The Wall of Debt - Deflation Deferred Stagflation Inferred
I had the pleasure of attending Goldman Sachs' Global Industrials Conference last week. I will spare you the details on the various updates from the manufacturing and cyclical company managements, as well as the railroad execs' reactions to Berkie's bid for Burlington Northern Railroad. Suffice it to say that the corporate executives were generally in accord that the bottom of the "great recession" had been seen; so too were they in general agreement that there was no "V" shaped recovery in sight. Perhaps the most interesting comments came from the Goldman executives who served as the lunch speakers at the conference. I believe some of the commentary yielded insights into the economy's impending peregrination through the valley of debt.
On Wednesday the lunch speaker line-up consisted of three Goldman Sachs executives: cyclicals I-banker, Matt McClure; Bruce Mendlesohn, a leveraged transaction restructuring advisor; and cyclicals private equity fund manager, Jack Daly.
McClure, the banker, told the audience what you would have guessed, that with great gobs of cash on corporate balance sheets, a sense that the crisis has passed and not much in the way of organic growth opportunities, corporate acquirers are again entertaining transactions.
I would aver that this trend, if allowed by the now more vigilant antitrust regulators, portends more industry consolidation, and increased layoffs in the near term. This to be followed by continued productivity growth but ultimately increased pricing power.
Daly, the private equity investor who actually was last to speak, cracked wise that normally the restructuring consultant would bat clean-up to the LBO artists. He admitted that private equity investors generally were up to their eyeballs in alligators due to now problematic pre-crisis deals in their portfolios. He noted (with graphics depicting comparisons of 2007-era leveraged loan rates and corporate bond rates) that his ilk no longer enjoyed a cost of funding advantage over corporate acquirers, who would be more likely to lead the charge in the current wave of M&A. In answer to an audience question he confessed that in some cases private equity funds were being asked by their limited partners not to draw on committed capital to do any deals in the current environement. Basically private equity investors are still hiding in their bunkers, but they are starting to put up periscopes and survey the battlefield for opportunities.
By far and away the presentation that was most interesting to me, and gave the greatest insight into likely future trends in the economy, was given by Bruce Mendlesohn, a managing director in Goldman's leveraged restructuring advisory group. Mendlesohn addressed the aforementioned mountain of LBO debt to be repaid or refinanced over the next three years (see chart).
This "wall of debt" has an uncanny resemblance to the mountain of commercial real estate loans and CMBS debt under similar circumstances(View image). So it was of no small interest to me when Mendlesohn went through the extensive tool box being utilized to cope with this massive problem. These strategies included distressed debt open market buybacks, asset sales, exchange offers, refinancings and amend/extend agreements that are all being utilized prior to the last resort of bankruptcy filings. He discussed the strategies and bargaining tactics being utilized by various players in the capital structure to try and protect their interests - much like the "tranche warfare" being witnessed in the commercial real estate market. Mendlesohn mentioned in his presentation that despite the severity of the current downturn, 48 month default rates on corporate debt was running at 17%, which is much less than the 30.2% and 30.6% levels seen at similar points in the 1992 and 2003 recession years.
He did not opine on whether it was in fact creditors' unwillingness to "take their medicine" which had resulted in this better performance, but he did aver that he expected to be very busy for several years to come. That said, Mendlesohn illustrated graphically how the efforts of restructurring artists were putting a pretty decent dent in the "wall of debt," and how if you projected forward the current rates of debt rehabilitation, you can actually visualize a non-catastrophic conclusion to this situation.
Having spent the last few weeks studying up on the U.S. commercial transportation industry, the recent debt exchange offer by YRCW Corp. (The old Yellow Freight), the nation's largest Less-Than-Truckload (LTL) trucking company, seems instructive particularly in light of Mr. Mendlesohn's presentation. YRCW took on a bunch of debt and made a big acquisition a couple of years ago, which was never fully integrated. The company has subsequently been on the ropes since the economic implosion began a year ago. During the course of the year, despite what was becoming a more and more obvious inability to meet a large debt payment due in early March 2010, the bank lenders to the company made a multitude of concessions regarding debt covenants, payment of fees, asset sales, etc.
The bottom line was they didn't want back the trucks and warehouses that represented their collateral (and were about the only thing that wasn't nailed down, which the company had not sold). In a market that is swimming in oversupply, about 18% according to estimates by Stifel Nicolaus & Co. Inc., what would such collateral be worth in liquidation anyway? (Note that few shippers would stay with a bankrupt trucking company that might see severe declines in service levels). Of course, once the banks did take back their collateral, they would have to actually take the full hit to their capital bases. So last week, after many unnatural acts by the banks and even the Teamsters Union which represents the firm's workers, the mangement of the company was actually able to persuade its note holders (lesser secured debt holders) to accept about 95% of the equity of the company in exchange for their debt. In one fell swoop the equity of the company was basically wiped out outside of bankruptcy court, while a pile of debt that was not converted to equity remains on the company's balance sheet.
Ok Jeff, so why do I care? The seemingly extraordinary story of YRCW (and trust me, both Mendlesohn's tactics and the YRCW solution are relatively extraordinary vis-a-vis the traditional "workout" models of the past) is happening all around us on a gargantuan scale in corporate and commercial real estate debt. It is time to contemplate the impacts of this kind of dissolution of debt.
In this respect, the comments of YRCW competitor Con-Way Freight on their recent earnings call after the YRCW debt restructuring was announced are enlightening.
According to Con-Way CEO Doug Stotlar, "as long as we are in a situation where there is excess capacity in the LTL marketplace, pricing is going to be difficult to come by."
I think that it is becoming clear that rather than choking on the twin walls of leveraged corporate and real estate debt, the markets, with the help of an army of lawyers, bankers and restructuring artists as well as regulators' blessings, will push these maturities out, convert them to equity and preferred equity and otherwise defer the ultimate paying of the piper. While this will prevent a second meltdown of the financial system, it also traps capital in inefficient investments that don't promote growth in employment or productivity, while preserving a corrrosive environment of over-capacity and aggressive pricing, as the assets age in place. In the case of commercial real estate, which never goes away no matter what happens to the owner, we will likely just see a longer period of negative rent trends, rather than a swift decline from properties being re-based in distressed dispositions.
Tune in for my next piece on the second leg of the commodity boom as foretold by Goldman's commodity economist. In it I will consider what happens when raw material inflation meets infarcted bank lending markets and excess productive capacity. I'll ponder the question, will Uncle Sam be forced to do a debt for equity swap?.....So you've got that to look forward to.
From the Blogosphere:
The Worrying Wall of Debt
A Look at Commercial Real Estate Debt
FDIC Calls For Debt Restructuring
Up Against a Wall of Debt