Corporate Accounting Woes Weigh on Firm's Bond Pool

Wall Street West by Benjamin Mark Cole

It's been a challenging year for Western Asset Management, the Pasadena bond manager that has quietly assembled a $100 billion bond portfolio over the past three decades.

Last year, Western Asset's strategy of investing in either mortgage-backed securities or corporate bonds even BBB-rated bonds which yield more than U.S. Treasury bills, helped it outperform the broader bond market. Its Western Asset Core portfolio returned 10.1 percent in 2001, outperforming the Lehman Brothers Aggregate Bond Index by 1.6 percentage points.

Institutional investors took notice, as they are ever keen to add even one percentage point to annual returns on bond portfolios.

Western Asset manages money for at least two large local pension funds, the $150 billion California Public Employees Retirement System and the $28 billion Los Angeles County Employee Retirement Association.

This year hasn't been so good. An unusually blunt assessment of the accounting profession and Western Asset's performance can be read in a summary of the markets posted on the firm's Web site this month.

"The recent collapse of WorldCom amid allegations of widespread fraud has brought a dispiriting end to an already difficult quarter. Western Asset's investment in WorldCom now looks beyond meaningful recovery, and the firm's (and other investors') reliance on audited financials now appears foolish," concludes a report penned by Western Asset Chief Investment Officer Kenneth Leech.

Leech goes on to note that investors are questioning whether any bond issuer's books can withstand scrutiny. "As a result, the challenge to Western's primary investment theme of overweighting corporate bonds and focusing particularly on BBB securities has caused the firm to significantly underperform (the market)."

During the second quarter of 2002, the Lehman Brothers Aggregate Bond Index returned 3.695 percent.

Western Asset, with a focus on large institutional clients, keeps a low profile, despite its stature as the biggest bond house in town, with 300 employees. It was founded in 1971 inside of First Interstate Bank. Baltimore-based Legg Mason acquired Western Asset in 1986, but left it more or less independent.

Its chief executive, James W. Hirschmann, declined a request for an interview. "We have a policy of not talking to the media," he said.

But with commentary like Leech's making the rounds on Wall Street, it is perhaps not surprising that Congress has legislated serious reforms for Wall Street.

Ask Dick Clark?

So has the market really bottomed?

Maybe investors should turn to music host Dick Clark for the answer.

Burbank-based Dick Clark Productions, after years of lassitude on Wall Street, recently went private in a deal that took the company's shares off the Nasdaq.

When the pace of going private transactions quickens, it's sometimes a sign that Wall Street has gotten too bearish about prospects for small- and mid-cap fortunes, said Brooks Dexter, managing director with USBX Advisory Services Inc., boutique investment bankers in Santa Monica.

If public valuations sink low enough, private investors might snap up other such "orphan stocks." In a going-private transaction, shareholders will get a hefty premium often running between 25 and 33 percent over the trading price.

So far, there has not been a wave of these transactions, although Dexter says he is getting more inquiries about the strategy from public company chiefs. One problem is that banks are still chary of financing leveraged buyout transactions.

But Dexter thinks there's another reason some public companies wish to go private: "The liability of being a public company in this regulatory environment, and the cost of compliance, often outweighs the advantages of being public," he said.

Indeed, under a law signed last week by President Bush, chief executives are personally liable for reported audit numbers, even though the arcana of auditing can sometimes fog the sharpest intellect. "Being the head of a publicly traded company is no longer a fun thing," Dexter said.

New Shingle

A fixture in the Los Angeles investment banking scene for almost 20 years, Scott Wendalin, has hung out his own shingle, with the name Prospect Financial Advisors LLC.

Wendalin was formerly head of investment banking and a board member with Sutro & Co. Inc., which last year was swallowed up by Royal Bank of Canada.

The Harvard-educated Wendalin said his investment banking advice is free of institutional conflicts. "The investment banks have become very product focused," Wendalin said. It's a polite way of saying that investment banks only want to serve clients that need stock deals or bond deals underwritten, or help with mergers and acquisitions.

"We will tell a client that maybe nothing needs to be done, or that a merger is a bad idea, or that it is the wrong time to sell," Wendalin said, citing three outcomes that generally mean lower fees for investment bankers.

Does Wendalin feel any sorrow that the 144-year-old Sutro name has vanished? "Not really," he answered. "That's just the way the business is going these days. The Royal Bank of Canada wanted the distribution network to flow (stocks and bonds) through, and Sutro had it. So they bought Sutro. It's business."

Short Takes

The topic of employee stock ownership plans, addressed in this column twice in recent weeks, still has readers' passion. The suitably named Adam Smith, financial analyst with ESOP valuation firm Sanli Pastore & Hill Inc. in West Los Angeles, wrote that ESOPs "are the only way many owners can sell their companies" given timid banks and current market conditions. Other pro-ESOPers hint that Wall Street types don't like ESOPs, despite obvious benefits, because an ESOP is not a Wall Street transaction, and takes a company out of circulation, usually for good... Mike Nichols, founder of Westwood-based Windward Capital Management, thinks the investing public has stomached the bad news on corporate accounting, and is ready to belly up for seconds. "The media has been playing up the corporate accounting scandals, and as long as it gets ratings, it will continue to play them up. But sooner or later that story will fade, and the economy appears to be recovering," said Nichols, who thinks financial stocks have a good run in them.



Contributing columnist Benjamin Mark Cole writes about the local investment community for the Los Angeles Business Journal. He can be reached at sevencontinents@mindspring.com .

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