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.

Source Churchill Financial; 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.

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 CEO’s 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 it 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.

Don’t get me wrong, Stanford abused the trust of thousands of investors, many of whom are presumably innocent, and he will likely be punished severely for his apparent wrongdoing.  But so did the big banks.  Had the big banks been allowed to fail in September, as they surely would have absent the federal bailouts, the damage to investors would have been far more dramatic and the retribution on their executives would likely have been far bloodier.  The difference is that they hail from the financial and political centers of the U. S. and are far better at gaining support in Washington.  Instead of indictments and fraud charges, they are given audiences with the President and free rein on CNBC and Bloomberg to make their cases for support.  And yes, even after they’ve sold some of their jets, I’m not likely to see any of them on row 21 the next time I fly Airtran.

Disclosure: No Positions

This article originally appeared at the author's Tough Times Blog and is reproduced here with the author's permission.

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.

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.

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 mark 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

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:

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

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.

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.

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.

Disclosure: No Positions

This article originally appeared at the author's Tough Times Blog and is reproduced here with the author's permission.

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.

Disclosure: No Positions

This article originally appeared at the author's Tough Times Blog and is reproduced here with the author's permission.

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, Bank of America, Citibank and Goldman Sachs) 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. 

Mr. Whalen paints a picture of financial instruments created for the purpose of enabling financial as well as non-financial companies to falsify their earnings through the issuance of insurance contracts calculated to remove certain assets and liabilities from companies’ books and by doing so to bring them into compliance with regulatory capital requirements or shift earnings and losses between reporting period, with the presumed intent of manipulating the equity prices of the counterparties.  He further asserts that these ostensibly “economic” transactions were converted to blatant fraud through side letters never disclosed to company management, auditors or regulators that absolved the writers of these contracts from responsibility for honoring their commitments.  These activities are further described as the essence of the SEC’s charges against AIG in a Complaint brought against AIG in 2004.

In broad strokes Mr. Whalen then concludes that AIG FP changed its business practices around 2004 to absent itself from issuing insurance products of the type described above.  Instead Mr. Whalen suggests that AIG FP pursued the Credit Default Swap market as an alternative mechanism to accomplish similar goals:

It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.”

Whalen goes on to raise substantial questions as to the enforceability of the AIG CDS contracts:

Are the CDS Contracts of AIG Really Valid?

The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between "fees" paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.

Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters,  that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.

Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG's operations.

Former AIG Chairman Maurice Greenberg is reported  to have testified before Congress that AIG’s counterparty banks should be required to return a portion of the settlements they received from AIG following the Fed/Treasury bailout.  The Government Accountability Office has added to the chorus in its March 2009 report to Congress on the Status of Efforts to Address Transparency and Accountability Issues with regard to TARP, at page 61 of the report, recommending in part that: 

Based on our previous work on government assistance to the private sector, as well as the Treasury Secretary’s position, as articulated in the Financial Stability Plan that government support must come with strong conditions, Treasury has an opportunity to take additional steps to strengthen its agreement with AIG by requiring AIG to seek to negotiate concessions from management, employees, and counterparties, as appropriate, before the agreement is finalized. For example, Treasury could require that AIG seek to renegotiate contracts with its employees, such as existing contracts similar to the contract for retention bonuses with AIG Financial Products’ employees, and with existing counterparties that would face substantial losses were AIG to have its credit downgraded or fail. While we understand that Treasury is making an investment in AIG, Treasury’s failure to act in this instance could cause additional harm to its repute and impair its ability to seek additional funding for TARP that might be needed in the future.” (Emphasis added)

It seems apparent that, whether through a forced bankruptcy proceeding in which the Trustee seeks return of the settlement amounts under the Fraudulent Conveyance provisions of the Bankruptcy Code, or through political pressure on AIG’s counterparties similar to that applied to AIG’s executives with regard to their bonuses, a great deal of pressure is building for AIG to unwind the payments made to its counterparties in settlement of the CDS transactions.  It is yet unclear whether AIG took full advantage of the setoff opportunities and other loss minimization techniques outlined by the Comptroller of the Currency-Administrator of National Banks in its quarterly report on Bank Trading and Derivatives Activities-Fourth Quarter 2008 which are discussed in detail in our prior post on the subject.  As of April 7 these issues were reported to be under investigation by Neil Barofsky, the Treasury’s Special Inspector General for the Troubled Asset Relief Program. 

Unwinding these payments would have serious implications for a number of financial institutions, both domestic and foreign.  As Tyler Durden reported last month, $49.5 Billion had been paid out to AIG counterparties either directly by AIG or through the Fed’s Maiden Lane III facility.  A required repayment of these funds could be particularly troublesome to Goldman Sachs where credit exposure to swap transactions ballooned in Q4 2008 to more than 1000% of Risk Based Capital. For a chart showing major institutions' derivative exposure in relation to risk based capital and additional analysis of this subject see Tyler Durden's recent article on the subject here.  

Finally, in addition to the direct impact of a potential unwinding of the AIG CDS contracts, there remains the larger issue raised by Chris Whalen: i.e. the potential unenforceability of many CDS contracts as a result of secret side letters.  The OCC’s rationale for minimizing the potential credit exposure of derivative transactions to the financial institutions depends in great part on their ability to set off obligations to particular counterparties against balancing transactions.  In the event contracts are held unenforceable as a result of side letters or other defects in their execution, the setoff rationale would no longer hold true and the overall exposure could be far greater than currently assumed.  Presumably the Special Inspector General will be exploring these issues during his investigation.  Should this activity prove to be pervasive and should these letters and emails extend beyond AIG to its counterparties, we could find the $16 Trillion notional amount of CDS contracts issued by the major financial institutions becoming a major Achilles Heel for the Treasury/Fed/FDIC’s efforts to save the wholesale banks.

Disclosure: No Positions

This article originally appeared at the author's Tough Times Blog and is reproduced here with the author's permission.