The following post by Edward Jay Epstein, author of the forthcoming The Hollywood Economist: The Hidden Financial Reality Behind the Movies (available from Melville House on February 23rd), is the fifth in a series leading up to publication of the book. You can read more of Epstein’s writings about Hollywood’s hidden economy at his website, here.You can also see Epstein in Oliver Stone’s forthcoming Wall Street 2: Money Never Sleeps wherein Epstein plays the head of the Fed …. Click here to read all posts in the series.

Back in 2003, after Kirk Kerkorian let it by known that he was (yet again) prepared to sell MGM, Viacom (which owns Paramount) considered buying it. Although MGM no longer had sound stages, backlots or other physical facilities, and now produced only a handful of movies, it owned an incredibly valuable asset: a film library with 4,100 motion pictures and 10,600 television episodes. The crown jewels of this collection: its James Bond movies, which was possibly the most valuable entertainment franchise ever created. By licensing these titles over and over again to Pay-TV, cable networks, and television stations around the world, and selling DVDs from it, this library brought in roughly $600 million a year.

But that gross was an elusive number as it had to be split with others who had rights in the titles. Each title had its own contractual terms governing payments to partners, talent, guilds, and third parties. Just making these payments entailed issuing more than 15,000 checks per quarter. Not only did titles have different pay-out requisites, but their future revenue stream depended on factors specific to each movie, such as the age of its stars, its topicality, and its genre.

To figure it out, Viacom assigned a team of 50 of its most experienced specialists to estimate  how much each and every title would bring in over a decade. The Herculean job took the team two months. From this analysis, as well as considering other benefits of merging MGM with Paramount, Viacom’s executives agreed MGM was worth between $3.5 and $4 billion.

But before they could arrive at a bid price, Viacom’s President, Mel Karmazin, asked whether the value of the MGM vast library might go the way of the music industry, which had been decimated by Internet down-loading. When none of the executives could rule out that possibility, Karmazin said “In that case, we are not bidding on MGM.”

Sony also set its sights on MGM, but for a very different reason. Since it had staked much of its corporate future on Blu-Ray as a high-definition format it would use for its Playstation-3 as well as its movies, it needed to get other major studios to choose it over a competing format, backed by Toshiba and Microsoft, called HD-DVD. Sony had learned from bitter past experience that format wars are often decided, not through superior technology but through side payments made to studios. Toshiba and Microsoft (which had X-Box), were already offering huge cash inducements–one studio would get $136 million–to put their titles exclusively on the HD-DVD format. Given their rivals deep pockets, Sony desperately needed the heft of the MGM titles on Blu-Ray, since its library, together with its own, could give it Blu-Ray an unassailable lead.

To accomplish this strategic goal, Sony did not need to itself need to spend billions to acquire MGM, it only had get effective control of its library for a few years. So it put together a consortium it would lead that would be financed mainly by Wall Street private equity funds. Even though the LBO would wind up costing $4.85 billion, Sony invested only $300 million of its own funds (and for that it got the profitable right to distribute MGM movies). Another $300 million came from The Comcast Corporation in return for the rights to put the MGM’s library on Pay Per View on its vast cable system. The rest of the equity money came from four renowned Wall Street investors: Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking Partners, and Steve Rattner’s Quadrangle Group. These savvy funds put in a billion dollars. The leverage part of the deal was organized by JP Morgan Chase, which arranged for the consortium to borrow $3.7 billion (or up to $4.2 billion, if needed) from some 200 banks. The deal closed in September 2004.

For Sony, the gambit succeeded brilliantly. Putting some 1,400 MGM titles exclusively on Blu-ray, helped established Blu-Ray as the industry standard for high-definition, and it won the format war. It also made back a large share of its $300 million investment just on the distribution fee it earned on two new Bond movies — Casino Royale (2006) and Quantum of Solace (2008).

But for the Wall Street players, it was nothing short of a disaster. To cut to the chase, they lost almost their entire billion dollar investment. They had relied, perhaps naively, on impressive-looking projections showing that the net cash flow from a movie and television library would be sufficient to pay the interest on the nearly $3.7 billion of debt over s decade. What they had not counted on was a sea change in DVD sales. In the US alone, MGM’s net receipts from DVDs fell from $140 million in its 2007 fiscal year (which ended March 31st 2008) to just $30.4 million by 2010. As a result of collapsing sales, higher pay-out for participants, increased distribution costs and other problems, MGM’s crucial operating cash flow catastrophically fell from $418.4 million in 2007 to minus $54.2 million by 2010. In addition, it owed Fox Home Video $60 million for an “adjustment” in the DVD distribution contract it had taken over from Sony. By October 31, 2009 MGM, sinking in a sea of red ink, found itself unable to make its mandated interest payments on the $3.7 billion it owed banks.

Ordinarily when a company fails to make such payments, its bank creditors can seek to recover their money by forcing the company into bankruptcy. With MGM, however, the bankruptcy option presented a real problem since many of its intellectual property rights, including those to make sequels in the James Bond franchise, stipulate that in the event of bankruptcy they would automatically revert to another party. In the case of the James Bond franchise, for example. the sequel rights would revert to Danjaq, LLC. (These bankruptcy clauses are not mentioned, even in a footnote, in the 38-page “Confidential Information Memorandum” that MGM sent out to prospective buyers in the winter of 2009.)

So the creditors, learning that bankruptcy would destroy a significant part of the remaining value of MGM, gave it a three month “forbearance,” which meant it had until January 31, 2010 to come up with the money. The idea was that MGM would sell itself to a white knight and use the proceeds to repay the banks. So the deal book was sent out to a dozen or so prospective buyers calling for bids by January 15. As for the hedge funds, having already written down 85 percent of their billion dollar investment in preparation for what may be a near total wipe-out, they may have learned the hard way that when a Hollywood deal seems to good to be true — it may not be.

Edward Jay Epstein studied government at Cornell and Harvard, and received his Ph.D from Harvard in 1973. His master’s thesis on the search for political truth (Inquest: The Warren Commission and the Establishment of Truth) and his doctoral dissertation (News From Nowhere) were both published as books. He is also the author of The Big Picture: Money and Power in Hollywood.