Breaking the Chapter 11 'Tsunameter'
Ilia O'Hearn -
Evan D Flaschen
The subprime mortgage debacle that led to the fall of colossal financial institutions such as Bear Stearns and Lehman Brothers in 2008 has been the temblor generating the recent tsunami of global restructurings and chapter 11 filings in the United States.
Evan Flaschen
The financial crisis affecting Wall Street since 2008 has resulted in tight credit and loss of consumer confidence, derivatively affecting Main Street as companies struggle to survive what some are calling the worst economy since the Great Depression. Unemployment in the United States is the highest in 16 years, retail had its worst holiday season in years, and the effects of the slowdown in the US economy have rippled globally as well. The US is one of the largest global consumers, but as fluctuations in the currency cause the dollar to lose its purchasing power, compounded with lost jobs and increasing foreclosures, US consumers have decreased their demand for imports, contributing to a deteriorating global economy. Over US$750 billion in corporate debt will become due this year and will lead to many more bankruptcy filings as companies continue to be unable to secure adequate financing and to effectively transform business models.
How did this mess get started? Government policies promoted widespread home ownership in the late 1990s and led to the exploding phenomenon of collateralised mortgage pools courtesy of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corporation (Freddie Mac), after which Wall Street jumped on the bandwagon. Then, after the burst of the dot-com bubble, a recession, and with the devastating events of 11 September 2001, the Federal Reserve repeatedly reduced interest rates and the government instituted substantial tax cuts. Money became cheap and very available. Companies and consumers gorged on debt. Commercial banks also became highly dependent on borrowed money to finance operations and investment banks levered their balance sheets to stratospheric levels. The pressure for high returns and the never-ending Wall Street creativity led to the development of increasingly complex derivative financial instruments, which, whether fully understood or not by the credit agencies, were all highly rated. Risky loans were bought and sold with apparently little concern for quality or collectibility. Partly due to the explosion in actual and synthetic credit default swap instruments, and in the search for high returns, financial institutions were lending and investing carelessly. The regulators were seemingly comfortable with these largely unregulated market developments as though they did not know a new paradigm had replaced all the old rules of conservative financial practices.
With all of the easy money floating around, the relatively sound underwriting criteria of Fannie Mae and Freddie Mac gave way to subprime and other higher-risk mortgages, many with interest rate resets that could quickly double the monthly cost to the homeowner. And that is exactly what happened in 2007, coupled with declining home values due to oversupply. By the fourth quarter of 2007, the housing bubble began to burst. Many subprime borrowers could no longer afford to make payments under adjustable rate mortgages or refinance their underwater loans. A new wave of foreclosures began, which together with an already large inventory of homes, pushed home prices even lower.
At the time, Freddie Mac and Fannie Mae - which buy loans from mortgage originators and either hold the loans on their portfolios or bundle the loans and resell them to investors in the secondary market as mortgage-backed securities with a guarantee that principal and interest payments will be passed through to the investor timely - owned or guaranteed about half of the US's US$12 trillion mortgage market. An avalanche of defaults caused mortgage-backed securities to lose hundreds of billions of dollars in value. The Federal Housing Finance Agency was forced to place Freddie Mac and Fannie Mae into conservatorship in September 2008. The US Department of the Treasury agreed to provide each with up to US$100 billion of capital as needed to ensure they continue to provide liquidity to the housing and mortgage markets.
The subprime mortgage crisis was also a major contributor to the collapse of Bear Stearns during the spring of 2008. Customers began losing confidence in the financial giant after two of its hedge funds succumbed in 2007 to the subprime mortgage fiasco, and rumours spread that Bear Stearns was having liquidity problems as lenders froze credit and customers started to withdraw funds. Unable to leverage its operations, Bear Stearns collapsed in March of 2008, notwithstanding a rescue package that included a multibillion loan from JP Morgan backed by the US government. Bear Stearns was eventually sold to JP Morgan for US$2 a share.
Lehman Brothers, the almost 160-year old investment banking institution, filed for chapter 11 protection on 15 September 2008 in the Southern District of New York, setting off another round of market panic and credit tightening. Lehman Brothers had been one of the largest investment banks in the United States and a major underwriter of mortgage-backed securities. However, after the earlier collapse of Bear Stearns, market panic about liquidity crunch and the subprime mortgage crisis drove Lehman into bankruptcy. Almost immediately after the bankruptcy filing, Lehman sold the majority of its North American operations to Barclays. Lehman has also been divesting itself of its worldwide operations.
The US government, which had intervened when Bear Stearns collapsed, refused to rescue Lehman, ironically, not to set a precedent that it would save every ailing institution. Bear Stearns inevitably marked a new era of government intervention into the private financial markets. Merrill Lynch, which had acquired a major subprime mortgage lender in 2006, was also facing liquidity constraints and sold itself to Bank of America in mid-September of 2008 for US$50 billion. Earlier in 2008, Bank of America had acquired Countrywide Financial Corp, another active participant in the subprime mortgage market. Bank of America itself required government financing in 2009 due to both of these acquisitions. The government also provided AIG in the autumn of 2008 with a loan backed by AIG's stock, acquiring a 79 per cent interest in the company. Citigroup has received multiple injections from the US government, receiving US$45 billion so far and a further US$300 billion guarantee of its liabilities.
On 26 September 2008, Washington Mutual, Inc, the parent company of Washington Mutual Bank (WaMu), filed for chapter 11 protection in Delaware. The previous day, the United States Office of Thrift Supervision had seized WaMu, the largest US savings and loans association, and at the time one of the largest banks in the US, from its parent Washington Mutual, Inc. JP Morgan paid US$1.9 billion for WaMu in a government auction. The Office of Thrift Supervision seized WaMu after the withdrawal of close to US$17 billion in deposits over a bank run that lasted several days.
No one really knows with certainty the magnitude of the financial crisis and how long it will last. For example, each month it appears that new housing starts have bottomed out, only for the statistics to be even worse the next month. The surviving banks have already suffered enormous losses from subprime mortgages. But with a deepening recession affecting all areas of the economy, bank losses will continue to expand to other areas. As companies continue to downsize or fail completely and as the unemployment rate continues to soar, more defaults and foreclosures are triggered and more companies fail seriatim. The retail, manufacturing and automobile industries, to name a few, have felt the undertow of the financial crisis. Dozens of auto suppliers filed in 2008 for bankruptcy protection and GM and Chrysler are close to the precipice. Retailers in 2008 experienced the worst holiday season in years. Some retailers like Circuit City, a large seller of consumer electronics, had filed for chapter 11 pre-holiday season hoping that traditionally strong holiday sales would carry them through a successful reorganisation. However, the strategy did not work and Circuit City ended up liquidating altogether. As with prior economic down-cycles, this too shall pass, but until consumers start spending again, it will not pass soon.
LyondellBassell, the world's third-largest chemical maker, with annual revenues of over US$50 billion, filed for chapter 11 protection on 6 January 2009. Lyondell Bassell was created by the US$12.7 billion merger of Dutch firm Basell Polyolefins and Texas-based Lyondell Chemical Co. LyondellBassell combined carried billions in legacy debt - US$23 billion at the end of 2007. Liquidity became a serious issue for the company when oil and gas prices soared during the first half of 2008. The falling of oil prices in the second half of 2008 did not ease the trouble as the downturn in the economy lowered demand for petrochemical derivatives used in automobiles, construction materials and other consumer goods. Declining sales and inability to raise additional financing (outside an in-court restructuring) to meet operational and debt requirements caused the company to file for chapter 11. LyondellBassell was able to secure an US$8 billion debtor-in-possession (DIP) but at a hefty price.
Nortel Networks, the telecommunications equipment maker, filed for bankruptcy protection in Canada, the US and Europe on 14 January 2009. Nortel filed for chapter 11 relief in the United States; for reorganisation under the Companies' Creditors Arrangement Act (CCAA) in Canada; and certain of its subsidiaries made comparable reorganisation filings in Europe. Nortel had started to transform its operations in 2005, but such efforts were halted by the ongoing global financial and economic crisis. A decrease in sales and its inability to comparably reduce expenditures caused liquidity constraints. Nortel filed for bankruptcy in part to preserve its cash reserves of over US$2 billion while it restructured its operations. Nortel had failed to obtain DIP financing and it had US$100 million coming due to bondholders. Its cash reserves will be used to continue funding operations. Nortel's reorganisation strategy includes divesting of certain assets, which may provide cash that may not otherwise be available to Nortel through conventional financing in this credit crisis; and hopefully the liquidity necessary to exit its reorganisation proceedings. Nortel had entered into an arrangement with its key supplier to maintain the supply chain during the bankruptcy proceedings. This is a very important arrangement because one of the challenges for companies in bankruptcy proceedings is maintaining good relationships with suppliers, who for fear of not getting paid will often discontinue shipments, freeze credit lines or impose more rigorous payment terms.
Smurfit-Stone Container Corporation, one of North America's premier containerboard and packaging companies, filed for chapter 11 on 26 January 2009; and also plans to reorganise its Canadian subsidiaries under the CCAA. Smurfit-Stone has over US$7 billion in assets and, as is increasingly common these days, has filed for bankruptcy to restructure its debt. Demand for its products decreased in the current recession and the company was unable to secure out-of-court financing. Smurfit-Stone, however, was able to obtain commitments for up to US$750 million in DIP financing to fund operations, pay critical vendors and employees. A portion of this DIP is a replacement of existing accounts receivable securitisation facilities both in the US and in Canada.
The "tsunameter" will continue to rise in 2009 and 2010. Over US$750 billion in corporate debt will become due in 2009 according to Standard & Poor's. According to Moody's, the high yield debt default rates is expected to rise to 15 per cent by the end of 2009, compared to 4 per cent at the end of 2008. But the current depression-era mentality of dry lending and low spending will compromise companies' ability to meet minimum cash requirements needed to continue operations and meet short-term obligations (pay trade; make interest or coupon payments and meet short-term maturities). Companies will either have cash to pay debt as it becomes due or will need to refinance at rates considerably higher than when the original debt was incurred. Financial restructuring will be an alternative for companies that cannot secure refinancing but either have sufficient cash reserves to maintain liquidity through the reorganisation or can negotiate a DIP and exit financing with either new money or existing lenders. As interest payments become due, companies without sufficient liquidity will be required to ask their lenders for extensions on such payments or may be required to file for chapter 11 to preserve cash reserves, if they are lucky to have that. But such loan extensions are expensive - so either the company has the cash to pay the fees or lenders agree to creative solutions such as accepting PIK interest, which in itself may be expensive as loan agreements or indentures may need to be amended, requiring fees from the lenders or holders for the concession and to pay the professionals.
Expensive DIPs with stringent covenants or untraditional financing structures may not be available if collateral values are significantly depressed and lenders perceive the investment as overly risky. Existing lenders may need to provide the funding - perhaps undersecured creditors that want to protect their position in the distressed company. Debtors may be required to accept untraditional financing structures or break up DIP loans into tranches for various groups of investors, as it was done in the chapter 11 cases of Lyondell and Tribune. Companies that use receivables as a source for financing will face major difficulties in the midst of a credit crunch due to decreases in sales. But if sales are strong, an accounts receivable securitisation facility, as done in Smurfit-Stone, could provide an alternative to financing. Another issue is how much funding the company can obtain and whether it may be sufficient to carry it through exit - which will depend on whether the company can improve revenues and curtail expenditures adequately. It may be the case that the company may only be able to get enough for an asset sale leading to an orderly liquidation, as opposed to a successful restructuring.
Chapter 11 may be a good opportunity for companies to revamp their business operations if they can secure DIP and exit financing. In chapter 11, a company can get out of burdensome contracts and leases; reduce or eliminate non-critical labour; close out non-profitable stores or unproductive facilities; and obtain leverage to renegotiate contracts with suppliers, who may very well be hurting themselves. Additionally, through chapter 11, a company may obtain the financing that may not be available outside of bankruptcy due to the credit crisis. Bankruptcy filings are costly and a pre-pack is recommended to secure funding and have a quick exit. But it will be important for companies to have their major constituencies aligned pre-filing so that the chapter 11 case does not become the opening of Pandora's Box.
By the time this article is published, the US government will have begun to implement a stimulus package of close to US$1 trillion in the hope of saving this ailing economy. But consumer confidence and the financial sector are not easy to fix, and it is uncertain how long it will take for recovery even with massive government help. Until consumers start consuming again and the financial institutions restore their confidence in lending, it will continue to get worse before it gets better. And when the United States sneezes, the world catches a cold. So, for now, wherever you are, keep your life vest on