We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted by John Slater on April 14, 2009

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 market 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.

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