Wachovia, Clear Channel and Fair Value Madness

Last week in Washington, as we talked to the attendees at the PRMIA Global Events Series: "Credit Risk & Basel II Post Subprime" (to download the audio files of the event, click here), a senior federal official concerned with accounting policy suggested that many banks would have difficulty completing their year-end financial statements on time because of problems valuing illiquid assets. We agree.

The crisis which began with worries over the credit risk emanating from subprime mortgage loans is not so much about confidence as it is about astounding credulity - by regulators, politicians and investors. As our colleague David Kotok described in last week's interview ("Sleepless in MuniLand"), we have desensitized our society to risk with the promise of "credit enhancement," but credit and market risks are only part of the problem.

Over the past decade, we allowed Wall Street and the City of London to migrate their trade from transparent, multilateral public markets to opaque, private bilateral over-the-counter markets. And to top it all off, even as we have made our markets less liquid, we now force our companies and banks to engage in a ludicrous "fair value" accounting exercise for loans and OTC structured assets for which there is no market. This is the financial equivalent of self inflicted wounds.

Simply stated, under fair value accounting, market risk is all that matters when it comes to valuation. The combination of a liquidity drought in OTC markets and fair value accounting has not only created tens of billions of dollars in non-cash losses for many banks, but erects an almost insurmountable disincentive to banks from new lending in situations where the "fair value" of underlying assets may prove volatile or uncertain.

A case in point comes with the news that Wachovia Bank (NYSE:WB) is backing away from two Clear Channel Communications (NYSE:CCU) transactions, one to sell its television assets to Providence Equity and the second, larger deal a recap/lever up of what's left. WB's exit from these deals is, we hear, just one example of the Charlotte-based bank trimming back on all types of risk exposure from consumer credit to municipal bonds to commercial loans.

To us, CCU is no thing of beauty. With $5 billion in debt and $12 billion in goodwill and intangibles decorating its $18 billion asset balance sheet, we can understand why the conservative bankers at WB are getting queasy, especially with ad spending in a free fall. Just look at the macro economy downdraft pulling at Google (NASDAQ:GOOG) and you'll get the idea. Of note, despite over $2 billion in EBITDA, the Altman Z-Score assessment for CCU calculated by the IRA Corporate Monitor has been generating a "danger" rating since 2003.

WB behavior in backing away from the CCU transactions is not an anomaly. Fact is that the nation's fourth largest bank has been trimming overall risk exposure for some time and has accelerated the process in the past 90 days.

WB is less aggressive than the large bank peers, with an Exposure at Default of just 60% of existing lines vs. 63% for the other top US banks. But WB and its large bank peers have been trimming unused credit lines since the end of 2004, when the peer average EAD calculated by the IRA Bank Monitor was over 110%. Look for this indicator to drop below 50% for large bank peers before we touch bottom, a grim prognosis given what that means in terms of credit availability for all classes of borrower.

Likewise, WB's Loss Given Default has been rising for several years, again a significant business model change flag for those paying attention. After hitting a trough of 44% in 2002, WB's LGD has been steadily if erratically rising to the current level over 75%. This is still half a standard deviation below peer but unusual for WB, which averaged < 60% LGD during the mortgage boom years. At 30bp for 2007, WB's bank unit default rate is still below peer, but the trend tells the story about how WB management feels about taking on new credit risk.

By the way, further to our earlier comment about WB's mortgage portfolio and particularly the old World Savings unit, at year end the bank now known as Wachovia Mortgage FSB had shrunk by two thirds to just $59 billion in total assets. Defaults rose to 9bp (annualized) vs. 2bp in Q3 2007, a significant change but still well-below peer. Be interesting to see if WB extinguishes the FSB charter altogether in coming quarters.

If you extrapolate from the defensive behavior of WB across the US banking sector, the image that emerges is one of a sharp contraction in credit availability. The issue is not simply that the $3 trillion once-upon-a-time market in private label securitized financing is being liquidated - and it is - but that the available lending bandwidth on bank balance sheets is likewise disappearing, either due to fear of the accounting treatment or because there simply is not any liquidity available on bank balance sheets.

During last week's trip to DC, another attendee at the PRMIA conference asked if we thought the dire predictions by Nouriel Roubini of NYU of a systemic crisis hitting the US economy and millions of Americans walking away from their underwater homes aren't overblown.

Nope. Because of the hugely negative impact that fair value accounting is having on the risk taking preferences of financial institutions of all types, we fear that Nouriel could be proven right. Indeed, we'll make a prediction of our very own: By September, political leaders and maybe even presidential candidates are going to be calling for a forcible roll-back of fair value accounting rules. If today Barak Obama and John McCain don’t know what FASB stands for, they will by Election Day.

Q: Wonder if Chairman Christopher Cox and the rest of the SEC commissioners are smart enough to get ahead of this issue.

By the way, on March 12, 2008, we will be appearing at American Enterprise Institute in Washington with Nouriel, Alex Pollock of AEI, Tom Zimmerman of UBS, Desmond Lachman of AEI, and John Makin of Caxton Corp, in the third in a series of discussions: "The Deflating Mortgage and Housing Bubble, Part III: What Next?"

Comments

[G.A.]

Here is something interesting that kinda supports your thoughts on CCU debt. This hit the wires on Feb 26th....

CCU Debtwire says Credit Suisse taking aggressive approach to unloading Clear Channel debt - FT Mergermarket (33.80)
StreetAccount notes that the Mergermarket report is provided by Debtwire and is available in the FT today, but may have been released to subscribers previously. Citing sources familiar with the situation, Debtwire says that Credit Suisse has once again broken ranks with a bank syndicate and has been aggressively looking to offload chunks of the $19.5B credit facility for the Clear Channel deal. According to the article, Credit Suisse even offered a "name your own price" strategy to select buyside accounts on orders over $100M. Of interest, sources note that in a somewhat similar move, the bank also ventured out on its own to unload its portion of a $7.25B backing the buyout of Harrah's Entertainment before the other arrangers could even price the transaction. Citi is the lead bank on the syndicate, which also includes Deutsche Bank, Morgan Stanley, RBS and Wachovia.

[rc whalen]

Thanks for the comment and news clip. The key issue right now is whether the market for speculative paper such as Clear Channel or Harrah's is going to recover. If not, then the US economy is in cold turkey for a while. I don't believe the US economy can withstand such a reduction in credit availability. Will kill valuation of financials for foreseeable future, which means very hard for broad market to advance.

[Judy Hughes]

Does the author's comment about FASB mean that he believes Senator Obama will win the Democratic primary or that Hilary Clinton knows the meaning of FASB while Obama does not?

[Saul Sterman]

Christopher Whalen insinuates that the larger Bain & Lee buyout is at risk as WB has pulled out or is going to pull out. To the best of my knowledge, WB would like to pull out of all of their prior M&A commitments but will not do so as they will be heavily penalized for years to come. Likewise, if they try to go it alone and stop playing ball with the rest of the boys on the block, they will find that they are walking down a very lonely, dark cold alley that eventually leads to a dead end.

There has never been a bank that has succeeded by ignoring the rest of the industry, only failure. Sooner or later, all the major players need to deal with each other. An unofficial boycott of WB would most certainly be far worse than taking a temporary hit on a few deals as the rest are doing.

No one is complaining about CS as they try to unload CCU deal debt by bypassing the syndication. There are rules what is permissible during hard times and what is unacceptable. Competition does exist between the banks and what CS is doing falls within the accepted norms of competition. What the author is insinuating that WB is contemplating does not adhere to the definition of competition. This would be a declaration of all out war on the rest of the industry as it undermines the very foundation that the industry is built on.

Does the general investing public know the meaning of reneging on a financing commitment without the consent of the buyers and sellers?

CCU has stated again and again that it wants the deal to close before 3/31/08. Perhaps WB promised Bain & Lee all sorts of goodies if they would be willing to back off (just guessing / no knowledge). WB has to be careful about a tortious interference suit by CCU and shareholders which could lead to another Texaco like fiasco (bankruptcy).
~~~~~~~~~~~~~~~~~~~~~~...
" So, can the banks here simply pay all or a substantial portion of the termination fee to persuade the private equity buyers to walk?
Perhaps. The trouble is that Clear Channel in those circumstances may have a claim of tortious interference with a contract against the banks.
The mere invocation of possible liability for this tort is likely to send shivers down an M&A lawyer’s spine. In the seminal case of Pennzoil v. Texaco, Pennzoil had an alleged informal, binding contract with the Getty Oil company to purchase the company. Texaco intervened with its own proposal and in a San Antonio, Texas court Pennzoil won a $10.53 billion judgment from Texaco on a tortious interference claim. Texaco was forced to declare bankruptcy and eventually paid a lower negotiated amount of $3 billion.
And here Clear Channel is in Texas so they are also likely to sue there.
To recover for tortious interference with an existing contract under Texas law, a plaintiff must prove: (1) the existence of a contract subject to interference; (2) a willful and intentional act of interference; (3) that the act was the proximate cause of the plaintiff’s damage; and (4) that actual damage or loss occurred.
Clear Channel could allege that the bank’s actions interfered with its own buyout contract and caused a breach of that agreement. It’s an uncertain claim, but it could end up being a question of fact for a Texas jury. Given what happened to Texaco, the banks might not want to take that risk."
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See full article:
dealbook.blogs.nytimes.../

As an aside and loose connection with Judy Hughes's comment, Bain wants CCU before the upcoming presidential election. Need I spell out who the heavyweight is in Bain Capital Partners? I find it interesting that this is the first time I have seen politics and the CCU buyout connection surfacing; though it was not intentional.

Saul Sterman
Disclosure: long CCU