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 P/E 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.

Recently we have been presented with the spectacle of a high flying banker in deep financial trouble proclaiming that he and his organization have been wrongly singled out for reprisal by the Federal government. The charges are clear. His bank aggressively sought deposits from around the world to fund a portfolio of outrageously bad investments, leading to the bank’s insolvency. The bank funded high paid executives’ lavish lifestyles, including Caribbean junkets, sports sponsorships, a fleet of private jets and outsized bonuses unrelated to actual performance. Insider loans were made to bail out the personal financial problems of those in control. Yet that banker has the gall to blame overzealous government actions for his problems.

We are speaking, of course, not of Allen Stanford of Stanford Financial, but of the CEOs of America’s largest banks. While there is certainly a difference in degree and Mr. Stanford’s personal style is less than savory, the biggest difference between Stanford Financial and several of our nation’s largest banks, is that the U.S. government chose to bail these institutions out of their mistakes rather than prosecute them as has been done with Stanford Financial. And these bankers are whining daily about their inability to pay “adequate” compensation due to the restraints placed upon them under the TARP legislation.

This morning the New York Times reported that the Treasury is planning to convert TARP holdings of preferred stock into common equity at a number of banks. As we previously raised, the real issue is whether and why the Treasury is committed to protect the bondholders of the big banks. There is a great deal of capital in the banking system in the form of unsecured debt. In a normal world, when a company goes broke, some or all of the debtholders’ interests will ultimately be converted to equity capital either in bankruptcy or in an out of court restructure.

The current issue of The Institutional Risk Analyst makes a very interesting proposal for conversion of Citibank debt into equity, which would address the capitalization issue once and for all. It’s time the Treasury explains in clear English why they are electing to further commit taxpayer funds to bailing out the big banks’ bondholders.

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.

Our previous post raised the question of just how much risk is being assumed by the U. S. Treasury with its apparent implied guaranty of the unsecured obligations of the major financial institutions. We asked whether the $188 Trillion (notional amount) of derivatives transactions on the books of four major banks (J. P. Morgan Chase (JPM), Bank of America (BAC), Citibank (C) and Goldman Sachs (GS)) could potentially pose risks not fully understood by the banks or their regulators.

In evaluating the potential risks inherent in the derivatives positions of the banks (and more particularly at the risks of the Credit Default Swaps ("CDS")), it is necessary to look at the one situation where similar risks have been converted to real losses: i.e. AIG Financial Products (AIG FP). Chris Whalen of Institutional Risk Analytics has done so in depth in a recent article posted here.

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: Bank of America, 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.”

Sunday 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.

“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 1920s that precipitated the Great Depression of the 1930s.

The Ides of March is two weeks off. 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.

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 Hold'em. 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.

On Monday, the Wall Street Journal published an article containing the chart below showing that some of the major recipients of TARP funds have been shrinking their lending in recent months. What the chart failed to show is why this is the case. The answer is straightforward, but not pretty. Most of the TARP money has been pumped into desperately troubled financial institutions. It should come as no surprise to anyone (other than perhaps politicians) that institutions fighting for survival are unlikely to be focused on taking on new risky investments.

click to enlarge

Picture the scene. It’s late 1992. The U.S. is still recovering from a severe recession and financial crisis. But there’s trouble on Main Street. One of the nation’s most venerable industries is in shambles. Upstarts from Silicon Valley created a new technology that is rapidly destroying the main frame computer business, one of the great success stories of postwar America. And now low cost competitors from Asia are rapidly destroying the competitiveness of the U. S. chip manufacturers.

As a new administration is preparing to bring historical change to Washington, hordes of blue suited, white shirted IBMers descend on Washington to demand a bailout for their critically important industry. Joining the chorus are congressional leaders from New York State, fearful that high paying jobs are about to be lost. The nation is galvanized as Congress passes and the new President signs the Computer Industry Relief Act of 1993.

AIG (AIG) yesterday announced a deal with the Federal Reserve that will have the effect of increasing the Fed’s bailout financing to AIG from $85 billion to in excess of $167 billion (and most likely counting).  Any seasoned distressed company investor knows that the first new money put into any failing company is likely to be lost unless the investor is prepared to follow the initial investment with a lot more (sometimes referred to as “good money after bad”).  More than one wag has described this phenomenon as “the second mouse gets the cheese."

The other big economic news of the day revolved around the proposed bailout of General Motors (GM).  Clearly something is likely to happen here with three million jobs at stake and a lot of political power in play with the United Auto Workers.  Given the inevitable, wouldn’t it make more sense if the money comes in as part of a pre-packaged Chapter 11 which cleans up the company’s balance sheet before the money comes in?

From 2003 through summer of 2007, a significant portion of the credit boom was funded through what Nouriel Roubini has described as the Shadow Banking System. By Prof. Roubini’s definition, the Shadow Banking System comprised approximately $10.5 Trillion in 2007, including $2.2 Trillion of commercial paper conduits, $2.5 Trillion in the repo/reverse repo market, $4 Trillion of brokerage assets and $1.8 Trillion in hedge funds. 

For analytical purposes I believe it makes sense to define Shadow Credit more broadly to include various other financial institutions, conduits and debt markets not regulated as banks. These sources of credit include private equity groups (PEGs), mortgage backed securities (MBS), structured investment vehicles (SIVs) , collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), Fannie Mae, Freddie Mac, etc., etc.  Many of these vehicles have been supported by credit default swaps (CDS), further leveraging their impact on the monetary system.