Tools to Help Business Owners Understand and Survive the Financial Crisis

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.

SURVIVOR- Main Street America’s New Reality Show

Posted on November 13, 2008

Shading Denote Recession

Shading Denotes Recession

By now we know the story all too well. Sixteen strangers debark onto a jungle island and are told they must work together to survive. While they pretend they’re on the same team, from the start they scheme to position themselves to outlast the other contestants, because at the end of the day they know there will only be one SURVIVOR.

Every business leader in America (and the World for that matter) is anxious to understand the impact of the financial crisis on their own business and personal prospects. How bad is it going to be? Does the crash present new opportunities? What should I do now? And yes, “What must I do to survive?”

Based on conversations with our clients and with financial and strategic investors, many are choosing to “hunker down” and ride out the storm. For some firms this may be an appropriate course. Yet to make such a decision without a realistic evaluation of your firm’s financial survivability in light of the new circumstances would be shortsighted at best. Unless you have capital reserves sufficient to weather a very protracted (perhaps eighteen months or more) and severe downturn, your business could be at grave risk. And if you depend on leverage, this calculation must also take into account the potential impact of reduced loan availability and dramatically higher loan pricing, which may well come sooner than you expect.

What We Know

The U. S. economy is in the midst of what will likely be the worst recession in the postwar era. It appears that the decline is rapidly spreading around the world and that we may well experience a serious global recession that will dramatically affect even the (until now) rapidly developing economies of Asia and Latin America as well as the developed world. The effects of this recession are expected to impact the economy through much of 2009 and possibly beyond. While all eyes are now on housing, autos and consumer goods, which have rapidly declined in recent months, other industries will be impacted soon.

The financial crisis is far from over. The Treasury has put a Band-Aid on the banking industry with its $250 Billion preferred stock investment and the Fed has already provided over $1.5 Trillion dollars in new liquidity to the financial system worldwide to free up the frozen capital markets since March 2008, with much more to come. (For more information on the explosion of the Federal Reserve balance sheet see the excellent chart maintained by Cumberland Advisors here). To date the worldwide financial industry has experienced $684 Billion in losses from financial asset write downs, primarily from sub-prime and other improvidently granted mortgages and these losses have been replaced with $690 Billion in new capital (see chart here), from private investors, sovereign wealth funds and increasingly from government bailout investments in the U. S. and Europe.

What has not yet been addressed are a number of asset classes that have until now held up reasonably well, but which will almost certainly witness increasing write-offs in the coming months. These include:

  1. The leveraged loans that funded the buyout boom of 2004-2007
  2. Alt-A and even traditional mortgages that are increasingly under water as home prices continue to decline
  3. Credit cards
  4. Auto loans
  5. Land, Development and Construction loans
  6. Commercial real estate loans

Nouriel Roubini , among the most pessimistic, but also among the most accurate observers of the current economic scene, has recently predicted that, before the crisis is over, worldwide writedowns by the financial industry will total $2 Trillion. This almost guarantees a dramatic reduction in credit worldwide over the next 18-24 months.

In Q2 2008 total public and private debt in the United States was almost 3.6 times Gross Domestic Product, well over twice the level just prior to the Great Depression. By comparison this ratio was 2.6 ten years ago at the time of the world’s last major credit crisis.

debt-to-gdp1

(An excellent, but somewhat dated longer term chart of the same data from Ned Davis Research can be found here) Since then the U.S. financial system has created unprecedented levels of leverage, making the economy much more susceptible to economic shocks such as the one we are now experiencing. The current economic pain is not likely to end until this burdensome debt is significantly reduced in a process euphemistically called “deleveraging”.

So What Does this Mean for Me as a Business Owner?

Joseph Schumpeter, the great Austrian economist, popularized the idea of “creative destruction” as one of the great engines of progress inherent in the capitalist system. When you’re on the receiving end there is nothing creative about it. It’s just destruction. Just ask one of the thousand auto dealers expected to go out of business this year.

In the short term, one of the primary sources of pain for business owners will be the banks. The chart at the beginning of this article tells the story. From 2005-2007 loan terms and pricing, particularly at the higher end of the market were more liberal than at any other time in the past forty years. The chickens have now come home to roost and we are witnessing a dramatic tightening of loan terms and a sharp increase in pricing. Loan covenants that permitted debt to cash flow ratios of 4-4.5 times will be renegotiated at 2-2.5 times or less; and pricing spreads are currently jumping two to three hundred basis points. This trend will continue, notwithstanding all of the government’s efforts to force easing. Even more conservatively financed businesses will feel the heat as banks, desperate to improve their risk ratios, squeeze those customers most able to adjust to make up for those that cannot. Companies that are unprepared for the onslaught are at extreme risk over the next six to twelve months.

Given the current challenges, many businesses will not survive. We are already witnessing a dramatic increase in business bankruptcy filings and this is just the tip of the iceberg. Additionally many other firms will be forced into shotgun mergers as the only alternative to outright failure. To avoid becoming road kill in the panic, companies must act now.

Action Plan for Survival

Deleveraging is going to occur whether or not you plan for it. At the individual business level, deleveraging can come about in several ways:

The Extreme

  1. Repudiation. In America the primary tool for business debt repudiation is Chapter 11 and it’s not pretty.
  2. Negotiation. Many creditors understand the value destruction inherent in bankruptcy and are willing to make concessions on the theory that something is usually better than nothing. Often such negotiations will encompass conversions of existing debt into equity ownership, the essence of deleveraging.

The Practical

  1. Some firms, particularly those that did not succumb to high levels of leverage during the boom, will weather the storm without radical surgery. For those that remain profitable, ongoing accumulation of retained earnings and repayment of debt will reduce leverage over time.
  2. Even those companies in comparatively good condition must review their current operations and act aggressively to eliminate all unnecessary expenditures.
  3. Non-core or less productive assets and businesses can be sold to further reduce leverage and build up a reserve for opportunities ahead. Once these disposition opportunities are identified, the owners should act quickly. This is not the time to hold out for top dollar. Values are likely to decline further and those who delay may later find themselves selling the family jewels to survive.

The Necessary

  1. If a careful evaluation of your company’s financial position leads to the conclusion that your current financing arrangements are not adequate to weather the storm, you should consider raising additional capital as soon as possible. The market for junior (mezzanine) capital remains strong for good companies with proven cash flow, though more expensive than a year ago. Additionally many banks, particularly community and regional firms that did not get involved in sub-prime lending, are still seeking loans and asset based lenders are available to fill the gap for companies that have strong collateral but an earnings hiccup that makes them unattractive to the banks. Even if you don’t suspect that your bank will pull the plug at renewal time, now is the time to begin looking for alternatives, just in case.
  2. Sometimes, after a realistic evaluation of your situation, you may conclude that your firm’s chances of surviving a deep downturn are slight. If that is the case, sale of the business may well be the best alternative. Consolidation is the watchword in M&A today. Larger, better capitalized, firms will see opportunities to improve their market position through geographical or product line growth. Often these firms can generate profitability, even from acquisition of a money-losing operation at a price in excess of liquidation value, through elimination of duplicative functions and expenditures. Such a sale may not achieve an exit at the price levels seen in 2006-2007, but today’s price will be far better than can be obtained later, after the seller’s operations have felt the full impact of the recession. In any case a sale today trumps a likely bankruptcy somewhere down the road.

The Home Run

  1. Tomorrow’s success stories are often born in tough times like these. If your company has financial strength and superior operational capability, now is the time to jump ahead of the pack. Companies will be available for acquisition that you could never have dreamed of buying in the boom, often at distressed prices. Now is the time to put in place an aggressive program to reach out to the market and see what’s available. And unlike in the boom years, you are less likely to be faced with crazily priced auctions and the need to act before you have a chance to do your due diligence. If you play your cards right, you may even be looked upon as a White Knight, ready and willing to lend a hand to companies in a less fortunate situation (but of course at a great price and on favorable terms).
  2. If you’ve got the skills to grow, but not the bucks, private equity continues to be a good source of the growth capital you will need. Now is the time to establish alliances with potential backers, so that you will be ready to act when the opportunities come along.

At the end of the season there will be only one SURVIVOR, but there will be fifteen losers. You’re now playing in the toughest game of your business life. Which one will you be?

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