Are Derivatives Accounting Rules Helping the Big Banks Overstate Their Earnings?

Posted on November 21, 2011

Profits do not mean the same thing for the major banks as they do for ordinary businesses.  If you manufacture or distribute widgets, calculating your profit on a sale is pretty straightforward.  What did it cost to acquire or make the widget? What did you sell it for?  The difference is profit.  For a broker/dealer it works pretty much the same way.  What did the bond cost me?  What commissions did I pay?  The difference is profit.

Now consider the case of the major money center banks.  Thanks to the repeal of Glass Steagall they are in the position to act not only as a broker dealer, but also as a principal, holding the financial instruments they create in their long-term investment book.  During the heyday of the mortgage securitization boom, this permitted the banks to package bundles of mortgages into mortgage-backed securities (MBS), booking a hefty spread in the process.  The MBSs could then be repackaged as collateralized debt obligations (CDO) and the CDOs could then be re-repackaged an infinite number of times as synthetic CDOs thanks to the magic of credit default swaps.

At each step of the process the bank earned a hefty origination spread, the investment bankers, brokers, lawyers and a myriad of consultants and rating agencies made their commissions and fees and everyone was happy, at least as long as the securities could be pawned off to some Norwegian village north of the Artic Circle.  At some point the music stopped and the Norwegians went back to hunting reindeer, but not so the bankers.

Thanks to the repeal of Glass Steagall the banks were able to find new customers for the convoluted structures their well-oiled machines were churning out by the hundreds: they held them on their own books.  By booking the securities at “retail” this process enabled the … read the rest

Preparing for an Asset-Based Financing

Posted on November 20, 2011

Many businesses have recently faced a new reality when they are abandoned by their traditional commercial banks and are forced to search for non-traditional sources of capital. Commercial banks have tightened their credit standards dramatically over the last several years or have abandoned commercial lending entirely. For many middle market distributors, manufacturers and service firms, asset-based lending (“ABL”) may be the best alternative.   Such firms typically have plentiful working capital assets that have historically not been leveraged to their full potential.

The basic concepts of an asset based financing are simple.  Rather than rely on balance sheet ratios or the earning power of the business, the lender can advance funding based upon the expected net liquidation value of the available collateral, typically inventory and receivables.  In theory asset based lenders (sometimes call “hard money lenders”)  can provide funding to even the most troubled borrowers.  In fact debtor in possessions (“DIP”) loans in Chapter XI bankruptcy have been a stock in trade for a number of such lenders.

The reality of ABL financing turns out to be more complex.  Most ABLs do care about the financial condition of their borrowers and will expect to see historical cash flow performance that supports loan payment plus a comfortable cushion. The resulting financial package will often include a variety of constraints, many of which the borrower may not be aware of until the closing table:

  • Restrictions on advances, dividends, and other related party transactions
  • Restrictions on capital expenditures and leases
  • Strictly constructed personal guarantees (including spousal)
  • Tight financial covenants
  • Requirements to maintain excess liquidity or deposits
  • Reserves for technical collateral protection issues (landlord payments, payroll taxes, lender-perceived weaknesses in working capital collateral, etc.)
  • Prohibitions on disposition of assets
  • Prohibitions from entering alternative financial arrangements and acquisitions
  • Surrender of cash management to the lender

Planning for the Transaction

It … read the rest

Gear Up for the Refinancing Wall

Posted on November 14, 2011

Remember the fall of 2009? We had just survived the worst financial crisis since the Great Depression and the stock market was enjoying the early stages of a very powerful bear market rally. We could all breathe a great sigh of relief. Of course a few party poopers were still around to remind us in articles like this one published by the Wharton School that a mountain of debt built up during the bubble years of 2006 and 2007 would need to be refinanced by the middle of the next decade. This debt, measured in the trillions of dollars, encompassed both commercial loans–many generated to support highly leveraged buyout financings–and commercial real estate funding.
Chart: Distribution of leverage loan maturities, 2010-2018

No need to worry, 2012 was a long way in the future. Well that future is now and Wall Street is again teetering on the brink of panic. Many firms that survived the crash have seen their profits–if not their revenues–return to past highs. Large profitable corporations have successfully refinanced much of their debt with very low cost long term bonds. For much of 2010 and the first half of 2011, strong high yield and leveraged loan markets enabled even middle market firms to stabilize their debt with relatively low cost funding as well. So the question is, “Have we dodged the bullet?”

Unfortunately, two recent reports answer the question with a resounding NO. The Financial Times, in an article entitled “Door Slams Shut for Corporate Have-Nots,” describes a two tier world in which a few very strong companies like Apple Inc. have taken advantage of the recovery to build up tremendous hordes of cash. On the other hand, weaker firms remain overleveraged and at extreme risk in the event of another financial crisis or a material rise in interest rates.

To accentuate the depth of … read the rest