Tools to Help Business Owners Understand and Survive the Financial Crisis

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.

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.

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.