Tools to Help Business Owners Understand and Survive the Financial Crisis

Commercial Lending – Schizophrenia Reigns Supreme

Posted on June 26, 2009

senior-loan-officers-survey

Many companies remain under pressure from their lenders, but we have seen recent signs that selected lenders are becoming more aggressive in offering new loans to credit-worthy borrowers.  We are quite active in helping companies find senior debt to replace existing lenders and are getting good response from selected lenders, primarily banks that were less impacted by the financial crisis and independent asset based lenders.  In prior years there was little or no need for an investment banker’s assistance in arranging senior facilities, as multiple lenders (both banks and non-banks) aggressively chased all but the worst of credits.  That is no longer the case; today senior deals take a lot of work and persistence, but they can be done.

To summarize the current situation:

•    At the higher end, the loan syndication market remains catatonic with no signs of near term recovery.  This both reflects and creates the almost complete collapse of the Private Equity acquisition market for the larger deals north of $100 million.  Most syndication activity that does occur relates to restructuring of existing credits.

leveraged-loan-maturities
Source: Churchill Financial and Standard and Poors

As the chart above demonstrates, we’ve only seen the tip of the iceberg in leveraged loan maturities.  The peak years for refinancing/renegotiation of the loans created in the buyout boom are 2013-2014, but we are already seeing a strong increase in the number of buyout bankruptcies.  This five year overhang in potentially troubled leveraged loans, means that we are a long way from cleanup of the problems created by excessively liberal lending practices during the buyout bubble.  This indicates that we are unlikely to see another debt fueled boom in the buyout industry before we are well into the 2010’s.  The chart below provides a dramatic demonstration of the extent of the decline in syndicated loan volume, with very little indication of a pickup in this market, green shoots notwithstanding.

leveraged-loan-volume
Source:  Deutsche Bank Principal Finance

At $5 billion per month, the leveraged loan market is off more than 90% from its peak in the first six months of 2007.

•     Healthy banks, particularly the community banks, are trying harder to make loans, but credit standards remain high and many banks complain that they are having trouble finding good loans to make.  Many remain constrained by workouts of construction loans and concerned about the quality of their commercial real estate portfolios.  Deterioration in CRE could have a significant impact on bank earnings over the next several years, as recent bubbles in the construction of shopping centers, hotels and office buildings are worked off in many markets.  There’s good news for operating companies in all of this as lenders are increasingly reaching out to the commercial & industrial market to offset deterioration in consumer and real estate portfolios.

•    Asset based loans are beginning to see a resurgence as selected lenders perceive these loans as a way to put funds to work while keeping a lid on risks.  We particularly see this in the asset based lending operations of some the healthier regional banks and a few of the stronger national institutions.  Even the strongest lenders have some weak performers in their existing portfolios, however, and this has clearly had an impact on underwriting standards.  Trends of note in this market:

o    Appraisals are far more conservative than in the past, which restricts loan availability.  Many lenders now require third party inventory appraisals.

o    Lenders which pushed highly leveraged recaps on the market two years ago, now require that their borrowers demonstrate positive tangible net worth.  Debt to EBITDA ratios are far lower than in the past, with senior debt offerings of 2-2 ½ X EBITDA from lenders that might have offered 3 ½ - 4 X or even more in 2006. That poses quite a problem for thousands of companies which used the heady markets of mid-decade to pay large one time dividends or structure acquisitions at a multiple of GAAP book value.

o    Companies hit by the recession with what we call “black canyon” income statements (i.e. a precipitous drop in earnings for six to nine months as they adjusted to the “new normal” of reduced sales and production), find that they must present clear evidence of EBITDA recovery to entice new lenders.

o    Interest rates are up across the board.  Loans that might have been structured at 175-200 over Libor at the peak of the boom now carry rates of 300-400 over.  Many, if not most, proposals include interest floors or use formulas based on the greater of Libor or the bank’s prime or base rate, which means that effective rates are above formula rates in the current low rate environment.  And rest assured that “covenant light” is not the order of the day; expect even asset based loans to have meaningful performance triggers to prevent a repeat of the zombie deal overhang from the 2005-2007 leveraged loan bubble.

o    Refinancing existing deals often requires something more than a new lender.  Shareholders are frequently required to inject additional equity to show a level of commitment to the borrower.  For the stronger credits, mezzanine debt or minority equity may fill the gaps left by tightening lending standards.  Increasingly the existing lenders are being asked to contribute as well, by forgiving some portion of the existing line to close the deal.  This is much easier for those lenders which have reserved meaningfully against their troubled credits than for those still hiding their problems under the rug.

Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted on April 23, 2009

Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.

The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.

From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.

leveraged-loans

Source Churchill Financial - On the Left; S&P LCD Index

At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in the last four months, the LCD Index now reflects normalization of spreads plus a fifty year flood, a substantial improvement, but far from Nirvana. The market collapse in fall 2008 had far more to do with the deleveraging of the hedge funds and special purpose entities than it did with a considered pricing of risk. A cry of “give me a bid, any bid” could be heard across the land. As the deleveraging has run its course, inventories have declined and prices have recovered.

In a thoughtful piece in Tuesday’s Wall Street Journal, Michael Milken described past manic swings in the leverage levels of America’s corporate balance sheets. He pointed out that every cycle of overleveraging has been followed by a period of recapitalization, through debt for equity exchanges, repurchases of discounted debt and new equity offerings, which restores corporate balance sheets and provides the foundation for a renewal of new investment and growth. The current rebound in leveraged loan pricing may indicate that this process is now underway in the current cycle.

So long as existing senior debt was trading to yield potential returns approaching 20% per annum, those lenders with capital remaining had little incentive to provide new debt at acceptable spreads. With that competition for investment dollars winding down, new loans will become increasingly available, though still at spreads far in excess of those available at the peak of the boom. While we are a long way from a return to the frothy M&A market of mid-decade, it’s reasonable to expect a return of the financial buyers to the marketplace and a far more active M&A market for the balance of the year than we have seen over the past six months.

We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted on April 14, 2009

Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG.  These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008.  But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.

Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s.  For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence.  We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer.  Another “green shoot” is the middle market M&A market, where I spend much of my time.  The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.

So what is the economic scorecard to date and what can we expect to see going forward?

1)    The World economy is in the midst of the first major global recession of the postwar era.  Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.

china-exports1

While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern.  Additionally, there remain a number of weaker economies (the Baltics, Spain, Ireland and Hungary among others) which could precipitate a currency and/or banking crisis at any moment.

2)    U. S. government commitments to the financial system bailout now total around $10 Trillion and perhaps more.  At this point we appear to have a two tiered banking industry, with most smaller banks reasonably well capitalized, though closures of the worst continue on a weekly basis, and a number of larger banks in the intensive care ward.  Both Chairman Bernanke and Secretary Geithner have said that these larger banks will not be allowed to fail, though additional capital may be required at some point.  The Treasury has committed to bet $1 Trillion of the FDIC’s credit on a public private investment plan (PPIP) designed to fix the balance sheets of the large wholesale banks.  Secretary Geithner has indicated that a primary focus of this plan is to restore the function of the securitization markets.  As we indicated last fall, the loss of these markets has had a far greater impact on credit contraction in the U. S. than credit tightening by the banks.  In fact, politics aside, indications are that the banks have been lending more to consumers, not less, since the crisis began.

consumer-loans

The primary unresolved issue with the big banks is whether there has been an impairment of their capital large enough to wipe out shareholders and potentially some of their unsecured creditors as well.  The PPIP is predicated on the belief that mark to market accounting has forced the banks to write down mortgage assets to levels below their ultimate realizable values and that, by stabilizing these values through injection of federal guarantees; the major banks will be able to fix their balance sheets and return to their normal businesses (primarily wholesale lending, trade finance, securitization of consumer loans, mortgages and other assets, and trading of derivative contracts).

A lively debate has developed over this point, with many observers convinced that the PPIP plan (combined with the earlier AIG bailout) is an outright subsidy to the banks, without compensation to the taxpayers.  As a result, a real question exists as to whether Congress will be willing to commit additional budget dollars when the fast dwindling TARP funds run out.  To prepare for this eventuality, Treasury and the Fed have asked for new authority to place major financial holding companies into receivership in the event of insolvency.  Additionally, trial balloons are being floated to test the possibility of a forced debt for equity conversion at some of the big banks similar to that now being push for GM’s bondholders.

Our view is that the wheel is still in spin with regard to the financial solvency of some of the larger banks.  With residential mortgage defaults still working their way through the system, there are at least three major categories of bank loans at risk:

a.    Credit card receivables.  Delinquency rates are at historic highs and expectations are for further deterioration through 2009.

b.    Commercial mortgages.  Leon Black, one of the most successful distressed asset investors, recently projected it will cost the banking industry $2 Trillion to clean up losses from commercial real estate problems.

c.    Leveraged loans.  Leveraged lending peaked in 2006-2007 at the zenith of the buyout boom.  Many of these loans were made on relatively short terms and will be coming due or moving into a period of rapid amortization over the next two years.  While some of the larger loans have most likely already been haircut under mark to market rules, many others are being treated as level three assets held to maturity and have likely not yet sustained any impairment.  Many of these will eventually default, particularly if the recession drags on into 2010 or worsens further.

Countering these negatives is the strongly positive yield curve being maintained by the Fed.  This is the perfect environment for bank profitability, leading some bankers such as Jamie Dimon of J. P. Morgan Chase to argue that they will be able to earn their way out of these issues, given a reasonable amount of time.

3)    The U.S. economy is far from healed.  Consumer confidence may have bounced at the bottom, but remains at historical lows

consumer-confidence

U. S. consumer spending was in free fall at the end of January and, based on today’s surprise report to the downside, has likely not improved much since.

retail-sales

The decline in U. S. manufacturing at the end of February was even more dramatic:

manufacturing

We previously predicted that yearend financial statements would cause significant stress in companies’ relationships with their banks.  This chart below, produced by Randy Schwimmer of Churchill Financial in their On the Left newsletter, shows Q4 results for selected firms financed with leveraged loans, as well as the dramatic impact in terms or renegotiated covenants and likely interest rate increases as well.

leveraged-loans

There is nothing in this picture that supports the cheer seen in the stock market in recent weeks.  As we have written previously, the real issue that must be addressed if the economy is to recover and resume its growth is the dramatic overleveraging that has occurred since the 1990’s.  Far from addressing this issue, the Administration’s bailout plans are calculated to maintain this high level of borrowing, which hit a new record of 3.7 times GDP in Q4 of 2008.

credit-market-debt

Notwithstanding all these negatives, an enormous amount of financial stimulus have been injected into the U. S. economy over the past four to five months.  Additionally the Obama administration’s fiscal stimulus package is just now beginning to flow into the economy.   With normal lags, this is likely to begin to have an impact on the economy in the next few months.  We expect to see some near term improvement in economic activity in some sectors.  This should not be confused with the end of the economic malaise; that will only come with the deleveraging of overstressed consumer balance sheets, which will likely take several years.  In the meantime, a better tone in the financial markets may present a short window of opportunity for companies to clean up their balance sheets through refinancing, loan restructures and asset sales.

It’s Raining; Has Your Banker Asked for the Umbrella Back?

Posted on April 13, 2009

The old saw goes “a banker is someone who lends you an umbrella when the sun is shining and asks for it back when it begins to rain.” It’s certainly raining now and we are working with a number of clients who are in danger of losing their umbrellas. My partners Stan Cutter and Mike Zook have recently published a very insightful article which addresses some of the issues companies are facing with their banks. One of their key points: you may be in trouble even if your company is performing well, if your lender is in trouble or has recently been sold. We’ve reproduced the article in its entirety below:

Is Your Company Ready to Face Financial Institutions in a TARP World?

By Stan Cutter and Mike Zook

What is your strategy if your bank calls and invites you to find a new lender? One of our customers recently met with their banker to find that their loan renewal would have substantially different provisions. The Bank requested:

* Higher collateral levels,
* Lower availability,
* An interest rate floor provision,
* Increased fees for changing the agreement.

Another customer was told to raise more equity before the bank would renew the loan!

Risks and Opportunities of Credit Restructuring Issues

Today’s credit environment is characterized by market turbulence, bank consolidation, markets in disarray and increased regulatory scrutiny. Many companies find themselves weathering the storm although business is not as good as they would like. But, even if every interest and principal payment has been made on time and there is no apparent reason for concern, the onset of credit restructuring issues can be sudden.

Companies and managers need to understand the risks and opportunities surrounding the financial markets’ impact on capital availability. While most often the impact is felt through banking relationships, the impact extends to other financing sources and can affect the company’s liquidity.

As the new year begins, your annual financial statements are with your accountant and they will be sent to the bank as usual. You expect no reaction, but perhaps your bank has gone through some changes:

* Have they applied for TARP funds?
* Have they merged or consolidated with another bank?
* Has their credit quality declined?
* Has your banking officer changed?

If any of these are true, you may want to prepare for potential changes in your banking relations.

Credit agreements are legal contracts that have a number of provisions which may affect your business during this turbulence:

* Is your company within stated covenants?
* Are your company’s minimum equity requirements met, or is the value of your collateral still sufficient?

If you do not understand the consequences of not meeting any of these provisions, you may be surprised by your bank’s reaction.

The Era of “Easy” Corporate Banking is Over

Needless to say, the credit environment has changed and it is likely that your bank will ask for substantial changes to the agreement if anything is out of compliance. The era of “easy” corporate banking has come to an end and banks have tightened their credit standards. In addition, the bank may not have full control over the decision as regulators may have caused the bank to re-examine its portfolio and lending practices.

Recent discussions with bankers have revealed several concerns which play in their credit decisions:

* Is the client or prospect strong enough to survive a prolonged downturn?
* Is the company proactively managing the critical factors in its business?
* Is the company’s Balance Sheet reflective of a financially well managed firm?
* Are there multiple ways to repay a loan beyond cash flow from the business?
* Will making a loan be profitable to the bank?

The banker translates these thoughts into a financial analysis, often historical, to seek answers, and to lead discussions with the company. A ratio analysis of the company’s historical income statement and balance sheets will be compared to others in the industry.

This financial analysis will eliminate or greatly reduce any inaccurate perceptions about the company’s performance. It will direct the banker into specific areas for questioning management and will look to formal plans and benchmarks for the company to overcome prior to a loan being made.

If the banker decides to move forward, the covenant, collateral structure, and the loan amount will be driven by the same analysis and designed to prevent the company from going too far astray. Loan pricing also will reflect the economic times and allow the bank a profit, even if prime rates fall to new lows. The banker may use an interest rate floor to protect himself as rates drop.

Proactive Companies Must Move to Understand Their Liquidity Position

This is not good news. Proactive companies move to understand their liquidity position, though liquidity planning is not usually part of the budget process. Budgets predict revenues and related costs to make sure they are in alignment, but liquidity planning centers on the operating cash needs of the company in comparison with its capital plans and budgets. If there is not enough cash, then budgets must be changed. If a faulty assumption is made about a banking relationship, the results may be devastating.

In-Depth Financial Analysis Can Better Position a Firm’s Capital Structure for the Future

A financial review is a proactive, analysis based plan for the company’s liquidity whose foundation is an interactive review of the company’s budgets, plans, operations and sales expectations. In addition to reviewing the company’s liquidity position, it also reviews the financing alternatives available to the company. The in depth analysis can review covenants to insure compliance over the budget period.

The results of the review may suggest that the company prepare for tough banking discussions, or to seek an additional banking relationship. The review also may suggest other financing sources that might bring capital to the company. There are active mezzanine lenders and minority equity investors who might support the company if the plans and opportunities are of sufficient size or materially change the company’s position.

How Much Risk is the Treasury Really Assuming from the Financial Institutions?

Posted on April 7, 2009

What does it really mean to talk about saving “the banks”?  The Treasury would like us to have a mental picture of Jimmy Stewart in It’s a Wonderful Life, protecting the savings and mortgages of the good citizens of Bedford Falls.  In truth, for all material purposes, the current Public Private Investment Plan (PPIP) is about saving four mammoth financial institutions considered too big to fail, BankAmerica, Citicorp, J. P. Morgan Chase, and Wells Fargo.

These financial behemoths, each as large as a significant number of the world’s national economies, bear as much relationship to the Bedford Falls Building and Loan as a rowboat does to the Titanic.  For public consumption, however, it is convenient for the Treasury to continue to describe its efforts as a rescue of “the banks”;   rescuing hydra-headed financial giants just doesn’t have quite the same ring.  Additionally by lumping these institutions under the category of “banks” the Treasury can continue the fiction that the bailout is about “getting the banks lending again.”

Notwithstanding this fiction, as we showed last week, even Secretary Geithner has abandoned the pretense that the PPIP program is about encouraging direct bank lending in the traditional sense of taking deposits and making loans, admitting that the primary purpose of PPIP is to restore the strength of these wholesale institutions so that they can restart the private securitization markets that fueled the credit bubble earlier in the decade.  So here’s the plan.  Just remove the toxic assets from the books of the financial giants and the system will be restored to its former picture of robust health.  Hopefully the PPIP will be sufficient to fund the fix.  If not the Treasury can use its proposed new liquidation authority, invest few hundred billion dollars more to fill the gaps and sell the freshly minted “clean” institutions to the capital markets for a premium.

On its face this appears to many to be a rational bet.  With the survival of the financial system at stake, risking a few hundred billion more to clean up the banks would indeed be far less costly than another liquidity crisis like that surrounding the Lehman collapse.  Unfortunately this calculation omits one major element of risk that has the potential to increase the cost of the bailout beyond even the capacity of the Treasury to fund: i.e. the derivatives portfolios of the major banks.

Last week the Comptroller of the Currency – Administrator of National Banks issued its quarterly report on Bank Trading and Derivatives Activities – Fourth Quarter 2008.  In reviewing the report, several things become quickly apparent.

1.    Derivatives Trading is a really big business; the notional amount of all derivatives positions at all U. S. commercial banks and trust companies that participate in this business was slightly more than $200 Trillion on December 31, 2008.  That’s more than three times Gross World Product which the CIA estimates to have been a little over $62 Trillion in 2008.

2.    Over 93.7% ($188 Trillion) of this gross exposure was held by only four bank s, J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs.  One institution, J. P. Morgan Chase, accounted for $87 Trillion of the total exposure or approximately 140% of Gross World Product.

3.    While the bulk of the exposure ($181 Trillion) was in the “traditional” derivatives markets, interest rate and FOREX swaps, almost $16 Trillion was in Credit Default Swaps, up from $1 Trillion in such transactions five years earlier.

4.    What had once been a very profitable business for the major banks, turned decidedly sour in 2008, with net reported trading losses of $836 million for the year as compared with profits of $5.5 Billion in 2007 and $18.8 Billion in 2006.  Drilling down to the details, Credit Default Swaps generated losses for the banks in 2008 of $12.6 Billion, more than offsetting gains for the year in Interest Rate and Foreign Exchange trading.

The OCC report provides a lengthy explanation as to why the notional amounts dramatically overstate the risk posed to the system by these contracts.  First, the real credit exposure is not the notional amount of the contract, but the amount that the market has moved from the strike price of the swap: i.e. the net amount the counterparty would be obligated to pay to true up the contract based on current market conditions.  This is referred to as the Gross Positive Value (GPV) of the contracts.  Since this GPV is in effect an unsecured claim against another financial institution, it represents a credit risk to the holder of the claims.  At yearend total GPV held by U. S. commercial banks was $7.1 Trillion.  Actual credit exposure was much lower, however, as the holders have the legal right to set off this exposure against certain of their counter exposures to the obligor institutions (Gross Negative Fair Values).

The netted credit exposure was estimated to be only $800 billion.  Added to this was Potential Future Exposure of $782 Billion based upon the amount by which the contracts could move in favor of the obligee banks to generate a Total Credit Exposure of $1.58 Trillion.  For the top five derivatives trading banks (the four above plus the U. S. operations of HSBC) total credit exposure averaged 489% of the institutions’ Risk Based Capital at the end of the fourth quarter.  At one bank, Goldman Sachs, credit exposure was more than 1000% of Risk Based Capital.  To be fair this calculation does not take into account pledged collateral backing a portion of the credit risks, which the OCC estimates as typical averaging 30-40% of the exposure amounts, so actual credit exposure was presumably somewhat lower.

By now your head may be swimming a little.  Mine certainly was as I worked to puzzle this out.  These are very large numbers.  Notwithstanding the OCC’s implication that all of this exposure is well managed and under control, I am reminded that we heard similar assurances with regard to subprime loans and CDOs, not to mention AIG’s Credit Default Swap portfolio.  The closest analog we can observe (AIG Financial Products) does not provide much comfort.  Apparently AIG FP had Credit Default Swap exposure of $440 Billion out of total derivatives exposure of $1.6 Trillion.  To date the AIG mess has cost the Treasury/Fed approximately $170 Billion to clean up.  With bank Credit Default Swap exposure in the aggregate reported at 36 times AIG’s CDS exposure, how much risk are the Treasury/Fed/FDIC actually assuming if they take on the unsecured debts of the big banks as they seem increasingly committed to do?  While I draw some comfort from the OCC’s explanation of netting and other factors limiting bank exposure on these volatile instruments, I am left with the nagging concern that there may ultimately be more risk here than meets the eye.   Absent more facts to the contrary, I’m reminded of the immortal words of Judy Garland as Dorothy Gale, “Toto, I’ve a feeling we’re not in Kansas anymore.”

Geithner Told it Straight (But you really had to listen)

Posted on March 29, 2009

This morning (March 29) Treasury Secretary Geithner appeared on Meet the Press to explain his plan for rescue of the financial system.  He described a series of actions to not only fix the banks, but to get the securitization markets working as well.  For perhaps the first time we heard a (relatively) clear rationale explaining how the Treasury expects the toxic asset rescue plan to lead to the restoration of credit for consumers and entrepreneurial business.

The interview started with an explanation of the difference between bank lending and securitization.  Per Geithner, “Typically somewhat less than half of lending for business and consumers comes from the securitization markets.”  As I have written previously the current financial crisis was created by an explosion of debt to unsustainable levels in great part through the mechanisms of the shadow banking system, which includes the securitization markets.  This created a massive amount of liquidity, much of which was not captured in traditional measures of the Money Supply.  The collapse of these mechanisms beginning in August 2007 created the credit crunch.  Sec. Geithner believes that, until these non-bank markets are restored, the financial system can’t be fixed.

There’s been much loose talk in the media claiming that lending to small business entrepreneurs can’t be restored until the toxic assets come off the balance sheets of the banks.  Here is what Geithner said on the subject of the toxic asset bailout:

“This is a better way to get these markets working again.  Let me just      step back for one second.  What we’re trying to do is get the entire financial system – our complicated financial system - working again so that we get credit where it needs to go in the economy.  And that requires strengthening our banking system.  It requires making sure there is enough capital in the financial system to withstand a wider and deeper recession.  And we’re going to make sure that capital comes with conditions to make sure that banks restructure; that there’s accountability for boards and management; that the firms emerge stronger, not weaker; and that there are tough conditions to protect the taxpayer.  That is a critical part of what we’re going to do.  But our system is much more complex, depends on more than just banks.  So we have to do things to get these markets working again by providing financing directly to those markets that small business, consumers depend on.”  (emphasis added)

So what does this really mean?  The last sentence above clearly states that the toxic asset rescue will do nothing directly to encourage small business and consumer lending.  That’s a job for TALF.  The bottom line is this.  The Treasury believes that a restoration of the securitization markets is critical to restore lending by non-bank lenders.  Securitization is the province of a few big banks in New York.  Two of these, Goldman Sachs and Morgan Stanley, have said they don’t need further help from the government.  So basically the task at hand is to save the other major players (primarily the four biggest banks) on which the securitization markets depend so that they can restart the merry-go-round.

Underlying all of this is a bit of sordid history.  Securitization is essentially an agency function.  Prior to the repeal of Glass-Steagall, securitization was conducted by investment banks, which were limited by their (relatively) small capital bases from taking on significant principal risk.  They bought loans for short holding periods during which the bankers and lawyers packaged the loans and quickly sold them off to investors.  If they got caught short and couldn’t unload the paper, they were soon out of business or merged into a larger player.

By the late 1990’s Wall Street had found these limitations to be too constraining.  As the instruments became more and more complex, it became more and more difficult to market the riskiest portions of the loan packages (the “toxic waste”).  If the toxic waste couldn’t be sold, there would be no deal.  No deal meant no commissions.  And no commissions meant no bonuses.  The repeal of Glass-Steagall enabled an ingenious solution.  Where the investment banks had no choice but to unload the toxic waste because there was no place to hide on their balance sheets, the major money center banks had much larger and deeper balance sheets and complex corporate structures with multiple regulators.  Aided and abetted by the invention of credit default swaps, which enabled the pooling of toxic waste into “investment grade” securities which could be sold to third parties or into off balance sheet conduits created and managed by the banks, the major players in these markets dramatically ramped up the securitization engine between 2003 and 2007, fostering the housing bubble.

While much of this activity was not conducted directly by the banks, the bulk of it was ultimately for the account of bank lenders, which in effect supported proxy institutions in the securitization market through lines of credit and asset purchases.  This appears, for example, to have been the case with Bank of America’s support for Countrywide mortgage.  When the music stopped, the biggest non-bank participants were quickly rolled up into the major banks (Countrywide and Merrill into Bank of America and Bear Stearns into J. P. Morgan).  The toxic assets the Treasury is now proposing to deal with through its bailout plan are the detritus of the securitization collapse that these banks could not unload on third party investors when the music stopped in the fall of 2008.  This was confirmed by Lloyd Blankfein of Goldman Sachs following last week’s meeting between the big bank heads and Pres. Obama, when he was asked whether Goldman would be selling assets into the new program.  His response was that with its business model Goldman didn’t have much exposure to that type of consumer assets and what they did have had already been marked to market.  I. E. Goldman (and likely Morgan Stanley as well) stuck to their knitting as investment bankers, quickly moving the paper they had created off their balance sheets and did not retain the types of principal risk taken on by the big banks.

More than half of U. S. banking assets are held by four banks that are also major players in the securitization markets: Bank of America, Citigroup, J. P. Morgan, and Wells Fargo.  Almost certainly a far larger percentage of the securities and loans that will be purchased from U. S. based banks under the toxic asset plan will be from the balance sheets of these four institutions.  If you believe that these new multibillion dollar conduits created by Treasury are going to be purchasing bad subdivision loans to clean up the balance sheet of Podunk Thrift Bank for Savings to enable it to make loans to local businesses, then I’ve got a bridge in Brooklyn I need to sell you.

So why, you might ask, should we be willing to put the U. S. Treasury on the line for $1 to $2 Trillion to bail out these banking behemoths?  Sec. Geithner’s answer today is that we must save the banks to restart the securitization engine.  What he doesn’t say, but which is likely far closer to the truth, is that the government is deathly afraid not to.  An outsized percentage of outstanding corporate debt was issued by the major bank holding companies.  When the government allowed a comparatively smaller player (Lehman  Brothers) to fail, the world’s financial markets ground to a halt.  Geithner’s unspoken answer:  we’ve got to bail out the bondholders of the big banks because their failure will crater the system.  Since it’s politically impossible to do so directly, we’ll do so by allowing these banks to unload their underwater assets on the Treasury.  We’ll dress it up by getting a few friendly institutions (many of which will likely be big holders of corporate debt) to take a small slice of the risk so we can put the pricing decision on them rather than the Treasury.  Once the big banks are cleaned up, they can again raise money in the capital markets and we can depend on them to again create a vibrant private securitization market so that the merry-go-round can again turn.

All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks.  There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks.  To not do so could irreparably damage the U. S. standing in the world capital markets.  I do object to selling this plan as being necessary to “get the banks lending again” or to provide liquidity to entrepreneurs.  That’s not what this plan is about.

The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society.  Inherent in the Geithner plan are a number of assumptions, which are presented as givens not open for discussion.  At a minimum the following questions need airing and extensive public debate:

1.    Is a banking system in which more than 50% of the assets are controlled by four institutions good for the economy, the political system or the social fabric of America?

2.    Should the taxpayers ever be called on to preserve the equity value of the shareholders of insolvent private entities?

3.    Should the Treasury be committed permanently to an implied guaranty of the debt (as opposed to consumer deposits) of “systemic” financial institutions and, if so, is there a regulatory structure that can be created that is adequate to protect the Treasury from the need to conduct similar bailouts in the future?

4.    Is a system in which 50% of credit is created through securitization healthy for the long run stability of the economy?  Do we have regulatory and monetary tools in place that can deal with the impact on the larger economy of the market swings inherent in such financing?

5.    Is our focus on the big banks preventing the allocation of capital to those institutions (community and regional banks) that have traditionally provided most of the financing for entrepreneurial businesses?

Let’s do what it takes to save the economy, but not at the cost of an open democracy.  It’s time to demand a debate over the real issues at stake, rather than blindly accepting the PR smokescreens of those with trillion dollar vested interests in the outcome.

Beware the Ides of March

Posted on March 1, 2009

We won’t be seeing bloody togas on the Senate steps, but there will be great pain and destruction in the American business community.  There’s an annual ritual which starts in March and generally goes through sometime in April, in which tens of thousands of private companies, the heart blood of the American economy, deliver their annual audits and reviewed financial statements to their banks.  For many the results will not be pretty.

In the fourth quarter of 2008, firms throughout the manufacturing, retail and distribution economy, and likely in a number of other sectors as well, were hit by a strong downdraft precipitated by the credit crunch of September and October.   Many of these companies sustained a precipitous drop-off in revenues and resulting operating losses for the quarter.  Others may have seen a dramatic decline in the value of their inventories, particularly if they were in industries dependent on volatile commodities or imported raw materials.  The bottom line is that many companies will report a loss for the fourth quarter and a substantial number for the full year 2008 as well.

Contrary to current opinion, banks don’t like to take losses and will do everything in their power to avoid doing so.  Until now banks have been relatively lenient with their commercial borrowers other than in industries related to residential construction, where the reality of losses is too obvious to be ignored.  Unfortunately for their borrowers, however, banks are subject to strict accounting rules and answer to regulatory supervisors that demand that action be taken to head off potential loan losses.  Delivery of the 2008 annual audits and reviewed financial statements will make the potential for problems all too obvious.

Partially in response to the CRA (Community Reinvestment Act), within the last ten years many banks began to apply credit scoring and other “objective” financial modeling to their credit analysis and management.  As the 2008 audits are plugged into these models, it will become quickly apparent that many, if not most, borrowers have not hit the financial projections on which their loans were based.  We are already seeing this with companies that depend on asset based loans and report on a monthly rather than quarterly or annual basis.  Many such companies are now in “negotiation” with their lenders, which are demanding higher interest, more collateral, loan reductions and more.  In such situations the borrower’s first response is layoffs, salary reductions and plant closings, further exacerbating the economic decline.  For many lenders this will not be enough.  Companies that do not act quickly and aggressively to shore up their balance sheets are in great peril.

Adding to the problem is the tremendous loss of wealth among the owners of small and medium businesses.  Frequently their lenders rely on guarantees backed by personal financial statements composed of stock portfolios, investment real estate and other assets, the value of which has declined precipitously in the market collapse.  We are aware of a small business lender that was forced to shut its doors when the owner’s stock portfolio dropped by 50% and the bank pulled its credit line.  The collateral damage impacted scores of small borrowers.

Perversely TARP has increased the likelihood that the scenario described above will result in more, not fewer, declarations of default and resulting business bankruptcies and shutdowns.  Troubled banks cannot afford losses, lest they fall below minimum capital requirements and become the subject of unwanted regulatory attention or even takeover by the FDIC.  However, once a troubled lender is recapitalized or acquired by a stronger bank, it has the breathing room to take strong actions to clean up its portfolio, particularly if those losses are covered by a guaranty from the Treasury.  Rather than working with borrowers, the recapitalized bank may elect to move quickly to cleanse its balance sheet through rapid write-offs, declarations of default and foreclosures.  In the process jobs, productive capacity and wealth are destroyed.

Much discussion is heard about the “other shoes” left to drop for the banks.  Those that have gotten some exposure include leveraged loans ($3 Trillion to be refinanced over three years), consumer credit and commercial real estate ($560 Billion in the U. S. over three years).  Little if any attention has been given to small and medium business loans.  Yet in an economy that depends on small business for 75% of job creation, this “shoe” will feel more like a pair of hobnail jackboots to the thousands of SMBs (and their employees) about to be crushed under foot.

We’re Fighting the Wrong War

Posted on February 28, 2009

“Generals are always fighting the last war.” Certainly this was true in Vietnam for many years. More recently we tried to refight Desert Storm in Iraq, without understanding that we were headed for another Vietnam.

But what about the economists? Are they subject to the same failings? Most certainly the answer is yes. We have now spent the last year fighting the Great Depression, when the current problem results from a very different cause. True the Great Depression followed the pricking of a stock market bubble, much like the worldwide equity bubble we experienced from 2002-2007. Yet there is one factor in the current market that is materially different from the conditions of the late 1920’s that precipitated the Great Depression of the 1930’s.

You have likely seen the chart below from Ned Davis Research sketching the history of leverage in the United States economy.

creditchart2

Leverage (Total Debt/GDP) peaked in the 1930s at ~2.6 x Gross Domestic Product. Leverage in the current economy peaked at 3.6 times GDP in 2007-2008. So what’s the difference? The difference is that there is no indication that, in the aggregate, the boom of the late 1920’s was caused by a massive leveraging of the economy. From 1923 through 1930, leverage ranged from 150% to 170% percent of GDP. On the other hand, in the current era from Q3 1998 to Q2 2008, a period similar in many ways to the boom times of the 1920s, leverage increase from ~2.6x to almost 3.6x. The massive spike in leverage to GDP from ~1.6x in 1930 to ~2.6x in 1934-36 resulted not from a credit bubble, but from the rapid decline of incomes and output while debt remained relatively constant.

The current down cycle is being driven by a phenomenon different from the forces that led to the Great Depression, i.e. a massive overleveraging of the American, and more broadly, the world economy. How did this happen? Starting in the 1980’s we learned new ways to create leverage. The then relatively recent invention of the credit card began to reach full blossom and consumers became empowered to “buy now pay later” at a previously unheard of rate. Similarly, the development of various securitization tools enabled the creation of new funding vehicles that drove a variety of markets, starting with home mortgages, but extending to all aspects of consumer, business and commercial real estate finance.

Mortgage securitization, which came into full flower from 2002-2006 with the invention of CDOs and credit default swaps, is now well chronicled. Less well understood are the mechanisms by which much of the rest of the economy became, in effect, a giant fractional banking system. The technology that drove mortgage securitization led to the ultimate securitization of “predictable” future cash flow streams from all aspects of the economy.

Not only were future consumer and business income streams securitized through pooling of credit cards, car loans, commercial real estate, equipment leases, etc., truly exotic products began to appear, such as securitizations of movie and music residuals. In 1972 the concept of royalty streams from Ziggy Stardust being securitized by Wall Street would have been thought even weirder than the music.

The net impact of all the securitization and borrowing was to bring to monetize future cash flows in order to make them spendable and investable in the present. This fueled a boom that has now clearly proven to be false. It appears that even the rapid growth major cities such as Phoenix and Las Vegas may have been fueled primarily by a housing boom built on the expectation of further growth in the future. Now the time has come to pay the piper. We are living in the future from which we borrowed in an earlier time. Now is the time to generate the excess cash flows that were leveraged so cavalierly during the boom.

It’s frequently assumed that, since the Great Depression ended as the world ramped up for World War II and government borrowed heavily to fund the war, that a massive increase in debt fueled spending dragged the U. S. out of the depression. The facts do not bear that out. The debt to GDP chart above indicates another mechanism at work during the period which may have been equally important. From 1936-1938 debt to GDP declined from 2.6x to 1.70x. Total debt to income ratios did not rise during the war years. In fact debt continued to decline a percentage of income through the mid-1950s, generally a very prosperous period for the economy. Clearly the exit from the worst of the economic malaise of the 1930s was accomplished without significant new credit creation.

There now seems to be almost unanimous agreement that future prosperity depends on the government’s ability to restart the economy’s credit creation engine. This has resulted in debt funded economic stimulus, TARP, TALF, and the nationalization of AIG, the GSEs and now Citigroup. Increasingly desperate calls from the likes of PIMCO for a restart of the securitization engine and other aspects of the Shadow Banking System indicate that the pressure comes not just from economists, but from the remnants of Wall Street as well.  This pressure comes from a misreading of the lessons of the Great Depression. The apparent growth in leverage in the 1930s was a consequence of the economic decline, not its cause.  In that scenario Keynesian stimulus made sense: fix the incomes and the leverage problem would fix itself.

In the current era on the other hand, leverage is the cause, not the result, of the economic crisis. We spent our future productive output and must now go through an extended period where we produce more than we consume. Until we wake up to this reality and develop economic theories, governmental policies and private actions to support the necessary era of capital formation and debt reduction, we are doomed to live in an era of privation where the focus remains on distributing a shrinking pie rather than growing our way out of the problem.

What Does a Bonus Cost?

Posted on February 15, 2009

Consider this fable.

You’ve decided to invest $5 million in backing a champion at the new World Champion Poker Standoff. The rules are simple. Two players will play a winner takes all game of Texas Holdem. Each player will come to the table with a $5 million stake. You might ask why you would consider such an “investment”, but this is not all that different from the game the big banks have played in recent years.

Once in the game, you win a flip of a coin and are given first choice on hiring one of the two champions who will play in the tournament. The only information you are given is the following:

  • Player A wants an upfront cash salary of $400,000 plus a bonus equal to 50% of salary.
  • Player B requires no salary, but demands a bonus equal to 20% of his winnings.

Admittedly you’re missing some fairly important information such as who has the better track record and whether one of the players is a drunk or cocaine addict. But this is a fable after all so you’ve got to play by fable rules.

Given no more information than this, which player should you choose and how much will each player cost you if chosen. I would posit the following:

Player B is the only rational choice. Player A doesn’t have the courage of is convictions. Player B does. While this could be based on a totally unrealistic optimism on Player B’s part, it is more likely based on Player B’s realistic confidence that he will win. Assuming this is the case then the odds favor Player B and the likely cost of each player is as follows:

  • Player A costs $5,400,000 (Salary plus 100% loss of capital)
  • Player B generates a net profit of $4,000,000 ($5,000,000 winnings less $1,000,000 bonus)

The major banks in the U. S. (and the world for that matter) have participated in a hardly restrained speculative orgy for the past five to ten years. Under the new stimulus bill, bonuses of top earners at the major banks will be capped at 50% of salaries and must apparently be paid in restricted stock in institutions widely considered to be hopelessly insolvent and in which the equity and the options are likely to be worthless. In a culture where top performers have traditionally had the ability to earn bonuses of tens or even hundreds of millions of dollars, this is going to cause some problems.

It’s easy to debate the merits of the old bonus plans, where even marginal performers have apparently been lushly rewarded, even when the institution itself lost money.  On the other hand no one can argue that, if the banks are going to continue to put massive financial positions (debt, derivatives, FOREX, etc.) at risk on a daily basis, billions of dollars at a time, there’s a pretty big premium on having good people in place to do the trading.

The big banks have ten of trillions of dollars of credit default swaps and other risk positions on their books. It’s not hard to picture recruiting calls going out from hedge funds and other trading firms not subject to the new law offering the best and brightest traders highly incentivized deals to move from the big banks to begin trading for these non-regulated firms. These traders will come armed with extensive knowledge of their former employers’ investment positions and will have every incentive to take advantage of that knowledge at the expense of their former employers and ultimately at the expense of the taxpayers who will likely soon own the big banks. And they’ll be trading against bank employees happy to take a comfortable salary and a 50% stock option bonus.

The stakes in this game aren’t millions, but trillions of dollars of taxpayer money. Odds are we just bet on the wrong champions.