Tuesday, November 25, 2008

Banks must return to refinancing ailing companies

(John Dizard @ FT.com) The US Treasury, accompanied in some way by the Federal Reserve, is about to get into the debtor-in-possession, or DIP lending business in a big way. The debate over the auto industry bailout, conducted by Congress with the calm deliberation of a parent facing a teenager who has taken a credit card without permission, is just a preliminary round.

DIP lenders to bankrupt companies have special status and protections under the 1978 revisions to the US bankruptcy laws. As long as a bankruptcy judge finds there are sufficient unpledged assets available in the "estate", or the balance sheet of the bankrupt, then a post-bankruptcy lender can have a priority claim on them to support new lending that keeps the company operating. The idea is that going concerns are more likely to pay back other creditors and stakeholders than businesses that go into liquidation.

The DIP lending business has, over the years, been a good one for commercial lenders. In return for putting up fully secured financing, the lenders could earn a couple of hundred basis points over indices of costs of funds, such as prime or Libor. In addition, there were commitment fees, fees on signing, legal fees, "points" up front. As long as you had the stomach or inclination for being a hardline negotiator, it was a great business. You have junk-bond returns and court-ordered security. It does take a lot of nit-picking transaction work, and staff detailed to the counting of boxes in warehouses.

However, these days, it's just not great enough. Leaving aside the question of how any auto-industry work-out, or restructuring, could be financed, there just isn't enough DIP lending capacity to deal with all the other current and prospective bankruptcies. There are two principal reasons for this: many financial institutions that have been doing DIP loans are capital constrained from taking on even high-return business, and those that are not can find even higher returns with less work elsewhere.

These days, those Libor plus 100 or plus 200 DIP lending rates are now up to Libor plus 500, and with all the extra fees, the real cost to the borrower can be more like Libor plus 800. That's a little more than 10 per cent, not a bad real return. But you can buy performing loans from your broker, or even electronically in the form of an index, for something close to twice that rate. And you don't have to count boxes in a Paterson, NJ, warehouse.

True, those performing leveraged loans don't have "super-priority" status granted by a bankruptcy judge, which could make it more difficult to seize and liquidate collateral to claim principal and past due interest. However, once a company moves from court supervised reorganisation, or Chapter 11, to liquidation, or Chapter 7, that collateral value can disappear like spit on a hot stove.

There's a lot of chit-chat among the partly informed financial commentators about how the US and Europe should avoid a trap such as Japan's in the 1990s, when "zombie" companies that should have been allowed to die were kept alive, slowly dissipating the nation's capital.

Guess what? We're in that trap now, thanks to the lack of reorganisation capital. There are a significant number of insolvent companies that would like to file for reorganisation under Chapter 11 that cannot, since there is insufficient DIP lending capacity. They would have to go into Chapter 7 liquidation. So they bleed out the capital they could use to get a reboot.

Sean Mathis, a partner in Miller, Mathis of New York and a corporate restructuring specialist, says: "I suspect the next tsunami will come in the second quarter of next year, which is when the private equity financed companies will feel the worst effects. Many of those companies bought insurance [against economic stress] with cov-lite loans [which do not impose strict financial ratio controls]. Even so, those loans had relatively short maturities, and nobody can refinance on those terms."

A year ago, over-leveraged companies in these circumstances could have turned to DIP arrangers such as Wachovia, Lehman, or Citibank. GE has been a major factor in the business, but, anecdotally, does not seem to be as active in pushing for new commitments. The credit funds, which had been moving on to the banks' DIP turf, need their cash for redemptions or collateral calls.

As Mr Mathis says: "What got lost in the past 25 years was the lending culture of the banks, which prevented people from taking extraordinary risks that could threaten the franchise. You also lost the trained work-out people, who could deal with trouble when it came up."

Could have, would have, should have. Now what do we do?

The banks need to recreate their work-out and DIP lending groups. Fortunately, I believe there are some people available for hire to staff them. And either the Federal Reserve has to create a discounting or funding facility for DIP lending, or Congress and the Treasury need to appropriate the money. Perhaps the next secretary of the Treasury could give an honest disclosure of its purpose. Just a thought.

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