The Phony War

(The Phony War is a phrase coined to describe the months following the German invasion of Poland in September 1939 and preceding the Battle of France in May 1940. The Great Powers of Europe had declared war on one another, yet neither side had committed to launching a significant attack, and there was relatively little fighting on the ground.)

 Every so often it is important to reflect on one’s earlier expectations for the market and the quality of the predictions that one has made to support and guide one’s business judgments. Here at Recovery Partners, we have been consistently bearish on events for the past three years – and we have been largely correct.

 The meltdown in the sub-prime area came as no surprise because, in addition to other factors, we had been flagging the weakened condition of the GSE’s for some time, while Paulson and Bernanke were hailing them as possible saviors of the US housing market.

During a TV interview in October of 2007 we projected that US Speculative Grade Default Rate would reach or exceed 5% before the end of 2008. At the time of the TV spot, it stood just a shade above 2%. It ended 2008 just below 8% and it is now over 10%.

In July of 2008 we published our “Zombie List” of the top “walking dead” banks. Of the 14 institutions on the list, fully 10 have either been bankrupted or forcibly merged. The others have all accepted TARP funds.

We have repeatedly warned that the stock market was vulnerable and that defensive-minded investors should avoid it altogether. We first provided a warning in January 2007 and repeated the warning before the avalanche in September 2008. The market is over 25% lower today than when we first piped up on this topic.

In January of this year we warned that the configuration of Bond Yields in the US was unsustainable and that rate rises should be expected in the immediate and medium term ahead. At the time of our call the US Ten Year Treasury Note was trading at a yield of 2.25%. Since then it has risen to yields approaching 4% before settling back somewhat. We continue to be very bearish on US term interest rates in the medium term.

We have for some time also said that the US stimulus package was unlikely to have the intended effect. The general view now is that additional stimulus is likely required and that US unemployment  will most probably rise yet further, contrary to the jawboning and promises made by various officials prior to the passage of the monster spending program.

With all of the foregoing under our belt, you would think that we would be feeling pretty good. Unfortunately this is not the case. We are disappointed because while making all of the earlier calls, our “sidecar” expectation was that there would be ample opportunities for Recovery Partners and firms like ours to provide advisory services to financial sponsors who were backing now-failing companies; and that this would be accompanied by a large flow of distressed loans into the market, thereby creating additional opportunities for us, our competitors, and our service providers.

Unfortunately, so far the bankruptcy statistics are not telling a tale of undue financial stress, and activity in the distressed M&A market remains at a low ebb. True, in the US the number of business failures is up about 190% from the trough in 2006. However the annualized run rate is only tracking on a par with the experience of the relatively mild recession in the early 1990’s. That said, the number of personal bankruptcies has escalated rapidly in the US, consistent with the scale of job losses. The weakness of consumer finances promises to restrain consumption activity and will further stress the corporate sector.

In Canada we have also seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. However, on the business side of the coin, the situation in Canada is positively perverse. In the latest twelve months of data, which arguably spans the most severe economic crisis of the Postwar period, the incidence of corporate failures in Canada has actually gone down! The data show that there were 5.7% fewer bankruptcies coast-to-coast in the year to April 2009 than in the twelve month period to April 2008.

Although it might seem unreasonable that the flow of defaulted loans has remained relatively light in the US and that it has actually decreased in Canada, there are some very good reasons why this is occurring and Recovery Partners is confident that the avalanche of activity that we along with other market participants have been expecting, is as a consequence, simply late in arriving:

• Recovery rates for both bondholders and leveraged-loan investors are hitting historical lows. According to Fitch, loan recovery rates for the first five months of 2009 came in at 57.5%, a full 10 percentage points lower than the 67.5% experienced during the last recession trough in 2002. This weakness in real asset markets has caused bankers to shy away from pulling the plug on weak customers in the hopes of better markets and prices ahead. 

• There were a number of structural issues associated with the boom in loan issuance in the four years that just preceded the recent Crash. Corporate balance sheets had become heavily tilted toward senior bank debt, but protective covenants that were normally embedded in loans were systematically relaxed or removed by market-share hungry bankers as the boom in loan issuance ran its course. This means that the early warning systems that signaled borrower problems in previous cycles do not in many cases exist in the current cycle and it is therefore now more time-consuming and laborious for banks to triage the Zombies in their portfolios.

• A reduction in market liquidity has not only impacted banks’ recovery prospects, it has also eliminated exit alternatives. In the years preceding the crash there were numerous leveraged loan funds, who, usually oblivious to credit quality, would eagerly pay up for whatever assets the banks happened to be selling. These participants are either out of business or have sharply reduced their activities.

•  Banks have been protective of their loan portfolios because they have wanted to appear as financially strong as possible in order to attract much-needed infusions of private sector capital. These issues were aimed at shoring up balance sheets that had been ravaged by sub-prime and related losses. Announcing large provisions on their loan portfolios would have done little to reassure investors who were being asked to put more money into these firms. This behaviour has to a greater or lesser extent been condoned by regulators and authorities in North America who have winked and looked the other way. Witness for example, the recent relaxation of mark-to-market rules in the US.

• Banks have extended forbearance terms to Zombie borrowers, jacking up spreads and adding on fees and restrictive covenants in the hopes of buying time until the economy improves. Then, one of two hoped for outcomes would allow the Banks to skate away from these problems: either (1) another lender would step in to take the Bank out of their position; or (2) the Borrower’s business would re-float in line with an improving economy generally. This strategy only buys time, it does not solve any problems.

 Unfortunately for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved and that in aggregate, US banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who are either falling into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.

Some of the stronger banks have therefore recently begun to aggressively set aside money for future loan losses. Last month Moody’s warned that over $400 billion in charge-offs the U.S. banking industry are expected to occur in 2010. While this number may be vastly understated, as have all of Moody’s and S&P’s recent similar forecasts, it should be expected that whatever the size of the number, a good chunk of the losses are expected to occur in commercial and industrial loans portfolios.

The situation is broadly similar in Canada with the exception that the amounts are rather smaller. Based on the differences in market size, and a reversion to normal default rate relationships between the Canadian and US markets, Recovery Partners estimates that there are at leastt $20 to $30 billion of loan-related charge offs in Canada that are bottled up on balance sheetss.

In both countries we forecast that the affected sectors will be Manufacturing (particularly automotive-related), Travel and Hospitality, Forestry and related, Construction, Commercial Real Estate, Media and Newspapers, and Transportation. In terms of timing we observe that this situation is persisting with the encouragement and approval of the authorities and there will not unwind as per cycles in the past. In fact we estimate that Canadian banks, given low nominal rates and profitable operations generall,  could sustain this state of affairs for some time to come.

 It took a good bit of time for the really serious shooting to start in WWII, and we reckon that we are now in the midst of a broadly similar lull (see last months post entitled “The New Normal”) that is seducing shell-shocked market participants with an array of false hopes as to the future economic picture. The World Economy is not out of the woods, additional, significant, credit-related carnage lies  ahead, as does therefore the bulk of the distressed investing and advisory opportunities that this cycle will eventually bring forth. In short:

“You Ain’t Seen Nothing Yet!!”

Randy Bachman,  Bachman-Turner Overdrive, 1974

Posted in Bank Loans, Canada, Economy, Fed Policy, Restructuring, Sub-Prime, USA | No Comments »