It’s tragically obvious now that BP has deep problems with operational risk management, but it’s no challenge to identify risks after the fact. For credit analysts the challenge is evaluating risks before they occur and to do it with limited information. Using publicly available information, what could a credit analyst have learned about safety at BP before the April 2010 Deepwater Horizon disaster?
We’ve been studying the safety data that all the major oil companies use to report on safety, and we think you may find it surprising. By most measures, BP has made great progress since an explosion and fire killed 15 people and injured 180 others at its Texas City refinery in 2005. By 2009, BP arguably had become the safest major oil company in the world.
You can see from the first chart how BP’s accident rate fell between 2005 and 2009 and how BP went from being the worst in the industry to closing the gap with long-time safety leader, Exxon.
The next chart shows how BP cut fatalities down to the lowest among the top three oil majors.
The third chart shows how BP reduced spills, an important indicator of process safety, to the lowest level among the industry leaders.
Before the terrible facts of the Deepwater Horizon explosion and the Macondo well spill, BP appeared to be in good control of its operational risks, but of course it wasn’t. So what’s the risk management lesson here? It’s that the conventional measures don’t always capture the complete risks.
That’s true not just for operational risk but for credit and market risk as well. Were there any signs of weakness in risk management at BP? We think there were, and we’ll talk more about it in our next blog post.
The last time we looked, Hovnanian Enterprises was trying for lower financial leverage. We saw signs of progress along those lines, but we were concerned about the company’s financial flexibility. Let’s see if they made any progress in the last six months.
Using cash reserves, the company brought debt down from $2.5 billion in 2008 to $1.8 billion in 2009. But debt was stuck at $1.7 billion in the second quarter of 2010. Cash flow wasn’t strong enough to let Hovnanian pay down more debt, and the company was reluctant use any of its $459 million in cash reserves.
Hovnanian also made big changes in its debt maturity structure between 2008 and 2009, as the chart shows. It cut $1.1 billion of the debt maturing between 2012 and 2015 by targeting prepayments on debt maturing in those years and by refinancing $785 million of old debt with new, senior secured notes due in 2016.
But the company was able to prepay only $100 million of its 2012-2015 maturities in the first half of 2010 — again because of weak cash flow and the need for large cash reserves. Ironically, one reason Hovnanian needed so much cash is that it had no revolving credit to help with liquidity needs. The company was forced to cancel its $300 million revolver to do the $785 million debt issue in 2009.
The lesson is that financial risk can be hard to manage. It involves complex trade-offs among leverage, flexibility, and liquidity. Hovnanian was able to reduce leverage and improve flexibility in 2009, but only by compromising liquidity. And it still has a $1.1 billion mountain of debt to climb in 2016.
For the 7th time in 10 years, Wal-Mart is #1 on the Fortune 500 list (in the other 3 years, it was #2). The company is the largest private employer in the U.S. and accounts for 8% of total retail sales in the US. As big box retailers (including Wal-Mart, Target, The Home Depot and others) have gained market share over their smaller competitors, consumer products companies feel the need to sell to these large retailers in order to grow sales. For some companies, however, selling to the big box retailers has a darker side – what we call “Wal-Mart Risk.”
Customer Concentration Risk
The risk is customer concentration – that a significant portion of a company’s sales are to one company. The dangers of customer concentration include:
1) Credit risk – the risk that the customer will go bankrupt and the company will be unable to collect its receivable.
2) Switching risk – the risk that the company will build capacity to satisfy a large customer, and then the customer switches to another supplier, leaving the company with significant excess capacity (and perhaps unsold inventory).
3) Buyer power – the risk that the customer uses its position as a large buyer to drive down the price it pays the company for goods.
In order to address customer concentration risk, revolving credit agreements that include a borrowing base often exclude accounts receivable from customers above certain concentration limits (say 10% of total receivables). This provision significantly limits revolver availability for some borrowers and does not protect lenders from the main risks of customer concentration – switching risk and buyer power.
How is Wal-Mart Risk different?
How should we look at customer concentration risk differently when the large customer is Wal-Mart or one of the other big box retailers?
1) Credit risk is significantly reduced. It is unlikely that Wal-Mart will go bankrupt and not pay its suppliers.
2) Wal-Mart takes advantage of its buyer power more than most. The downside of selling to big box retailers is that they will demand lower prices, leaving their suppliers with lower margins. In addition, Wal-Mart is well known for setting other strict terms for its suppliers in terms of product quality, inventory levels, distribution and returns.
Can we “structure around” Wal-Mart risk?
So how should lenders address the ever-increasing Wal-Mart risk among their borrowers?
1) Waive concentration limits for receivables from high quality vendors, like Wal-Mart, but consider lower advance rates to account for the higher dilution likely from aggressive return and warranty claims.
2) Consider the impact of the loss of a large customer on the borrower. Does the company have a contingency plan? Will it be able to bring down costs and capacity to match lower sales?
3) Lower leverage! Companies with significant customer concentration have higher business risk than companies with a diverse customer base and should thus have a more conservative financial strategy – that means less debt.
Have you seen companies and/or their lenders address this risk? Tell us how – we welcome your comments.
The problems of the last leveraged buyout bubble are still with us. From 2004 through 2007, the U.S. experienced an unprecedented level of LBO activity. That all ended with the collapse of the debt markets in the summer of 2007 (and the disappearance of the debt markets after the Lehman bankruptcy).
LBOs are funded primarily with debt – somewhere between 60% and 80% of the capital structure. These are the debt products used:
Institutional Term Loans (also know as “Term Loan B” or “TLB”) – often the single biggest tranche of debt, these loans are sold to institutional investors, such as collateralized debt obligations (CDOs) and prime rate funds. They have very little principal amortization and a final maturity of 6-7 years.
Pro-rata Loans (comprised of a revolving credit facility and a Term Loan A) – these loans are sold to banks and typically make up a smaller part of the capital structure than the TLB. Standard terms for a Term Loan A include significant principal amortization and a final maturity of 5 years.
High Yield Bonds – are sold to institutional investors. They have a bullet maturity (i.e. no principal amortization) and a final maturity longer than the Institutional Term Loans, typically 7-10 years.
The Debt is Coming Due!
Starting in 2012, we will see significant amounts of LBO debt coming due. Knowing the typical maturities of the debt products and counting forward from the boom years of 2006 and 2007, first we’ll see large amounts of pro-rata loans come due, then institutional term loans, then high yield bonds, as this chart shows:
What is the solution?
Highly leveraged companies have been working on this problem for some time. Given their earlier maturities, much attention has been focussed on refinancing the loans. Companies have issued new loans (with longer maturities) and high yield bonds in order to repay existing loans and extend their debt maturity profiles. There have also been many “amend and extend” agreements whereby existing lenders extend the maturity of their loans (in exchange for fees, increased interest spreads and other consideration).
Looking out into 2012 and beyond, the question is whether or not there will be capacity in the loan and bond markets to refinance all of the maturing debt. The jury is still out on this question.
We stumbled upon these striking charts in an article in the Financial Times recently. It has interesting implications for credit analysis.
The last decade’s boom in credit has been remarkable, led, of course, by mortgage-backed securities. But debt funding by companies is a close second, if you count “corporates” and “money-markets.”
There are plenty of reasons to believe the surge in corporate debt will continue. Equity’s miserable performance over the last ten years makes it much more expensive than debt, for one thing. And businesses in developing economies are hungry for capital, for another.
Although the article focuses on trading opportunities, debt markets move on a couple of drivers: technicals like changing interest rates and fundamentals like credit quality. After the market seizures of 2008, portfolio managers can’t be so confident they can trade their way out of a poor credit position. That means strong demand for credit analysis at origination and in the after-market.
Corporate loan and bond portfolios did not take the same drubbing as the mortgage-backed markets over the last several years, but doesn’t mean they were risk-free. At the worst, the global default rate on investment-grade bonds was 5.4% in 2009, and on non-investment grade bonds it was 13.0%. Commercial loan delinquencies in the United States were at a 4.5% rate at the end of 2009.
The debt markets got a memorable course of risk-aversion therapy recently, and they’re likely to remain acutely risk-conscious for some time. Regulators doubtless will be especially vigilant about credit risk as well.
Banks, investors, and traders who take credit risk will want to pay close attention to the fundamentals. Analyzing business risk, financial risk, and structural protections may not be glamorous, but it will be more important than ever.
Last post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences.
Here are a few of our favorites:
Although management was aware of the growing problems in the mortgage markets as early as 2006, Lehman decided to take on more risk “to pick up ground and improve its competitive position.”
It chose to do that by “making ‘principal’ investments – committing its own capital in commercial real estate, leveraged lending, and private equity investments.”
And it sacrificed liquidity along the way, so that “less liquid assets more than doubled during the same time from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”
But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.
This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns.
The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit.
There are plenty of other instances of management’s undisciplined approach to risk management:
Management played games with key risk measures and “omitted some of the largest risks from its risk usage calculation” until June 2008 and “did not revise its stress testing to address its evolving business strategy.”
“Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation,” in spite of the fact that managers were supposed to “use risk-weighted metrics such as return on risk equity…to determine compensation.”
After she resisted an increase in the firm’s risk appetite in 2007, Lehman replaced its highly regarded Chief Risk Officer, Madelyn Antoncic, in the third quarter of 2007 with the Chief Financial Officer, Rick O’Meara, who had no risk management experience.
Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool.
It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105.
A few weeks ago, the world was shocked to learn that Lehman Brothers was guilty of “window dressing” its balance sheet throughout 2007 and 2008. As the New York Times’ Dealbook put it, ”In Lehman’s Demise, Some Shades of Enron.”
The outrage is based on information in the examiner’s report on Lehman’s bankruptcy. We’ve read the report, and we think there is less to be upset about than the press coverage suggests.
The charge against Lehman is that they used accounting tricks to move assets of its books, making leverage ratios seem lower than they really were. The amounts were $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.4 billion in the second quarter of 2008.
These seem like big numbers. They certainly meet the test for materiality set by Lehman’s auditors, Ernst and Young, which was “any item that moves net leverage by 0.1 or more (typically $1.8 billion).”
But let’s look at their impact not from a reporter’s point of view, or even a lawyer’s. Let’s look at this the way a credit risk analyst would.
This chart shows Lehman’s net leverage ratio as reported (without the Repo 105 assets) and as adjusted (with the Repo 105 assets). It was a measure the company emphasized in its public reporting and in its presentations to the rating agencies.
Net leverage is total assets less restricted cash, securities held as collateral, securities held to resell, borrowed securities, and intangible assets divided by stockholders’ equity less intangible assets.
When we analyze financial ratios we like to look at two dimensions of the data: level and trend. Let’s take a look at both for Lehman’s net leverage ratio.
Repo 105 does not make a big difference in the level of Lehman’s leverage. It changes from 12.1x to 13.9x in May 2008, for instance, but that’s not a decisive difference. When the examiner told the rating agencies about Repo 105, none of them said it would have made them change their ratings.
And Repo 105 does not change the trend in the company’s leverage. From November 2007 to May 2008, it fell by 25% with Repo 105 and by 22% without it. Either way, Lehman was cutting its leverage significantly.
Repo 105 makes for exciting headlines and promising legal claims, but it’s just not that big a deal. The public dismay over Lehman’s window dressing is disingenuous: banks and investment banks having been doing it for years.
The fuss reminds us of the police captain in Casablanca who is “ Shocked to find there’s gambling going on in here!” just as he gets his winnings from the croupier. Lehman did plenty wrong, but Repo 105 was not the worst by any means.
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
For one, they all ran major companies. Tanzi was CEO of Parmalat, an Italian food company; Ebbers was CEO of WorldCom, an American telecommunications firm; and Groves was CEO of ABC Learning Centres, an Australian day care provider.
For another, each was a hard-driver who started small and made it very big. Tanzi built a global company from one pasteurization plant. Ebbers turned a rural telephone exchange into the third largest telecommunications company in the United States. Groves began with a single childcare center and grew it into the largest day care company in the world.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
Yet another common point is that all of them were involved in massive misstatements of their companies’ finances. Tanzi kept enormous amounts of debt off Parmalat’s balance sheet, while Ebbers and Groves kept tremendous amounts of costs off their companies’ income statements.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.
So what does all this mean? Is owning a professional sports team an early warning sign of financial fraud? Not really. But it does mean Tanzi, Ebbers, and Groves shared traits that led to their misdeeds, and those traits may be useful signals of misconduct in others.
What these three malefactors had in common is some combination of these behaviors, which are based on Sydney Finkelstein’s “Seven Habits of Spectacularly Unsuccessful People” from his book Why Smart Executives Fail.
They were domineering. They resisted any outside control, including accounting rules.
They had no sense of a boundary between their interests and the company’s. What was good for them must be good for the company.
They thought they had all the answers. Since they were always right, they made their own rules.
They eliminated resistance. They quashed dissent and had no one to warn them about the risks they took.
They were the public face of their companies. They reveled in public attention and professional rewards, and they saw financial statements mainly as public relations tools.
They underestimated difficulties. It never occurred to them they eventually would be caught.
They relied on what worked in the past. They were sure that if a little bit of deception worked before more would work even better now.
It’s a truism of credit analysis that character matters, but it doesn’t just matter in small and medium-sized businesses. It’s crucial in big companies too.
Tanzi, Ebbers, and Groves did not set out to create criminal enterprises. But their own flaws pushed them and their companies across the boundary between aggressive reporting and fraud, with grim consequences for shareholders, bondholders, and lenders. And disastrous consequences for at least two of them.
The return investors receive for owning a debt instrument, whether a loan or a bond, is driven by the various risks of owning debt. This Job Aid from Financial Training Partners does a good job in explaining the major risks faced by debt investors.
In earlier posts, we compared the pricing of corporate loans and corporate bonds. Here, we’ll look at how these markets interact, both in primary issuance and secondary market trading. First, some definitions:
The Primary Market is where financial instruments are sold from the issuer to investors. This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market). As part of this process, securities often pass through an intermediary, such as an investment bank.
The Secondary Market is where financial instruments are sold from investor to investor. The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).
The Investors
In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors.
In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds.
The key to rational pricing in these markets are the crossover investors – institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets. By analyzing the relative value of loans and bonds, they decide which to buy. For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans. This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market. Eventually, the spread between loans and bonds will narrow. Thus, the secondary markets for loans and bonds are related.
Likewise, the primary and secondary markets are related. The spread a company will pay on new bonds or loans should be about the spread at which its existing debt is trading in the secondary market (or, if the company has no debt outstanding, the spread at which the debt of companies with a similar risk profile are trading).
Risk Flows Through All Markets
Thus, if debt investors becomes more risk averse, as happens at the beginning of a recession or credit crunch, we would see it first in the most active market, say the secondary market for corporate bonds, where spreads would widen dramatically. This would lead to a sharp rise in spreads in the secondary market for corporate loans, and finally to the primary markets for both loans and bonds. Finally, investors will also be comparing loan and bond prices to the other market for corporate credit risk, credit default swaps (CDS).
In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond. For one company, Jarden Corporation, we showed that the bond’s cost is 50 basis points higher than the loan’s cost. Since both debt instruments were issued by the same borrower, shouldn’t they cost the same?
Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two. This applies if you are looking at it from the perspective of the issuer or the investor. For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).
Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. “high yield”) bonds is typically higher than the yield on non-investment grade (i.e. “leveraged”) loans. This is because high yield bonds are more risky to own than leveraged loans, for these reasons:
Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured. Thus, in a bankruptcy, the loans should get repaid before the bonds.
Maturity and Amortization: Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years. In addition, bonds typically have “bullet” maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time. This longer maturity and lack of amortization make bonds more risky to own than loans.
Covenants: Loans have more (and more restrictive) covenants than bonds. Thus, as a company’s operating performance begins to deteriorate, the loan will default long before the bond. This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.
Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.
Issuer: Risk vs. Cost
As with Jarden, for non-investment grade issuers, bonds typically have a higher all-in-cost than loans. This is because bonds are less risky for issuers and provide issuers additional flexibility.
Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it. If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk. Companies can reduce their refinancing risk by issuing debt with longer maturities. The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
Flexibility: Bonds place few restrictions on a borrower’s operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.
Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.
Loan-Bond Relative Value
When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis. In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.
If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.
If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.
Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam. On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012. Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities. Over the next 7 months, it completed two transactions.
August 2009: “Amend and Extend”
In August 2009, the company extended the maturity of $600 million of Term B loans (”TLBs”) from January 2012 to January 2015 through the creation of a “Term B4″ tranche. This new tranche was priced at LIBOR + 3.25%. The remaining $724 million of term loans remain due through 2012.
Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.
January 2010: Senior Subordinated Notes
In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020. The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.
So which is cheaper? With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond’s effective cost is 7.625%. So the loan is a cheaper source of capital than the bond? Not so fast! The loan is floating rate – if LIBOR goes up, the company’s interest cost will go up with it. The bond is fixed rate – no matter what happens to interest rates, the coupon on the bond will not change. So we cannot just compare the current loan cost of 3.5% to the bond’s cost of 7.625% – that would be comparing apples to oranges.
Combining a Loan and a Swap In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate. This is done using an interest rate swap. Let’s swap the loan to a fixed rate, as follows:
Step 1: The company borrows at LIBOR + 325 basis points.
Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.
The current quote for such an interest rate swap is about T+10:
The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract.
These transactions can be expressed as follows:
We can now calculate the effective fixed rate cost of the loan-swap combination:
Payment to loan holders: LIBOR+325 basis points
Received from the swap bank: LIBOR
Payment to swap bank: Treasury +10 basis points
The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders. The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335. The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.
Why is the bond more expensive? And why would the company issue the bond if it is more expensive than the loan? Watch the blog for answers to these questions.
We hope everyone is having happy holidays. Last time, we defended Lehman Brothers from Andrew Ross Sorkin’s attack in Too Big to Fail. We’ve stolen some time from the seasonal festivities to take another look at the numbers, and we still feel there’s a strong case to be made for the way Lehman Brothers managed its finances right before its fall.
We compared Lehman to Morgan Stanley from November 2007 through August 2008, the three reporting periods leading up to Lehman’s collapse in September 2008. We looked at the progress each firm made improving three key measures of financial strength: leverage, exposure to mortgage-backed securities, and liquidity reserves.
We calculated leverage as the ratio of total assets to shareholders’ equity, exposure to mortgage-backed securities as the book value of residential and commercial mortgage-backed securities as a percent of shareholders’ equity, and liquidity reserves as total cash and unpledged liquid securities. To gauge the improvement in each measure, we calculated its value in August as a percent of its value in November.
In Sorkin’s account, Lehman Brothers went bankrupt because it had too little capital to absorb the potential losses from its real estate investments. But Lehman did much more to reduce leverage and cut exposure to mortgage-backed securities than Morgan Stanley, yet Morgan Stanley survived.
It’s true that Morgan Stanley did a better job of boosting liquidity than Lehman, but it needed to. Morgan Stanley did much more prime brokerage business with hedge funds than Lehman. It was the run-off in prime brokerage funds that brought Bear Stearns down, and it nearly ruined Morgan Stanley too. In the week after Lehman failed, Morgan Stanley went through nearly all $180 billion of its liquidity reserves and had to go to the Federal Reserve for rescue.
So what’s the risk management lesson in all this? Did Lehman Brothers deserve to die? Did it commit suicide, or was it killed? Could it have done anything to save itself? Too Big to Fail makes Lehman’s fate seem inevitable, and we agree.
Like any investment bank, Lehman relied on confidence-sensitive financing, and in September of 2008 the financial markets lost confidence in Lehman – and Morgan Stanley and Goldman Sachs. Nothing they could do about leverage, exposure to mortgage-backed securities, or liquidity reserves mattered.
It’s nothing new. As Walter Bagehot observed more than a century ago, “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”
Except convince anyone it was doing anything right at all. In his new book Too Big to Fail, Andrew Ross Sorkin portrays the firm’s fall as a tale of arrogance, blindness, stupidity, complacency, and greed – nearly every vice but gluttony and lust. But the numbers don’t bear that out: Lehman reacted decisively to the problems it was facing.
November
February
May
August
2007
2008
2008
2008
Assets
$691,063
$786,035
$639,432
$600,000
Equity
$22,294
$24,832
$26,276
$28,443
Leverage
30.7x
31.7x
24.3x
21.1x
Liquidity pool
$35,000
$34,000
$45,000
$42,000
Repo financing1
37%
35%
33%
NA
1 as a percent of total funding
For financial institutions in trouble the prescription has always been: reduce assets, increase equity, improve liquidity. What did Lehman do? It cut total assets and raised shareholders’ equity, driving leverage down by 31%. It boosted its liquidity reserves to $42 billion, and trimmed short-term repurchase funding.
Lehman’s $2.9 billion loss for the third quarter of 2008 was hardly good news, but it came from what the Wall Street Journal called “savage cuts” to the value of its real estate. The Journal went on to say, “even longtime bears on the stock thought the firm was finally marking its residential portfolio to realistic levels.”
By the end of August 2008, Lehman had written down its troublesome real estate assets by 25% from the beginning of the year to $46 billion. With $28 billion in equity, it could afford to write them down by another 39% without destroying its capital base.
So why did Lehman’s damage control efforts fail? What sank the company? We’ll explore that in future posts, but it’s clearly not because Lehman ignored its problems, failed to act, or didn’t make real improvements to its finances.
There are lots of measures of liquidity. The classics are the current ratio and the quick ratio, but they’ve fallen out of favor because they don’t include cash flow, a critical component of liquidity. Cash burn is too recent to be classic, even though it’s been around for a while. But it’s limited to on-balance-sheet sources of liquidity.
The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here’s a short slide show about it.
The heavy burden of hidden debt
BT Group, plc, is one of the world’s largest telecommunications companies. Since the telecom crash in 2001, it’s been struggling with operating, management, and reporting problems. You can add financial problems to the list as well.
Its leverage – or “gearing”, as the English put it – is high. Reported debt to capital (adjusted for actuarial losses in its pension plans) is 66%. That’s based on the numbers reported on the company’s balance sheet.
Look beyond the balance sheet, and leverage gets much worse. BT has retirement benefit obligations that exceed pension plan – or “scheme,” as the English say — assets by £2,870. If you consider that to be debt, leverage increases to 71%. Treat operating leases as a form of debt financing, and BT’s leverage climbs to 75% (capitalizing annual rental expense at 8x).
Off-balance-sheet debt equivalents
What explains the difference between BTs reported leverage and its adjusted leverage? Why treat pension and lease obligations as the equivalents of debt? How do you tell if an off-balance-sheet liability belongs in your leverage analysis?
We use these criteria. To be the equivalent of debt, an obligation has to:
• Be a financial obligation, not money owed to a supplier
• Have an imputed or actual interest rate
• Have a fixed payment schedule
• Allow the holder to demand payment in full on default
• Be a substitute form of capital
By these standards, unfunded pension obligations are debt because they are financial, are discounted at an interest rate, and often have a payment schedule that is enforced not just by pensioners but by government regulators as well. Operating leases are debt because they are another way of financing assets. If BT securitized its trade receivables, that would be another form of off-balance-sheet financing equivalent to debt.
U.S. and international reporting rules are precise about what debt is, but those rules don’t always capture the economic reality of how companies finance themselves. Sometimes reported leverage understates real leverage. That’s the case for BT.
The November 2009 issue of The RMA Journal, The Journal of Enterprise Risk Management, includes an article entitled “Using Subordination to Define Intercreditor Priority” by Ron Carleton and Tim Delaney of Financial Training Partners. The RMA Journal is published by the Risk Management Association, a leading organization of professional credit, market, and operational risk managers.
Today, with credit portfolios under growing stress, minimizing losses is more important than ever. “Using Subordination to Define Intercreditor Priority” explains the different types of subordination and how lenders can structure debt to protect themselves in case of a default. For a free copy of the article and more information on Financial Training Partners, visit this page.
In the last 6 months, we’ve seen a number of “amend and extend” transactions. Typically they involve:
The extension of the maturity of a term loan and/or revolver (typically for syndicated, non-investment grade loans). This is only for lenders who agree to the extension (i.e. some lenders may keep the original maturity
Increasing loan pricing for lenders who agree to extend (to reflect current market conditions and the higher credit risk of the borrower) and an amendment fee.
Covenant relief for the borrower (reflecting operating performance below original the targets).
Why an Amend and Extend?
During normal economic times, a borrower would do a new syndication as the maturity date for an existing facility approaches. So why are we seeing amend and extend agreements rather than new facilities? Because many of these companies would have a hard time getting a new syndication done. The loan market is much more selective for high risk credits, and many of these companies have high leverage and weak cash flows.
Amend and Pretend?
It is clear why a borrower would want an amend and extend (despite the higher cost) – they get covenant relief and one or two more years to turn around the business and generate cash for debt repayment. But why are lenders agreeing to these transactions? Do they really believe the borrowers will be able to repay the loans 2 years later, or are they just deferring the day of reckoning – the day when the borrower will need to do a major financial restructuring (or even a bankruptcy) and the lenders will have to write down the value of the loans? Is it an “amend and extend” or “amend and pretend” (that the loan will actually be repaid some day)?
Getting Better and Worse The worst seems to be over for the housing industry in the United States. It may even be on the mend. In the competition for building sites, companies with less financial risk will have an advantage. Hovnanian Enterprises, the sixth largest homebuilder in the country, has been doing some interesting financial deals to improve its competitive position
Hovnanian had the highest leverage among its closest competitors. At the end of 2008, the company’s debt-to-capital ratio was 88.7%, while its rivals averaged 66.2%. With competitors buying foreclosed land from banks at historic-low prices, Hovnanian is forced to spend money on debt service instead.
Worse, Hovnanian had even less financial flexibility than the competition. Looking at maturities of debt over the next five years, Hovnanian had 28.3% of its debt coming due, while its competitors had only 23.0%. Worse still, the company’s debt was much more concentrated in a single year, as the chart below shows.
Maximum 1-year debt maturities as a percent of total debt are the highest value for debt maturities over the next five years as a percent of current period total debt.
Having so much of its debt maturities crowded into a single year is a problem for Hovnanian. It has a lot more refinancing risk than the companies it competes with. If its credit quality gets weaker or the capital markets take another dive when all that debt matures, Hovnanian will be in serious trouble.
Less Progress than Meets the Eye
To its credit, Hovnanian saw the problem and did something about it. Through exchanges offers, open market repurchases, and cash tender offers in the first three quarters of 2009, Hovnanian repaid $780 million of its debt. About $271 million of that was debt maturing in the next five years.
Unfortunately, Hovnanian’s efforts reduced leverage but reduced flexibility as well. Maximum 1-year debt maturities actually increased to 37.7% of total debt. The company had more success retiring its longer-maturity debt than the debt coming due in the next five years.
Financial leverage is a risk in its own right, but embedded in leverage is another risk: financial flexibility. And financial risks are closely connected to competitive risk. Good financial strategy manages all of those dimensions of risk effectively. Hovnanian seems still to be struggling to do that.
Since the credit crisis began in the summer of 2007, and especially since the credit markets fell of the cliff in the fall of 2008, we have seen credit spreads in the loan and bond markets increase dramatically. Some investment grade companies today are paying spreads that were reserved for high yield companies just 3 years ago. Of course, the higher spreads correspond with increasing credit risk brought on by the recession and by investors’ declining appetite for risk.
Lower LIBOR is Good News for Borrowers …
One piece of good news for borrowers is the dramatic decrease in LIBOR, the basis over which most corporate loans are priced. Although there have been some disruptions in the LIBOR market (like the fall of 2008), this rate generally tracks the Fed Funds rate. As a result, LIBOR has come down from over 5% before the crisis to well under 1% today.
US$ LIBOR
Source: Bloomberg
… But Loan Investors Still Get Paid
Loan investors, especially institutional investors, feel the pain when LIBOR goes down. So in addition to higher spreads, loan arrangers are using these two structures to increase the returns on term loans (especially Term Loan B’s) and jump-start the market:
LIBOR Floor: Borrower and lender agree that the basis for the loan will be THE GREATER OF actual LIBOR (currently under 0.50%) or the agreed upon floor. Floors in the market today range between 2% and 3%.
Original Issue Discount (OID): The loan is sold to investors below par and repaid at par. The difference is the OID, which in todays market is anywhere between 1% and 10%. You can think of the OID as another form of an upfront fee for investors.
Digg This!
The last decade’s boom in credit has been remarkable, led, of course, by mortgage-backed securities. But debt funding by companies is a close second, if you count “corporates” and “money-markets.”
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.
