed bonds to do so. These bonds were backed by the future revenue streams of the telecom companies, but when the telecom bubble burst in 2000, the value of these bonds plummeted. This led to a number of telecom companies defaulting on their debt, which in turn caused the collapse of the industry.

Merchant banking and excessive use of “junk bonds” also played a role. Telecom companies used merchant banking to finance their expansion by issuing high-yield debt securities, also known as junk bonds. These bonds were often sold to unsophisticated investors who were attracted by the high yields.

Synthetic securitization also increased risk., Synthetic securitization is a type of securitization that involves creating a security that is linked to the performance of another security. Telecom companies used synthetic securitization to transfer their debt to other investors. This allowed them to reduce their debt burden, but it also made them more vulnerable to default if the underlying assets declined in value, which they did. 

Off-balance sheet financing also minimized the actual amount of debt firms were taking on. 

Even debt-equity swaps increased risk. Telecom companies used debt-equity swaps to reduce their debt burden, but it also made them more vulnerable to default if their stock price declined.

Aggressive accounting practices also used aggressive accounting practices to inflate their profits. In some cases, such practices drifted into fraud. Think Worldcom and Enron. 

These risky financing schemes allowed telecom companies to borrow more money than they could afford.

It is the sort of “irrational exuberance” one often has to watch out for.