FTI Consulting recently gathered six of the world’s top financial leaders to discuss the financial crisis, the new reforms, and whether they can truly protect global markets from another meltdown. Discussion leaders were former Federal Deposit Insurance Corporation Chairman William M. Isaac, who is now Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, and Stephen Kingsley, Senior Managing Director in FTI Consulting’s London office. The panel comprised Mark Carawan, Chief Internal Auditor at Citigroup; John C. Dugan, former Comptroller of the Currency and now a partner at Covington & Burling; Cornelius K. Hurley, Director of Boston University’s Center for Finance, Law & Policy and Senior Provost Fellow Professor of the Practice of Banking Law; and Simon Samuels, Managing Director, European Banks Equity Research at Barclays Capital.

WILLIAM M. ISAAC: We have four topics to cover, and we will lead off with John Dugan. The first question: Will the global financial reforms prevent the next crisis?

JOHN C. DUGAN: I don’t think we’ll ever fully prevent the next crisis, whatever it will be. I do think it was very important to increase the amount of common equity capital in the banking system. Once we did that, the crisis began to ease. But there has been too little work done on developing liquidity standards for the banking system, and I don’t think what is being put in place now is right yet — it needs a lot of work.

ISAAC: Was Dodd-Frank necessary? Regulators have always had the authority to deal with capital and liquidity issues.

DUGAN: I think the most important thing was to raise capital across the board, not just in the United States but also in other countries. You need an agreement among regulators, but you didn’t need Dodd-Frank for that or for setting new liquidity standards. Dodd-Frank addresses those subjects, but they’re not really at the heart of what Dodd-Frank gets at. I do think some of the Dodd-Frank reforms were necessary, especially the regulation of systemically significant nonbanks — but some reforms went too far.

CORNELIUS HURLEY: We are not better off with Dodd-Frank, mainly because there’s no structural reform. We’ve just nibbled around the edges. The Vickers Report proposes real structural and competitive reform.
I would have recognized the too-big-to-fail genie for what it is: a loose, destructive spirit in the land. Dodd-Frank called every financial institution over $50 billion systemically important, and that’s just not credible. The Vickers Report suggests a much more reasoned approach. It would confine the retail bank and allow the separate investment bank to do proprietary trading.

SIMON SAMUELS: I personally think the crisis was fundamentally about credit underwriting standards and liquidity. And ultimately the reason why Lehman fell was not from its starting position of capital, which was fine. It was due to a liquidity failure because people didn’t trust the underwriting.

DUGAN: I also believe that if we’d had some bare minimum mortgage underwriting standards, real documentation of income and even modest down payments, the whole crisis would have been much smaller. I would say, though, that a lot of people thought Lehman was very undercapitalized.

ISAAC: When I was running the FDIC my highest priority was increasing tangible equity in the largest banks. Going into the recent crisis, many of the largest firms simply did not have enough tangible equity capital, and the regulators allowed them to get away with it. The liquidity crisis occurred in significant part because the markets perceived that the banks had insufficient capital in relationship to the risks in their portfolios.

HURLEY: I think the lawyers were to blame too. Entire legal careers are spent looking for ways around regulation. I don’t see anything in the culture of the legal profession that says lawyers won’t do the same thing with Dodd-Frank or the Vickers Report — “We’ll guide our clients around regulations rather than helping them to comply with the spirit of the law.” That’s the gorilla in the room that no one dares to talk about.

MARK CARAWAN: One of the areas that we’ve not focused on is the role of management. While we are looking at enhancing capital and liquidity regulation, we should also ensure that management is ultimately responsible and held accountable for ensuring adequacy. Do we need more rules or is there scope to better enforce the ones we have?

ISAAC: It seems to me that we in this country didn’t make the structural reforms to prevent this crisis from happening again. Dodd-Frank slapped the regulators on the wrist and said, “Start worrying more about capital and liquidity. Do your job right.” But regulators already had the authority to get out in front of this crisis and take action if they had recognized the problems and had the political will to deal with them.

DUGAN: As comptroller, one of the problems that I saw was that there were a lot of practices that were okay, not great, inside the banks. But they were much worse outside the banks. There was no way to have a common set of rules that applied to both banks and nonbanks. I think odd-Frank has addressed that, although at times in a very cumbersome way. We will now have common mortgage underwriting and risk retention standards for all mortgage providers, although a lot of regulators have to agree on the rules. The CFPB [Consumer Financial Protection Bureau, the new consumer protection agency] will set common consumer protection standards for all providers too. Also, while the SEC [Securities and Exchange Commission] did not do a good job of regulating some of the investment houses that had increasingly become like banks, these companies are now deemed bank holding companies and can be regulated as such.

ISAAC: Okay, that will have to be the last word, as we need to move to the second topic: “too big to fail.”

STEPHEN KINGSLEY: How you think about too big to fail depends on where you are in the world. The United States has been used to banks failing regularly. In the United Kingdom, until Northern Rock, the last time we had a run on a bank was when Queen Victoria was on the throne. The cost of rescuing the banking system in some countries, including my own, has been very substantial. In some places, like Ireland and Iceland, the impact is going to be felt for decades. And taxpayers may not have the appetite for repeating what they did in 2008 and 2009.
One question is whether larger financial institutions will be allowed to fail next time or whether the politicians will rush back in. And can one large firm fail without precipitating a wider market collapse?

CARAWAN: We should be figuring out how to put in place the appropriate frameworks to ensure that government agencies focus on a robust commercial solution and not a politically driven one. They should be ready to make the tough decisions and close down banks that are insolvent so that there are market consequences for those that don’t manage or restructure properly.

DUGAN: Does anyone think that the existence of too big to fail caused the crisis?

ISAAC: I think it played an important role. The perception that some firms are too big to fail diminishes discipline that would otherwise be present in the marketplace. The suppliers of wholesale funds and capital need to believe that they are truly at risk. If they do believe that, behaviors will change in banks. I do not believe things could have gotten so far out of hand precrisis had suppliers of capital and liquidity believed they were at risk. Once thecrisis hit, the government going back and forth — bailing out one large firm and then letting the next one fail — utterly confused the markets and created panic.

HURLEY: Too-big-to-fail banks get a subsidy because they can buy funds at a cheaper rate, just like Fannie [Federal National Mortgage Association] and Freddie [Federal Home Loan Mortgage Association] did, knowing the sovereign will come to their rescue. We should quantify that subsidy and require those banks to segregate it on their books as a reserve account. That reserve account would be capital in the event of a bankruptcy.

SAMUELS: I’ve never understood the idea that you’d somehow act recklessly if you get bailed out, because you would long ago have been fired. And from a shareholder’s perspective, you get wiped out. So this is purely about the debt market.
This is the kind of debate that you have years down the line but not months down the line. The funding markets are so extraordinarily fragile. There’s a lot of uncertainty in the wholesale funding markets in the United Kingdom because of the Vickers Report. The presumption is that if you’re outside the ring fence, your wholesale funding costs will be higher. You’ve seen senior bondholders suffer haircuts [absorbing losses] in Denmark, and now large Danish banks are struggling with funding.

KINGSLEY: The liquidators of Lehman faced problems on both sides of the Atlantic because Lehman was very complex. Lots of institutions continue to live in that complex global environment. And it strikes me that those organizations are going to find it very hard to do a proper living will.
ISAAC: The Vickers Report is essentially a living will. You take the part of the institution that the people on the street worry most about in a crisis — checking accounts, mortgages, small business lending — set that aside and then put the more complex parts in another part of the organization.

CARAWAN: Both retail and commercial customers want global capability, low cost and instant information about their accounts. To compete in the marketplace means that you offshore, outsource and have service centers around the world in many jurisdictions. In a crisis, each regulator will ring fence activities in its own jurisdiction and follow its own course to stabilize its marketplace and resolve insolvent institutions. To structure readily resolvable global institutions is very complex and will involve huge organizational coordination, a web of service-level agreements and ample time to make things happen. One must not underestimate the challenge.

ISAAC: Let’s turn to question three: Are we focused too much on regulation and too little on improving prudential supervision of financial institutions?

SAMUELS: I think ultimately credit bubbles will damage financial institutions when the bubbles burst, regardless of what supervisors do. And arguably banks in some of the bestsupervised systems in the world, like Spain, have suffered terribly as the credit and housing market bubbles collapsed. I also think the complexity of some of the new rules that they’re being asked to apply represents a huge impediment to economic recovery.
The macro prudential angle is very important. Fixing things like the structure of the U.S. housing market, the nonrecourse lending in many states and loan-to-value caps would help the industry tremendously to withstand subsequent cycles and avoid bubbles.
Also, the Basel III capital framework includes a buffer to deal with market bubbles. The idea is that capital requirements will increase as a cycle reaches a crescendo, essentially to choke off that last piece of the bubble. In theory that could help enormously. But somebody has to decide, “We’re in a bubble and it’s now time for that buffer to kick in.”

KINGSLEY: A highly empowered, rightminded person at the center of the financial system in each country could say, “That’s enough, guys. We’re now going to stop the party, and we’ll raise capital requirements for particular kinds of loans. We will actually outlaw particularly unsound loan-to-value ratios,” or whatever it happens to be. And the fascination for me is: In a democracy, how do you actually empower somebody who can face off against the elected politicians?

ISAAC: I’m old enough to recall when the Federal Reserve, back in the 1970s, got concerned about the economy, and it told expansion-minded financial companies, “No. Your capital is too low, considering how overheated the economy is getting. Increase your capital and then we’ll think about your application.” We need to get back to the days when regulators actually had to think and use judgment.
The system needs firm underwriting standards, and firm capital and liquidity standards. And we need to allow the examiners to go in and actually look at assets and off-balancesheet exposures. That’s the job of management and the board of directors first, and regulators are a check on that system. But they should all
be using some judgment rather than just blindly relying on flawed models they don’t really understand — models that told us that residential real estate loans and sovereign debt were relatively riskless assets.

DUGAN: I think you do need some firm rules; it can’t be all about discretion and judgment. I just don’t know how much of this you can legislate — how much you can tell someone to be a better supervisor. When the system goes wrong, it’s hard to sort out how much failed supervision or failed regulation was at fault. The only way policymakers can react is with increased regulation. They can’t mandate better supervision.

KINGSLEY: That is a perfect segue to the last discussion topic: the impact — unintended or intended — of these regulatory and other changes on the banks and the economic recovery.

SAMUELS: I see a very slow economic recovery happening. I expect credit shrinkage or very anemic credit growth and I see banks being required to hold more capital. But I am just not sure that there is a clear linkage between all three. I think it is realistic to expect that when a recession was created by too much debt, then its recovery process will likely result in lower levels of debt. Whether or not banks need more capital now, it’s entirely reasonable to expect the economic recovery to be very sluggish because that is what usually happens after a financial crisis. I should also point out that the banking industry in Europe spent the whole of the 1980s and 1990s generating a return on tangible equity below its cost of equity. Today the bankers cry, “If you do this and this, our return on equity will go down too much and it will be unacceptable to our stakeholders and eventually we won’t be able to provide credit for the economy.” But throughout the ’80s and ’90s, economic growth across Europe was fine.

ISAAC: I’m chairman of Fifth Third Bancorp, and it has increased its capital rather dramatically. The bank is eager to make loans, but it can’t find enough decent ones to grow the loan book after you net out the paydowns of existing loans. A lot of people are deleveraging voluntarily or they’re bypassing the banking system and going right into the markets to lock in long-term debt at low rates. Having said that, if we keep increasing capital and liquidity requirements and imposing other significant regulatory burdens on banks, credit will continue to be less available and more expensive, which will impede economic recovery.

HURLEY: In each of our countries, the largest five or six banks occupy about 80% of the banking system, so they dominate the field. Their too-bigto- fail subsidy, depending on whose study you read, is between 25 and 75 basis points. In this kind of economy, there’s little incentive for the mega banks to do anything that is going to stimulate the economy when they can sit back and enjoy the bounty of that subsidy. So I think this question of the subsidy is linked inextricably with the capital issue and the timing of when we emerge from this crisis. Until there’s a sense of urgency, we will not get out of it.

DUGAN: I’m not sure I agree with that, for the reason Bill said. I think bankers make money through loans and want to put that capital to work — especially in a low interest rate environment where they can’t earn much spread by investing in Treasury securities or Fed funds. So I think they have every
incentive to try to make loans right now; it’s just hard to find them.

HURLEY: And the No. 1 problem facing bank management these days is “What do we do with all this money?” Banks in New York have started charging large depositors to put deposits in the bank!

SAMUELS: I think one of the enduring features, post–financial crisis, is that the idea of a level playing field goes out the window. Take capital: If you’re a regulator of a very large banking system that collapsed, your view toward how that should be regulated would differ from the view of a regulator of a smaller banking system that didn’t collapse. And so the United Kingdom’s starting point is a banking system that is, depending on how you measure it, between five and six times the gross domestic product of the United Kingdom. The starting position of the United States is a banking position that is a tenth that size relative to the U.S. economy. And so the chances of those two regulators agreeing on the same magic capital ratio number, I’d say, is zero.

HURLEY: When we use the term regulation, it means different things to Republicans and Democrats [in the United States]. Just the word regulation has become an attack these days. Regulation comes in many forms — I have a list of about 35 different types. And some of those regulations are really designed to promote market discipline, especially in the area of disclosure. So often the debate about regulation or overregulation or underregulation ends up being just a political diatribe where the parties never really have a discussion. They never start from the point, “What are we trying to accomplish, and what is the least burdensome way of getting there?” If we could just have that discussion, we might get to a place that yields a stronger, more resilient financial system that fosters sustainable economic growth.

ISAAC: That is a perfect thought to end on, Con. I wish we could continue all day, as this has been a fascinating discussion. Thanks to each of our panelists for taking the time to share your thoughts and wisdom.

A few recent headlines underscore the danger:

• The Carlyle Group lost $105 million after the Hong Kong Securities and Futures Commission suspended trading in China Forestry Holdings and brought criminal charges against its CEO.
• Shares of China Natural Gas plunged 59% after the company “restated earnings.
• Paulson & Co., one of the world’s largest hedge funds, lost more than $550 million after financial fraud was revealed at Sino-Forest.

Investors aren’t always cognizant of the role of audit firms. These firms primarily serve to verify documentation behind financial statements, not probe for evidence of fraud. Many investors also make the perilous assumption that an Asian company listed on the Hong Kong, New York or other established exchange meets the same standards of disclosure as Western companies listed there. Moreover, investors don’t usually have the resources needed to investigate a maze of jurisdictions and languages to verify a company’s claims.

But the next big corporate failure has already happened. It just hasn’t surfaced. When considering Asian opportunities — particularly in emerging markets such as mainland China, India, Indonesia, the Philippines and Thailand — investors need to conduct deeper and broader due diligence, beyond just reviewing audited financial statements. They need to scrutinize corporate governance and business structures, and examine in depth what lies behind the assets on the books.

What to Look For

Investors should dig deeply into these issues to vet opportunities and protect their interests.

Corporate Governance

Look carefully at corporate governance structures. An Asian company may not have the clean segregation of duties between board, CEO and management that is common in the West. Family relationships and personal networks play an enormous role in Asia. In many ways, these relationships hold the society together. Reciprocal obligations with extended family, or even someone who hails from the same village or town, can be a counterweight to the more objective business decisions expected in the West. Many publicly traded companies, for example, began as family-run enterprises. Family and friends may sit on boards or even audit committees. It is also not uncommon for the head of a family to be both CEO and chairman. Weak governance structures can allow for company investments to be based on family ties and needs vs. all shareholder interests.

Complex Business Structures

Unnecessarily complex business structures may be designed to conceal inappropriate activities. For example, Peace Mark (Holdings) Limited, a Hong Kong–based watch manufacturer, distributor and retailer, collapsed in the wake of financial irregularities. When FTI Consulting investigated, we discovered that the $900 million company had more than 300 corporate entities. The annual report disclosed 60. The complex group structure was being used to conceal various transactions and financial arrangements.

Assets and Holdings

It is crucial to verify the assets and holdings a company claims it has. Among the issues that led to suspension of trading for China Forestry: The company did not have the logging permits it claimed it did and the company also materially misstated its cash balances. China-Biotics, a provider of probiotics used as dietary supplements and food additives, reported that some 25% of its revenues came from 100-plus stores it owned and operated. Most did not exist.
Inventories and receivables are the asset types most often misstated by troubled companies trying to deceive stakeholders. There are countless stories of companies in China financing the same purchase multiple times and making sales to parties that don’t exist. Several companies may even pool inventories at audit time.

Reporting large levels of cash while increasing debt levels can be a warning sign. The company may be trying to conceal operating or other losses — or the cash may not have existed to begin with. Moulin Global Eyecare, a Hong Kong–listed company with operations primarily in China, shifted cash into a subsidiary from outside the group just before the financial year-end and then back out again immediately afterward. The purpose was to artificially inflate its consolidated cash balances.

Companies that regularly raise capital should also be scrutinized. Management may be trying to fund its way out of inherent operational weaknesses.

More than one acquisition every two or three years is a red flag as well. The company may be trying to mask underlying financial problems by increasing the size of the business.

It is not atypical for Asian companies in financial trouble to misrepresent their assets and transactions. Western investors can be caught by surprise if they do not look hard for troubles before they commit.

Arguably, the crisis was fueled by a vicious cycle in which fears over the potential downfall of a single financial institution reduced confidence in other institutions. To minimize future economic risks, global political leaders and regulators have made stability a top priority since the 2008–2009 crisis. As examples:

The G20 has committed to clear over-the-counter (OTC) derivatives through central counterparties and to encourage their trading on exchanges in order to reduce counterparty credit risks and enhance transparency.

The Basel III framework raises the quantity and quality of banks’ capital requirements and introduces liquidity standards. It aims to reduce the probability and severity of future banking crises while protecting financial stability and economic growth.

The European Financial Stability Facility (EFSF) was created — and later enhanced — to help indebted euro-area countries. Its bonds have already aided Ireland and Portugal.

The Thorny Dilemma: Stability vs. Competition

Despite the recent emphasis on stability, most politicians and regulators would agree that competition plays a vital role in the financial sector. It drives down prices and improves service for customers and performers.
Yet competitive markets have losers as well. As winners gain market share, less efficient competitors lose customers, become insolvent or are acquired by other companies.

European regulators and politicians clearly face a dilemma: They want to inspire trust among savers and investors by helping stable financial institutions thrive. They know that even the possibility of insolvency or bank failure could cause widespread panic and damage.
Yet efforts to improve stability by ruling out the possibility of insolvency run counter to the natural market dynamics. Strong competition means insolvency risks for the least efficient, weakest players that can’t match competitors’ prices and services.

To complicate matters, different public authorities have been given statutory responsibility to pursue one of three conflicting objectives:
Central banks and treasuries try to protect financial stability
Antitrust authorities promote competition and prevent monopolies
Some regulators and legislators must simultaneously promote stability and competition

In the European Union, the Directorate General for Economic and Financial Affairs (DG ECFIN) and the European Central Bank (ECB) have the role of ensuring financial stability, while the Directorate General for Competition (DG COMP) enforces European competition policy.

Similarly, the Directorate General for Internal Market and Services (DG MARKT) of the European Commission must reconcile these opposing goals in the legislative proposals it makes to the Council of Member States and the European Parliament.

For example, following Basel III, DG MARKT suggested increasing bank capital requirements to give banks a larger buffer to withstand financial shocks. It might seem hard to fault measures that promote stability. But in fact, higher capital requirements hinder competition by making it more difficult for new players to enter the market.

Moreover, by making capital requirements larger and more complex, regulators also increase compliance costs, which in turn drives consolidation and reduces the markets’ competitive vigor.

Three Outcome Scenarios for the Stability-Competition Rivalry

How will regulators and legislators escape from the stability-competition conundrum? Will one objective be prioritized over the other? What outcomes are most likely, and what are the strategic implications for companies in the European financial sector?

The most prudent course of action would be to develop a strategy for each of the most likely scenarios:

The Stability Scenario.

In this situation, regulators and legislators favor financial stability over competition. The recent multinational government emergency rescue of French/Belgian/Luxembourg bank Dexia shows that EU politicians and regulators still hesitate to let large financial institutions become insolvent.

Given ongoing political instability and financial market turmoil, policymakers may be willing to reduce competitive pricing pressures, helping financial companies earn greater margins and staving off insolvencies and the instability that follows.

The Competition Scenario.

In the second scenario, authorities enforce competition policies despite the risk of financial instability. Regulators and legislators may believe that the financial crisis has finite boundaries and that the long-term value of competition outweighs short-term stability risks. But given all of the pro-stability pan-European initiatives now under way, unbridled competition is unlikely in the short term.

The Balanced Scenario

Finally, it’s likely that regulators and legislators will continue their attempts to find that elusive middle path that balances stability with competition. As a result, industry stakeholders should expect that DG MARKT will continue to weigh competition arguments against financial stability concerns in issuing its legislative proposals.

This scenario is unsettling for financial firms, because legislators may decide their fates — insolvency or survival — case by case rather than “by the book.” This means that firms with a stake in such matters must influence the political debate in their favor. Winners will probably be those who act quickly, build a strong case for their position, and find allies who support their cause.

Victory to the Swift and Persuasive

In a balanced competition-stability world, financial market stakeholders should recognize the importance of early positioning. Stakeholders who engage constructively with regulators — not just stating problems, but offering creative solutions — can help shape their decisions.

To have the greatest success in favorably influencing the policy debate, stakeholders should:

• Establish a broad base of support among a diverse constituency, including other market players as well as nongovernmental organizations, the media, shareholder advocacy organizations and the general public
• Anticipate other stakeholders’ opposing arguments and plan to counteract them
• Enlist industry organizations to advance their viewpoint
• Most important, build a solid, fact-based economic foundation for any stability or competition viewpoint. Data should clearly show officials how taking the preferred position in the competition-stability debate will benefit the industry, consumers and the market in the long term.

Unintentionally, the ongoing political tension between competition advocates and pro-stability legislators has created a new field of competition among financial firms. It is no longer enough to serve customers, develop new products and operate efficiently. Now, to capture market share from weakened competitors or to simply survive until their fortunes rebound, financial organizations must help shape the debate.

Challenging Sacred Cows

Wells Fargo famously navigated the financial crisis better than most of its peers. Now the man who led the bank through the crisis to the high ground, former Wells Fargo chairman and CEO Richard Kovacevich, challenges what is becoming conventional wisdom about what drove the financial crisis.

Kovacevich argues that a bank’s risk has nothing to do with its size — banks fail because their risk is too concentrated. He firmly believes that TARP, stress tests and mark-to-market accounting did not stem the crisis; they made it worse by creating panic. Legally combining commercial and investing banking didn’t fuel the crisis — this particular crisis would not have occurred had the Glass-Steagall Act not separated the two industries in 1934. And the Dodd-Frank Act absolutely does not end “too big to fail.” Kovacevich also brings his experience to bear on the vexing challenge of emerging from the crisis and spurring U.S. economic growth.

The following are excerpts from the interview conducted by William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. He is the former chairman of the Federal Deposit Insurance Corp. Isaac also serves as chairman of Fifth Third Bancorp.

The complete interview is available at fticonsulting.com/critical-thinking. It further illuminates the dangers still inherent in the financial system and is a must-read for all who work in, regulate and analyze the banking industry — or, like most, simply rely on its health.

William M. Isaac: What event or events do you think turned the recent crisis into a panic?

Richard Kovacevich: One of the most critical was the process of bailing out Bear Stearns and then days later not bailing out Lehman. The biggest mistake was not, as most people think, failing to bail out Lehman. The mistake was bailing out Bear Stearns and then not bailing out Lehman. The investors just said: “We have no idea what’s going on. We don’t know what’s happening next. We are getting out of the market.”

And for the Fed and [former Treasury Secretary Henry] Paulson to say, as they have, that they had no authority to bail out Lehman is simply not true. How can they say they had the authority to bail out AIG but they had no authority to bail out Lehman?

In my opinion, we should not have bailed out Bear Stearns, which was much smaller and much less risky than Lehman. It could have been handled more easily.

If that had happened, there was no question in my mind that Dick Fuld [CEO of Lehman] would have said “Uh-oh, game’s up. I’d better sell this thing right away at whatever price I can get.” He may have been able to sell it. I’m told it was close many times. And if Lehman could have been sold, then you may not have had the run on the other investment banks.

Isaac: You’re arguing that they should have let Bear Stearns go and then Lehman would have taken care of itself.

Kovacevich: Because if they bailed out Bear Stearns and also Lehman, everyone would know that every financial institution was going to be bailed out. Then you’re back to too big to fail, squared. I think the reason Lehman was allowed to go bankrupt, and I know Hank [Paulson] pretty well, I think he said to himself, “Well, if we rescue Lehman, then we have to do it for everybody. And we don’t have enough money or political will to bail out everyone.”

When they let Lehman go down, and the markets all crashed and liquidity dried up, they then realized the world was coming to an end. They ran to Congress to get the $700 billion to purchase toxic assets under the TARP program. Then they realized that the $700 billion for assets would not even put a dent in the problem, so they ended up bailing out everybody by supplying capital.

To cover their mistakes, they claimed they had no authority to bail out Lehman and, with a straight face, bailed out AIG a few days later. Chaos occurs when people don’t think in terms of what’s the next step if we do such and such now.

Isaac: You and I are probably the two people in the world who hate mark-to-market [MTM] accounting the most. What role did it play in the crisis?

Kovacevich: A huge role. People thought the world was coming to an end because everyone was reporting huge book but not actual losses because of MTM accounting.

We had to write off $900 million on a prime mortgage portfolio that we thought had a maximum loss exposure of $100 million. Our current loss estimate for that portfolio is now just $35 million. But we had to report nearly a billion-dollar loss that never came to fruition. And that was just one relatively small portfolio. I could give you many more examples.

Also, we wanted to purchase some assets because we knew they were undervalued. We were very reluctant to be a purchaser, however, because we would have to take an MTM loss if the asset went down further, even though we knew over the cycle it would be profitable.

This caused the markets to cease functioning. It destroyed a lot of companies and ultimately forced the Fed to intervene with trillions of dollars and be the buyer of last resort. Mark-to-market accounting was a huge culprit in the financial crisis and caused unnecessarily massive damage to the economy, and to housing in particular.

Kovacevich: I quickly learned that the riskiest part of the banking business is lending. If your loan risks become concentrated, whether geographically, by borrower or by industry, a bank’s total risk becomes excessive, even if you’ve underwritten those loans well. Banks fail due to concentrated risk. Risk has little to do with the size of the bank…. In fact, more small banks fail than big banks because they are generally more concentrated geographically, by product and by industry. Now if a big bank is concentrated, then obviously it is a higher risk.

Even if you underwrite well, when real estate goes to hell or the economy slows significantly, you’re going to get hammered. So you must underwrite well. But then to mitigate the macro factors you can’t control, you have to spread the risk. Risk management in banking should be more like it is in an insurance company. There you spread and diversify the risk.

I believe that the chance of Wells Fargo’s failing today at $1.2 trillion in assets is less likely than when I joined Norwest. It was a $20 billion company with a narrow product line concentrated in the upper Midwest and in agriculture-related lending.

Isaac: I’ve noted that the five largest institutions control more than 50% of the financial system and that is an undue concentration. Do you agree with that?

Kovacevich: I don’t. Five or fewer companies control more than 50% in every industry, from cereal to automobiles. Five banks control more than 50% of their industry in about every country in the world.

Isaac: You don’t believe banking is different or special compared with, say, the beer or cereal industry?

Kovacevich: No. In any given product line or geography the largest bank has, on average, 15% of the business. Some banks are big only because they have product and geographic diversity. That reduces the concentration of risk. If U.S. banks had been allowed to bank nationally from the get-go, as was the case in most other countries, few would even question their market share today. Texas banks in the 1990s were small by today’s standards. But they all failed because they were not allowed to bank outside of Texas. Savings and loans in the 1980s, individually, were not big. But they were excessively concentrated and required hundreds of billions of dollars of taxpayer money to be resolved. In the recent crisis, the taxpayer is unlikely to pay a dime for bank failures.

When we acquired Wachovia, it doubled our size but reduced our risk because it doubled the geography in which we operate. I believe that deal reduced risk for the system — as it increased our ability to serve more customers, with more products and in more geographies — and is absolutely positive for the economy.

Isaac: Do you believe that we have, through the Dodd-Frank Act, ended too big to fail?

Kovacevich: Absolutely not. But too big to fail must be stopped. No bank, none whatsoever, should be too big to fail. I worked on this issue with the Minneapolis Fed 20 years ago. Gary Stern [former president of the Federal Reserve Bank of Minneapolis] has been writing books and papers about this for two decades. It’s very simple — the only way we can solve too big to fail is when it’s clear that everybody that supplies capital to a failed bank, except insured depositors, is going to take a haircut [absorb losses] in a failure. That includes the failure of a $300 million bank or a $1 trillion bank. Until we force haircuts on all suppliers of capital to failed banks, we will be living with too big to fail.

Administering haircuts requires a huge liquidity fund from the Fed or from the FDIC because it could take months to fully wind down the bank, and there’s not going to be enough liquidity to do that without the government supplying the temporary funding. But banks should be able to be wound down at no cost to the insurance fund or taxpayers. The cost will be borne by the debt holders, the uninsured depositors, and the common and preferred stockholders. I believe that haircuts will cause those who provide capital to banks to be more disciplined about determining to whom and how much will be provided. Capital suppliers will monitor a bank’s risk appetite more closely, and will restrict additional capital when the risk grows too large and banks become too concentrated. In fact, I believe self-interested vigilance on the part of capital suppliers will be more effective in reducing bank failures than our regulators have been.

Kovacevich: The Fed called us after they completed our stress test and said we needed to raise something like $15 billion in additional capital. I was shocked. I said: “How did you get $15 billion?” They had reduced our earnings forecast. There was very little difference in projected credit losses. In fact, the Fed actually had our credit losses a few million less than ours really were. Where you would expect there might be differences, such as operating expenses, there were no differences. Instead the Fed had reduced our revenue forecast by more than 30%, which was the sole reason they had reduced our earnings forecast. I said: “What?” Just making sure I understood.

Isaac: Something tells me you didn’t just say “What?”

Kovacevich: “So you are saying that between May and November, our revenue is going to decline by 30%?” The answer: “Yes, that’s what our model shows.” I said: “That’s mathematically impossible. I couldn’t do it even if I tried. Let me see your model.” And they said: “We’re not going to show it to you.” How’s that for transparency in prudential regulation?

I pushed back: “How can I accept needing $15 billion in capital when it is based on a revenue assumption that is mathematically impossible?” “That’s it,” they said. “You need $15 billion.” As we stated in our earnings press releases in subsequent quarters, our actual revenue turned out to be even higher than our own forecast. So the Fed’s 30% revenue reduction and $15 billion capital raise as a consequence of that were totally wrong.

Now that’s what happens when you have a strong single regulator.

Isaac: Do you believe that the repeal of the Glass-Steagall Act helped lead to the crisis in 2008 and 2009?

Kovacevich: Not at all. In fact, if we had eliminated Glass-Steagall 40 years ago instead of nearly 15 years ago, this crisis is unlikely to have happened. The biggest problem of this crisis was the nonregulated investment banks that grew to an enormous size and with substantial and concentrated risks under the protection from competition by the Glass-Steagall Act.

One reason why this particular crisis will not happen again is because there aren’t many of these bad guys left. The ones that survived are regulated by the Fed, and therefore there is less chance that they will make these obviously bad decisions of high leverage, liquidity issues and concentrated risk that the SEC totally ignored.

Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges. We don’t have to originate risky structured products or take proprietary trading risk. We have 95 other businesses from which to make profits. There’s no way investment banks can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

the Wells Fargo Way

The benefits of cross-selling in financial services

Kovacevich: If you’re only a lender, the only way you grow is by making more loans. But as you do that, you are increasing your risk and your concentration.

The loan is the hook — that’s what customers want the most. So you have to give them the loan and hopefully some deposits will come in return. But customers buy 14 products from financial institutions — both consumers and businesses — and the majority of those products don’t entail credit risk. They might involve operational risk, but it’s a different type of risk. So you can grow your bank while reducing and diversifying your risk.

Now if you do that, three other things that you haven’t thought of turn out to be true. The cost of selling an incremental product to an existing customer is about 10% of the cost of selling that same product to a new customer. You don’t open up a new account. You don’t advertise. You don’t take other risks.

You can say to the customer, if you bring over your treasury management product, your business or personal insurance, your credit card, your 401(k) or whatever, I’m going to give you a better deal than the competitor who is selling you only one product because of the 10% cost versus that 100% cost. You give a better deal to your customer, and they want to buy more. You benefit because you’re making more profits. You benefit from lower risk, and then finally you have the phenomenon that the more products that customer has with you, the longer they stay with you.

So it’s magic. We reduce cost, increase revenue, make higher profits, have less risk, and the customer gets a better deal. This is a business model for financial services that is far superior to any other one that I am aware of.

Execution

Kovacevich: Let me ask you, is this easy to do or hard to do?

Isaac: Well, I think it’s easier relative to the other approaches because you can sleep better at night.

Kovacevich: No, it’s harder, much harder, because you need to manage hundreds of businesses and products. Systems have to be capable of aggregating products and profitability by customer so you know what more to sell them and what better deals you can give them to incent them to give you more business. You need to be geographically dispersed. We have 100 different businesses out there doing some very complex things that are difficult operationally, and yet they have to work together as if we are one business from the customer standpoint. And that’s why most people don’t do it.

Relevance to management of risk

Kovacevich: Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges and all the standard investment banking activities. We don’t have to originate risky structured products or take proprietary trading risk and so on because we have 95 other businesses to make profits from. There’s no way that an investment bank can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

Isaac: So you’re saying that you believe affirmatively that investment banking and commercial banking need to be mixed together?

Kovacevich: Absolutely, for diversity of risk. And what got us into trouble was they weren’t. I’m telling you that as bad as Citicorp was, if we didn’t have Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs, this crisis would never have reached the level it did. Citicorp survived this crisis, despite doing most of the same things as the investment banks that failed, because it was more diversified, including a deposit base.

The Path To The Precipice

When Sheila Bair became chairman of the U.S. Federal Deposit Insurance Corp. in 2006, the housing market was faltering and subprime delinquencies were on the rise. But even so, analysts were predicting only an 8% drop in home prices and a 15% loss rate in subprime mortgages. No one was taking precautionary action. Within two years, regulators were scrambling to avert the collapse of the banking system.

The following are excerpts from an interview of Chairman Bair by William M. Isaac, Bair’s predecessor at the FDIC under Presidents Carter and Reagan, and currently Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. Bair gives a unique behind-the-scenes view of how the FDIC came to terms with the scope of the crisis and how improvements in transparency can prevent one in the future. She also voices a strong concern for the vibrancy of community banks and the regulatory demands that could stifle their role in economic growth.

As a financial crisis silently loomed in 2006, the FDIC was among the first to see the early warning signs.

William M. isaac: How did you come to realize, so early, that the banking system was in grave danger?

Sheila BAIR: To the credit of the FDIC staff, on the day of my arrival they were talking about the deterioration in mortgage lending standards. We were seeing a marked increase in subprime delinquencies, even in 2006. We bought private data on mortgage-backed securities to try to get a better handle on what was going on. As you know, most of this information was not on the bank balance sheets and therefore not reported to us. What we saw was pretty frightening.

There was already an effort under way to tighten standards for nontraditional mortgages, which are basically the negative amortization products like option ARMs [adjustable rate mortgages]. There were clearly some problems there. Subprime mortgages were deteriorating. So we pushed very hard to tighten lending standards for subprime mortgages and to get the states involved because they had the authority over the nonbank mortgage originators.

I was somewhat in tune with these issues from my days at Treasury, but I credit the FDIC staff for identifying the problems early on. Congress had bills pending to deal with subprime lending issues, but those bills weren’t going anywhere. Ironically, the Federal Reserve had authority to set lending standards across the board for bank and nonbank mortgage originators. But it had decided not to use it.

People said we were being alarmist, and the problem was contained. In researching my book, I’ve gone back to look at the financial market commentary during late 2006 and 2007. Analysts were saying, “Oh, it’s going to be maybe an 8% decline in home prices over a couple of years and maybe a 15% loss rate on subprime mortgages.” That was in line with the groupthink back then. Everybody said housing was going to correct a bit, but it would just be ones with subprime mortgages. The losses would be manageable. So I credit the FDIC staff with being on top of that early and understanding it could affect the insured banks as well. However, nobody, including people at the FDIC, thought it was going to get as bad as it did.

A lot of that will be contained in the living wills and resolution plans. The critical exposure reports, if properly implemented, could be a huge boon. A key bit of information that we were missing: If a financial institution goes into an FDIC resolution process, or if a nonbank goes into a bankruptcy, what’s going to be the impact? Who’s going to take the losses? We just didn’t have that information. We didn’t know who the counterparties were. We didn’t know who the bondholders were. It was very, very difficult. And so the credit exposure reports now put the onus on the institution to basically tell the regulators: If they fail, who else could be materially affected? Or, if some other institution fails, will it have a material impact on the bank or its holding company? I think that’s huge.

Isaac: A lot of people are concerned that we’re going to lose a large part of our community banking system.

BAIR: I believe community banks should be strengthened by recent events. People are not angry at them. People want the high-touch banking that they can provide. Though we had a fair number of small bank failures, on a percentage basis the amount of distress in the smaller banks was significantly lower than it was with the large institutions.

Small banks weathered the crisis pretty well. The big issue is regulatory burden. I’m a regulator. But I believe in common sense and efficient regulation. A lot of the reforms are targeted toward practices that you find in larger institutions. If we just layer lots of new regulations on everyone, even though they don’t really have anything to do with what small banks do, we are going to hurt the community banking sector.

So before I left the FDIC, I started a community bank impact analysis of any proposal that we were going to move forward. We did a community bank impact statement once a rule or proposal went out.

I hope the new consumer protection agency in particular will be sensitive to this issue, because many consumer compliance rules can be quite daunting to a smaller bank. A lot of smaller banks would like to do more in the consumer banking space, but they are reluctant because of the expense. There is some valid concern there.

At the same time, we need to simplify the rules because, frankly, one of the reasons consumer regulation has been weak is that it’s so complex. Consumers can’t understand what their rights are, much less the products. So simplification could really help the community banks and consumers. 

Restoring A Shaken Citi

When Richard Parsons was named chairman of Citigroup Inc. in January 2009, the bank had just announced an $8 billion quarterly loss. It was on the brink of being nationalized.

Parsons sat down with William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, to recount the harrowing experience of preventing one of the world’s largest banks from collapsing. To Parsons, the government played a major role, and he is less critical of its actions than many of his peers. He argues, for example, that TARP [Troubled Asset Relief Program] and its follow-on measures helped restore confidence in the banking system.

Fast-forward to the present: Citi posted profits of $10.6 billion in 2010 and $6.2 billion in the first half of 2011. Having brought Citi back to life, Parsons articulates the bank’s leadership role going forward, including its commitment to housing finance.
The following are excerpts from the interview.

William M. isaac: What was it like being at the top of Citi during that period?

Richard Parsons: Citi was perceived to be the worst of the worst of the big guys. So trying to navigate that was a challenge. In my view, and I’m certain that it was the view of Tim Geithner [then president of the Federal Reserve Bank of New York] and every thoughtful person in Washington, we just couldn’t let Citi go down. The federal regulatory establishment was committed to the general proposition that we had to figure out how to get this big bank through this crisis — and in a way that was defensible given the toxicity of the environment. We had to figure it out and try to avoid making a mistake that could cause the bank to implode.

It was dicey because it’s all about confidence — whether it’s depositor confidence or counterparty confidence. One of Citi’s issues was that a huge part of its balance sheet and operations was funded in the wholesale markets. If those markets were closed to you, or if investors got spooked, your funding might disappear overnight. So we had to make sure we were doing the things needed to keep the markets calm. Then there was the heat of the battle in Washington. Every bank and all the bankers had become pariahs to many of my good friends and colleagues in the Washington establishment. Bank bashing and fat cat bashing were in vogue.

Isaac: How do you view the way the government handled the crisis? How would you grade its effort?

Parsons: B+. I’m talking about how the government handled the crisis once it was on us. I really do think the system could have melted down. I was told by the Treasury Department that there was about an hour on the Tuesday after Lehman collapsed when interbank trading around the world stopped. Nobody would clear anything. It just halted.

The financial world could have been thrown into total chaos. The government’s response, putting TARP in place and the follow-on measures thereafter, salvaged at least some confidence in the system. The bottom line is we worked through the crisis.

Isaac: But Lehman is part of that story in terms of the government’s actions, right?

Parsons: Certainly, it started off badly. But even if Lehman had been bailed out the way Bear Stearns had been, then the next one would pop up. There could have been more forethought to the handling of Lehman. But I’ve heard people argue that Lehman had to happen, so the sooner the better.
From the failure of Lehman forward, the government’s response was pretty good. But neither our government nor the industry did a good job of communicating why the financial system is different from other privately held industries, and the consequence of letting the financial system slip into chaos. So the angst and the anger caused by the crisis and the government’s response to it were higher than they needed to be. The situation was not helped by the handling of AIG — how we dealt with credit-default swaps and who was made whole without participating in any of the pain. In hindsight, I’m sure people would look at that and say we could have done a better job.

Isaac: What is Citi’s future?

Parsons: Here’s the way I think of it. Citi right now thinks of itself as being in three businesses: institutional or wholesale banking, retail banking, and global transaction services. GTS operates in about 96 countries but serves clients in 140 countries around the world. We have by far the biggest global footprint of any U.S. bank. HSBC is a distant second to Citi in terms of its global footprint.

I think of this GTS system as a circulatory system of the corporate body. It doesn’t have the highest amount of reported net income, although it’s highly profitable. But it connects all the other parts, both in country and across borders. We have a new tagline at Citi, which hasn’t actually been publicly promulgated yet: “America’s Global Bank.” Citi is going to continue to provide connectivity for its largest institutional clients and particularly for the top 5,000 corporations in the world.

Isaac: You said that the GTS is not the most profitable part of Citi. What is?

Parsons: It will bounce back and forth between the securities and banking business and the retail business and cards. Credit cards for a long, long time were a quarter of Citi’s earnings.

Isaac: Is there a future for housing finance at Citi?

Parsons: Yes, there has to be. The most stable and therefore valuable source of funding is deposits. If you’re going to be in that business, you’re going to be dealing with retail customers. You have to have a full suite of products and services to keep them there. You can’t just say, “Look, we want to take your deposits, but we don’t do anything else.”

There will continue to be a significant residential and commercial real estate component to Citi here in North America. But the old business of having a whole network of mortgage brokers out there so that you can get the mortgages and run them through the warehouse, package them up and sell them off as securities — that’s gone.

Then, European corporations sent their treasurers from bank to bank shopping for the best deal, and capital was there for the asking.” Today, however, there are new banking regulations, loan structures and products, and the bankers themselves have changed. “It might take 10 calls within a bank to find the right person for a CFO to speak with, and then she still might hear ‘No’ several times before she hears ‘Maybe,’” says O’Callaghan. That, he notes, is especially true in Europe, where “a mountain of corporate refinancing” is chasing a competitive, finite pool of capital. “C-suite executives who never viewed refinancing as a priority will be getting a rude awakening during the next 18 months,” he predicts.

A Revitalized U.S. Loan Market In the United States, where acquiring capital through the high-yield bond market is a much more accepted and developed business practice than it is in Europe, most companies find that route open again after steep declines in 2009. The high-yield bond market had one of its best years on record in 2010 in terms of volume, with $259 billion of new issues. Merger and acquisition activity was also strong, with $43 billion in leveraged buyouts and $37 billion in dividend recapitalizations. By the fourth quarter of 2010, U.S. lending was up 100% from the previous year. “The increased inflows to the bond market and the leveraged market meant there was more capital available to lend,” says Kris Coghlan, senior managing director, Corporate Finance/Restructuring, in the Philadelphia office of FTI Consulting.

From the perspective of U.S. bankers, “the loan market is the healthiest it has been recently, certainly since the fall of Lehman Brothers and arguably since the summer of 2007,” says Joseph P. Powers, senior vice president and marketing manager for Bank of America Business Capital. “Once banks built fences to contain their problems and began to get their own capital ratios in order, they started seriously looking for opportunities to lend.” A dramatic improvement in corporate-bond default rates — from more than 10% of all bonds in 2008 to less than 2% recently — also reassured banks that companies again had become reasonable credit risks. “For quite some time, Bank of America and other institutions have had many billions of dollars of available credit that went unused because companies reacted rationally to the severe economic downturn and weren’t borrowing to build plants, invest in inventory or start hiring,” says Powers. This situation is beginning to change, though, as companies become increasingly bullish on the recovering economy. “Our outstanding loans are still down from where they were before the crisis, but we are prepared to lend aggressively, and that’s true for mostbanks,” says Powers.

Good Credit, Bad Credit

As lenders compete to get loans on their books, companies with high quality credit profiles are being offered interest rates 50 to 100 basis points lower than what they could have gotten a year earlier, along with more favorable covenant structures. Dividend recapitalizations are also being considered, Powers says. Large deals of more than $100 million might command rates of London Interbank Offered Rate plus 250 to 300 basis points, while interest rates may be even more competitive for middle-market companies seeking smaller loans. “There is less discipline for banks doing local lending on smaller deals than there is in the broader syndicated market,” says Powers. “Middle-market companies, even those with somewhat marginal credit, may be able to get great deals from local lenders, especially if there are a number of banks vying for that business.” Companies with a more challenging credit story face an evolving plateau. “Companies that have had some trouble can still get loans, but they are not priced anywhere near as favorably as they were before the crisis,” says Carlin Adrianopoli, senior managing director, Corporate Finance/Restructuring, in the Chicago office of FTI Consulting. “Nor are banks lending as much to these companies.” Each situation is unique, but in general, says Adrianopoli, a bank will lend a troubled company as much as 3½ times EBITDA , while, for those with good credit, it’s 4½ times EBITDA . “And whereas before the downturn, there could be a spread of 100 to 150 basis points between the two types of loans, now you’re looking at a spread of 200 to 300 basis points,” he says.

Even companies that haven’t had past credit problems may face skepticism about overly bullish business projections. “Banks these days are much less forgiving of a hockey-stick business plan for which a bridge to an acceptable EBITDA or an acceptable level of earnings is built into the forecast but hasn’t yet been achieved,” Adrianopoli says. “You will have a much tougher time commanding competitive pricing with a business plan that has an unproven level of growth than you will with one that demonstrates a track record of earnings.” Companies turned down by their banks have other options, including mezzanine lenders — hedge funds that will take a second lien or a junior position behind a bank on lending in exchange for a higher return on an investment. “Hedge fund lenders are out raising capital again and have resolved many of their portfolio-management issues,” says Coghlan. “They’re optimistic that they’ll get back into the lending market, which will create available funds for underperforming or distressed companies.” And while a traditional lender won’t lend these companies more than 3 to 3½ times EBITDA , a mezzanine provider may be willing to go as high as five to six times EBITDA , says Powers. Private equity investors are another option. “Companies without good credit that are looking for capital don’t have to restrict themselves to a traditional bank lender,” Powers notes.

A More Stringent Europe

In Europe, however, to be considered for a loan, companies may have to measure up against a much longer list of criteria. Some banks will lend only to corporations with headquarters in their local jurisdiction, for example. Others routinely turn down loan requests from companies in certain industries, including construction and real estate, or they may court only those in sectors in which the banks have had successful deals in the past. “If you understand a bank’s sweet spot and can tailor your request, asking for financing becomes an easier conversation,” says Mark Dewar, senior managing director, Corporate Finance/Restructuring, in the London office of FTI Consulting. Banks can afford to be highly selective because there are far fewer traditional institutions willing to take a pure lending position on deals in Europe today. “In the past a number of banks would have been quite happy putting £30 million to £40 million to work at LIBOR plus 250,” says Dewar. “Now banks have to pay an internal capital charge against that money, and the economics don’t work out unless the bank can, for example, also underwrite a bond issuance for the company or generate additional income through ancillary business such as hedging or cash-management services.”

That’s not a concern for very large corporations or very small ones. “If you are on the top of the pile, you’ll always get your financing, no problem,” says O’Callaghan. “And there are political pressures on banks to keep lending to small companies so they’ll also get the financing they need. It’s the midmarket corporates wanting to borrow $50 million to $200 million that can end up in a difficult place because they’re not big enough to go to the debt capital markets — you need a minimum of $200 million to $300 million for that — and they don’t generate enough ancillary fees to support a large syndicate of banks. Many of these mid-market companies have loans that are maturing, and it’s unclear where they’ll get the money to pay off those obligations.”

One strategy for dealing with that uncertainty is to refinance existing loans now, even if a loan doesn’t mature for another year. “You may pay a premium over today’s rates to refinance early, but that may be a price you’re willing to pay to secure future financing,” says O’Callaghan. And that approach could be preferable to seeing your company’s valuation take a hit if investors get worried. “There’s a tangible link between securing refinancing and valuation of shares,” O’Callaghan says. “If there are concerns about your ability to refinance, then it clearly will affect investor sentiment.”

European executives also need to embrace the American model of asset-based lending and bonds as part of a company’s financial model, O’Callaghan adds. “As a result of regulatory requirements, traditional European credit lines and products now can carry some of the highest capital charges for the banks, whereas asset-based lending often carries the lowest charge, and bonds are even better for banks because they involve only a fee and not a hold position,” he says. “In America asset-based lending is highly sophisticated and accepted, but some European corporations wrongly see it as a last resort. And there is a much longer history of U.S. companies going to the bond market to finance debt than there is in Europe. It’s going to be a cultural adjustment for European companies.”

Lenders as Strategic Partners

On both continents, forging strong relationships with bankers, always important, has become an absolute necessity. “More than ever, CEOs and CFOs need to view their lenders as strategic partners,” Adrianopoli says. “The business environment can change quickly, so you need lenders who are willing to stand by you through business cycles and are ready to capitalize on opportunities. You don’t want to be the CEO who comes to his bank group only when something is wrong. Lenders hate surprises, and they hate it when you talk with them only when things are bad.”

Adrianopoli recommends that companies with a syndicated loan involving several lenders use the lenders for each aspect of their financing needs, such as for hedging and cash management. Developing multiple relationships within your banking group may cost you more in banking fees, “but your lenders will be more in tune with your financial needs than if you’re viewed as simply another loan,” he says. Often, flexibility is at least as important as pricing. “You want to make sure that your loan gives you an adequate line of credit for short-term liquidity needs, that it has a flexible capital structure so you can repay your debt early with limited penalties, and that the lenders will be receptive to a business acquisition opportunity or foreign expansion if that’s what you need,” says Adrianopoli. A lender that markets itself to your industry may be a good fit for your company, but only if the bank has a track record of staying with businesses through good times and bad, he notes. “A bank’s expertise in lending to particular sectors shouldn’t be the only deciding factor,” he cautions.

Also new is the need for the CEO and the CFO to get involved in choosing lenders and “proactively engaging in the lending process,” says Dewar. That’s a departure from the passive slamdunk refinancing that a corporation’s treasurer would have handled in years past. Talking with bankers today requires the same careful crafting of mission and message that corporations rely on to prepare for a stock offering or an M&A deal. “You have to be ready to articulate your credit story in a concise and compelling way and realize that bankers are carefully listening to what your customers, your creditors and the analysts are saying about you,” says Dewar. “Demonstrating that you have complete control over your company’s finances is key. You can’t have overdue receivables, your inventory turns must be in line with industry norms, and you need a clear view of your cash flow requirements for the next 18 months.”

Proceed With Caution

Though most bankers now appear eager to lend to highly creditworthy companies, any number of economic problems could cause credit markets to seize up again. “Several troubling macro indicators — sovereign foreign debt; U.S. federal, state and local municipality debt; underfunded public pensions and other medical benefits; and long-term unemployment — are present despite a growing bullishness about the economy,” says Adrianopoli. “Until we have true fixes to these problems, be prepared for lending choppiness to come back.” Banks seeking new business may later pull back on their lending criteria and pricing. That’s why it’s crucial to develop a strong relationship with a lending group, says Adrianopoli. “You need to cultivate the relationship so your bank group won’t just walk away from you if the lending and business markets become harder. If you have a flexible lending line and strong relationships, you’ll have access to capital when you need it, you’ll have competitive pricing, and you’ll be able to prosper and grow your business in any lending environment.”

By sitting on mountains of cash until the recession has safely passed, companies may think they are acting prudently. On the contrary, they could be setting themselves up to be overtaken by competitors that have been strategically using their financial resources to make acquisitions, launch new products and create more efficient ways of doing business. Over the course of the 2007–09 recession, as credit markets froze and revenue plunged, companies jettisoned millions of workers and took the scalpel to their budgets, especially in Europe and the United States. Of course, those moves boosted corporate earnings, and companies’ coffers swelled. In Europe, for instance, cash makes up 12% of total assets on corporate balance sheets and is almost a third higher than at any point in the last economic cycle, according to UBS.

Globally, nonfinancial corporations are sitting on $4 trillion in cash today, a full trillion dollars more than they had on their books in 2007, according to Citigroup’s Corporate Finance Advisory Group. Yet, while the National Bureau of Economic Research in the United States reports that the recession officially ended in June 2009, many companies have maintained a viselike grip on liquid capital. Whether they worry about a double-dip recession, a lack of investment opportunities or the need to rearm against Asian competitors, their financial prudence risks becoming a liability. The reason: Competitors are already investing strategically and are gaining substantial ground. In industry after industry, companies like Netflix, W.R. Grace, Banner Health and Maersk have used the recession to invest aggressively in new products, markets and operations. As the global economy recovers, these companies will have first-mover advantages that will be hard for others to overtake.

Firms that keep hoarding cash face a big risk of being left behind competitively and frustrating multiple constituencies that want them to deploy their capital. Because returns on cash are at historic lows, investors are taking a dim view of many companies’ cash positions. A survey by the law firm Schulte Roth & Zabel in late 2010 showed that excessive cash positions would be the primary catalyst of investor activism over the next 12 months. Political pressure is being brought to bear as well. In February 2011, in an address to the U.S. Chamber of Commerce, President Obama implored CEOs to start investing and hiring, pointing out that “American companies have nearly $2 trillion [in liquid assets] sitting on their balance sheets.”

Yet the most important reason for getting off the sidelines and deploying that cash is neither shareholder pressure nor political cajoling. It is that companies will lose competitive advantage. According to numerous studies, companies that emerged in the best shape from past recessions had invested more and saved less than their competitors. As a 2002 McKinsey & Co. study found, the companies that came out of the 1990–91 recession the strongest had outspent peers in R&D (by more than double) and acquisitions while maintaining cash balances 40% lower than their competitors’. By spending their cash on pursuing market share, developing new products and opening new markets, they had significantly strengthened their competitive positions. It isn’t too late for companies that have been conservative with their cash to catch up. But the window of opportunity is closing.

Spending cash in all the Right Places

A number of companies have used the recession of 2007–09 to enhance their prospects. Even though the days of economic turmoil are not far behind them, they are already reaping the benefits of their contrarian investing ways. How they invested in the downturn while most of their competitors pulled back is instructive ways. How they invested in the downturn while most of their competitors pulled back is instructive. Consider the case of W.R. Grace. As the recession took hold in 2008, the $2.6 billion (revenue) global specialty chemicals company moved quickly to slash working capital and operating costs. By reducing net working capital days by half (from 106 to 53), Grace freed up $350 million in cash, an amount that was triple its 2007 operating earnings. As the credit markets tightened, that cash became pivotal to Grace’s overseas expansion. The U.S.-based company bought and acquired manufacturing capacity in growing markets from China to Saudi Arabia to Brazil.

Those investments are already paying off. In 2010, Grace’s sales from overseas markets increased 13% over 2009 — more than four times the firm’s overall growth (3%). More important, the company, whose products include catalysts for oil refineries and plastics manufacturers, expects emerging markets to be virtually the only source of growth in those two industries over the next three to five years. Grace’s new factories are critical to its participation in that growth. Grace’s lesson: Reinvesting cash strategically is as important as reducing costs and working capital to free up that cash. “There is a direct correlation between the reductions we made in working capital and the cash we had available to make investments in emerging markets,” says the firm’s chief financial officer, Hudson La Force. These lessons apply to companies that are as different from process manufacturers like Grace as baseball is from cricket. Take Banner Health, a $4.7 billion (revenue) U.S. healthcare provider that owns 22 hospitals.

In the recession, the company not only had to contend with flat or declining patient volumes, but it also had to prepare for the healthcare industry’s looming day of reckoning: healthcare reform legislation. Hospital systems like Banner face a future of declining public and private reimbursements for treatments and hospital stays. And because future reimbursements will be tied to the quality of care, Banner’s senior management knew the company had to upgrade facilities and medical equipment. Indeed, it has — to the tune of more than $1 billion in construction projects for new and existing hospitals. W.R. Grace and Banner Health could have conserved their cash until the financial storm had long passed. The stockpiles of cash that companies around the world are sitting on today suggest that many firms have done just that. Yet both companies decided to invest and strengthen their competitive positions. They and other companies that exit the recession having laid the building blocks for growth are likely to outrun competitors that continue to hoard their cash.

Deciding where to Invest: The stories of Netflix, Polo Ralph Lauren and Maersk

So if companies decide it’s better to spend strategically today than continue to save, where should companies invest? To be sure, the answer will be different for every firm. The right opportunities depend upon a firm’s unique circumstances: the markets in which it sees the greatest potential, its core capabilities and competitive position, the unfilled needs of its customers and more. The stories of companies that have aggressively deployed their cash during the recession provide useful insights on where to look. I’ll organize these stories into three categories: new products, new markets, and redistributing work around the world.

New Products Netflix is the world’s largest movie subscription service. The firm has gone from launch in 1997 to $2 billion in annual revenue today and has 12 million subscribers. It is led by Reed Hastings, its CEO and co-founder. Hastings has long believed that, although DVD rental by mail will be a source of growth for Netflix for many years, subscribers will increasingly want the immediate response of movies streamed over the Internet to their television screens. In 2007, Netflix began investing in software that would enable streaming on other companies’ devices, such as Blu-ray players, set-top boxes, game consoles and TiVo DVRs. Netflix was faced with a big investment, one that could have appeared untenable as the economy began backsliding into recession. But the company didn’t flinch, making streaming a focus of its research and development efforts. Between 2007 and 2009, Netflix doubled R&D spending from $70 million to $140 million. Meanwhile, it ran down its cash balance by two-thirds, from $400 million at the close of 2006 to $134 million at the end of 2009. Today, Netflix’s investments during the bleak years look prescient. In the third quarter of 2010, two-thirds of its subscribers were streaming movies online, nearly double the number in mid-2009. The company’s revenue last year was 80% higher than 2007’s, and profits have soared 140%. At the end of 2010, Netflix’s cash position was on the mend, rising to $194 million. These numbers have clearly dazzled investors. Netflix’s stock more than tripled in value in 2010 alone. Since 2007, the share price has risen tenfold.

New Markets History shows that recessions spread pain unevenly around the globe. While demand can be moribund in a company’s home market, emerging economies can offer lucrative opportunities. The combined gross domestic product of the BRIC countries (Brazil, Russia, India and China), for instance, is now almost 70% of Europe’s aggregate GDP. But what’s more remarkable about the $11 trillion BRIC GDP is its impressive growth. Between 2000 and 2008, the BRIC countries contributed almost 30% to global growth, compared with 16% in the previous decade. Since the start of the crisis in 2007, the BRIC countries’ contribution has risen to 45%, according to analysis by Goldman Sachs. Companies like Grace believe that rapid growth requires participation in emerging markets. “If you are a global company, as we are, and you are not investing in these markets today, you really run the risk of falling behind,” says CFO La Force. Polo Ralph Lauren is another global company that took this to heart three years ago and ramped up its investments in Asia-Pacific. The $5 billion (revenue) apparel and fragrances company began buying its Asian licensees in 2008, believing the product range they offered was too narrow and their inventories too low. With sales of luxury consumer goods exploding in Asia, the company needed to capture a bigger share of the pie. At the beginning of this year, it acquired its South Korean distributor, the seventh successive purchase of a Polo Ralph Lauren licensee in Asia. In a February earnings call, COO Roger Farah made it clear that the firm’s $1.3 billion in cash and investments was at its disposal for more investments in Asian markets. Analysts and investors appear to have no problems with that. The stock has risen from the $70s last July to more than $120 this February.

Redistributing work around the World

This investment category is less obvious than the other two, and many companies have ignored it. But others have made substantial investments and have seen sizable returns. It is about redistributing the work of an organization — the activities of the finance department, information technology, customer service and other support functions — to take advantage of such conditions as lower labor costs and preferential tax treatments in other regions. A great example is the $60 billion Danish conglomerate A.P. Moller- Maersk Group. A major ocean shipping and energy firm, Maersk has been slowly but steadily building global “shared services” operations since 2003. Based in six centers in India, China, the Philippines and Denmark, these operations have enabled Maersk to standardize and reduce the costs of support functions, such as finance, accounting, human resources and IT.

In 2008 the global economic downturn produced the most challenging year ever in the container business. In response, as well as taking aggressive steps to cut costs, Maersk accelerated its investments in shared services. The company set a target of increasing the share of finance and accounting work done by the centers from 30% to 70%. Over 18 months Maersk hired 1,200 additional people for shared services, absorbing finance and accounting operations from 85 countries. The result: The operations are better standardized; the costs of those operations were reduced by 10% in 2010; the savings will increase as the remaining countries are rolled in and the new processes stabilize; and Maersk has a cost structure that better positions it to compete as the global economy recovers.

Getting past the obstacles to investing in lean times

Should every company follow the lead of Netflix, Maersk, Polo Ralph Lauren and W.R. Grace and make major investments in new products, markets or operations in spite of uncertain economic times? Shouldn’t some companies hang on to their cash until better times are clearly ahead? For most, we think not. almost every company has opportunities for growth in bad times as well as good.

Take the chemicals industry. Even though it doesn’t seem like a sector with high potential during a global manufacturing downturn, W.R. Grace found prosperity in distant lands. In any event, it isn’t necessary to hold on to a pile of cash for future needs such as making an acquisition. As Tenet Healthcare chairman Edward Kangas says in our roundtable discussion in this edition, “It’s generally better to arrange a large line of credit for that purpose than to keep a lot of cash.” Highly leveraged companies may have more urgent priorities for their cash, such as shrinking their debt. Firms uncertain about repaying maturing loans might consider refinancing and extending maturity dates first. (See “Restricted Access,” page 34.) But once they’ve straightened out their capital structures, even these companies should seek profitable investment opportunities. We do excuse some companies from investing during the downturn. Managers in mature sectors with more capital than they can profitably invest should consider returning it to shareholders through share repurchases or dividend increases. Or they might consider merging or being acquired, especially if they operate in a sector that is consolidating. But there is risk in doing nothing: Companies that are neither acquirers nor acquired may be marginalized by their shrinking market share, or their shareholders may take the decision out of management’s hands by forcing a sale, breakup or return of capital.

We continually hear executives argue against investing too soon. “The economy could tank again.” “Domestic markets are flat.” “Overseas markets are risky.” “We are in a mature sector.” “Deals are too expensive,” and so on. While there is truth in all of these objections, leading companies have managed around them, and in many cases investors are rewarding them for it. Several recent acquirers have seen the values of their shares increase after they announced acquisitions, in contrast to the normal market reaction. Danaher Corp.’s stock rose on the announcement of its acquisition of Beckman Coulter Inc. in February, despite paying a 45% premium on Beckman shares. Cliffs Natural Resources Inc. stock rose nearly 3% on Jan. 11 after it announced the purchase of Consolidated Thompson Iron Mines Ltd. At some point, the majority will follow the minority, and a stampede will commence. Several indicators say it is about to begin. History tells us that companies that deploy their cash before their slower-moving competitors can overtake them.

Amid the hubbub, it is important to remember a central fact about the banking crisis: it was caused by the failure of the sector to deliver in its fundamental societal role – i.e. to provide the economy with its money cabling and pipework, efficiently assess and spread risk, transform maturities and allocate resources where they are needed. The big question is why? Clearly banks are not the only ones to blame, but if we are to avoid an early repetition of the events of the past three years, it makes sense to work out some of the reasons for those events and to address them.

A Higher Purpose

Banks are different than other companies. If a Walmart or a General Motors goes bust, the consequences will be painful for thousands of workers and investors, perhaps even taxpayers. But there are alternative suppliers. The failure of a bank, however, creates serious practical problems for its customers, triggers panic and has repercussions that can be difficult to contain.

Our banks are essential to our way of life to a degree greater than their mere commercial role would indicate. But that lesson was not learned from the costly savings-and-loan problems at the end of the 1980s or the LTCM hedge fund crisis at the end of the 1990s, or the many other incidents that might have been taken as warnings that all was not well with the financial system.

This obliviousness had a parallel in the culture. Oliver Stone had intended Gordon Gekko – with his “greed is good” ultra-laissez faire credo – to be a cautionary tale. What happened? Thousands of young bankers emulated Gekko’s look, with greased-back hair, two-tone shirts and colorful suspenders.

Similarly, in a widely cited article in the November 2008 issue of Portfolio, author Michael Lewis recounted that when he wrote his 1989 book Liar’s Poker, which told of the reckless culture he found as a young banker working for Salomon Brothers, he too expected it to serve as a warning to readers. As Lewis writes: “I expected them to gape in horror when I reported that one of our traders lost $250 million, but six months after Liar’s Poker was published, I was knee-deep in letters from students who wanted to know if I’d any other secrets to share about Wall Street. They’d read my book as a how-to manual.”
These stories characterize a view of capitalism as being most effective when untrammeled. But the lesson of the past three years – at least from this European’s point of view – is that it ain’t necessarily so.

Feeding the Beast

Lewis’s Portfolio article goes on to chronicle, mainly through the more recent experiences of hedge fund manager Steve Eisman, how the culture fomented in the 1980s culminated in the subprime feeding frenzy of the past decade.

Subprime can be taken as the near-fatal symptom of the collision between Main Street and Wall Street, brought about by the reversal in their traditional relationship. Whereas the banks’ primary role should be to lend to businesses and individuals to facilitate their commercial activities, they encouraged people to borrow, sometimes recklessly, in order to feed the “originate-and-distribute” model that relieved them of any responsibility for loans that defaulted.

In a reality-based market, subprime lending should have been a small, specialized corner of banking, lending at appropriate terms to those with bad credit risk. Instead, it grew to account for 14% of all first-lien U.S. mortgages, with a nominal value approaching $2 trillion. Other variations of mortgage-backed securities and collateralized-debt obligations grew and proliferated, with credit-default swaps supposedly mitigating the risks.

The terms of the loans – eight or 10 times loan-to-value against mobile homes and low-cost urban dwellings – were virtually guaranteed to lead to default. It was a transaction-driven market that gave little attention to traditional models of risk management.

Because banks are essentially “virtual” businesses – their products are almost all variations of accounting entries wrapped up in legal contracts – they can scale up to the extent their regulatory capital ratios and processing systems allow. They also have a nearly limitless appetite for complexity.

So not only did banks balloon in size but too many managers didn’t fully understand their products or appreciate how these products impacted each other. When the financial system began to implode, another inherent weakness of banks was exposed: the fragility of liquidity. Funding short term in order to lend long makes banks susceptible to issues of confidence in both retail and wholesale money markets (as Bear Stearns learned after losing access to the overnight repo market). To paraphrase Warren Buffett, when asset prices fell and the liquidity tide went out, some banks were caught naked.

Regulatory Renaissance

What allowed this to happen was a combination of several factors:

• the blurring of the lines that had separated commercial banks and investment banks since the passage of the Glass-Steagall Act in 1933;
• high liquidity and low interest rates;
• neffective regulation in areas such as capital standards and the use of ratings;
• a focus on “fair value” as an accounting driver.

The dismantling of the Glass-Steagall Act was done bit by bit under various governments over more than two decades, with legislation usually following practice; but the biggest symbolic piece in the U.S. came with the Gramm-Leach-Bliley Act – also known as the Financial Services Modernization Act – in 1999, which essentially reversed the last vestiges of Depression-era rules.

U.S. President Barack Obama now appears likely to rebuild some of this regulatory architecture, with proposals tabled to separate federally insured bank business from proprietary and speculative activities. There are also proposals to overhaul the oversight structure, with some calling for a lesser role for the Federal Reserve, giving senior authority in an oversight council to the Treasury. Whatever structure is adopted in the U.S., it is likely to set the tone for the rest of the world.

The UK is on course to rebuild some of its regulatory defense walls that had been dismantled, and strengthen its key regulators, such as the Financial Services Authority. But specific proposals to shore up the capital bases of UK financial institutions – including “contingent capital,” a kind of quasi-equity, and a levy-based resolution fund – are controversial and still under discussion. As countries steer a course between the need for a better-regulated system and maintaining competitive advantage, it remains to be seen what oversight gaps might be left unfilled.

However, change must go beyond legislative reform, for it wasn’t simply deregulation on its own that can be blamed. Regulators on both sides of the Atlantic went into this crisis with the powers to approve or disapprove key management, the powers to vary capital to their own requirements and the power to stop individual institutions from doing business they didn’t like the look of. But most regulators didn’t exercise those powers.

Macro-Prudential Supervision

There was also egregious failure in terms of macro-prudential supervision – i.e. supervision at a level that takes into account the broader economy – with no one looking at the whole market and saying, “we have high asset prices, too much liquidity – we need to prick the bubble.” Or, to borrow the phrase attributed to William McChesney Martin, the Federal Reserve’s longest-serving chairman, central bankers failed in their primary role, which is “to take away the punch bowl just as the party gets going.”

In the UK, there was no role for macro-prudential supervision in Prime Minister Gordon Brown’s regulatory construct, where it fell between the stools of the Treasury, the Financial Services Authority, and the Bank of England. One of the starkest illustrations of this was the way Icelandic institutions were able to collect £10 billion from UK depositors. That couldn’t have happened in France, where bank regulation has historically been more intrusive.

The New Normal

What should a new regulatory system look like? There are three main elements required for effective regulation, two of which are relatively simple conceptually and one that requires a fundamental shift in thinking about bank governance.

The first element is macro-prudential supervision. This will help to keep banks safe from policies that may facilitate asset price bubbles that draw in borrowers and lenders alike, often at the wrong point in the economic cycle. Oversight requires less bureaucracy and more bright people (with lots of data) who are savvy enough to spot out-of-control liquidity and asset prices, and consequent bad borrowing and lending practices, and are empowered to stand up and say “Okay, we are approaching dangerous territory.”

The second element is customer protection. While fairly straightforward to design, implementation is another matter, as highlighted by the opposition to the proposed U.S. Consumer Financial Protection Agency. Opponents have argued that such an agency could stifle competition and raise the cost of finance for consumers. Its supporters argue that buyers of financial products are inevitably at a knowledge disadvantage compared with the providers, and need protection. It’s a battle about getting the right balance of red tape and market freedom.

The final element is also the trickiest: prudential oversight at the institutional level. Any well-run financial institution is comprised of management; the business; the platform – i.e. technology, processes and information systems; liquidity; and capital. Supervisors need to ensure that all of these functions are present and fit for purpose. In particular, regulators must ensure that management is equal to the challenge of running the business and is adequately challenged – by internal firm functions (finance, risk, internal audit, compliance, and legal) as well as by external functions (non-executive directors, auditors and regulators).

The real issue with supervision at the level of an individual firm is the competence of management and how they’ve organized the business. Oversight challenges have been brought to light by the financial crisis. To cite just one example, the head of group regulatory risk at HBOS, the fifth largest UK bank, claims he was forced out by management in 2004 when he raised concerns over excessive risk-taking, particularly in large commercial and real estate lending. Fast forward to September 2008, and HBOS is taken over by Lloyds in the days after the collapse of Lehman Brothers. The credit losses which have emerged at HBOS are far larger than anyone could have anticipated.

In the year ahead, a number of regulators are set to introduce requirements for better governance. The new norm will be a separate risk committee with wide-ranging powers and a chief risk officer (CRO) who can only be fired by the board. A further step to strengthen CROs’ independence would be to establish a statutory direct line to the external regulator. This change will be reinforced by new requirements around non-executive directors and the engagement of institutional shareholders. And, of course, the supervisors themselves are reinforcing their processes and their people. However, these changes will not amount to much unless there is a clear benchmark of what constitutes robust internal governance.

Accounting philosophy also needs fundamental reform. Accounting has not served banking as well as it might, with the failure to harmonize between different jurisdictions and the aggressive adoption of “fair value.” Fair value can be the wrong type of transparency – it cements a disconnect between real investment horizons and what the numbers show. It tends to accelerate profit recognition (and therefore bonus and dividend payouts), operating in ignorance of the business cycle to which banks are prone. Bank accounting should be more about evaluating cash flows – a “maturity ladder” approach.

It is somewhat bizarre that regulators determine banks’ capital requirements and accountants determine the quantity of capital in place, yet the two have no formal coordination. Having those two sets of people talking would send the right signal to bankers about the kind of regulatory regime they can expect. It is starting to happen, but there are obstacles in the way – not least a difference of opinion between the U.S. and everyone else.

Sorting out regulation is partly about returning to banking’s first principles. As economist John Kenneth Galbraith said, “The process by which banks create money is so simple that the mind is repelled.” Over the past two decades, the accuracy of that observation seemed to diminish. The banking crisis creates the chance to simplify and clarify, and it’s an opportunity that governments should grasp.

Executive compensation does not simply mean base salary; it is the total remuneration an upper-level manager receives in a corporation. This typically includes benefits such as bonuses, deferred and restricted stock, vesting periods, pensions and perquisites, as well as terms of employment including performance metrics, clawback provisions, and golden parachutes.

A Real Opportunity to Improve Incentives

Today’s situation risks more than bad public relations for public companies: there is a danger of missing out on an opportunity to improve incentives for top managers to increase the long-term value of their enterprises. Taking advantage of this opportunity has major ramifications not only for corporate stakeholders, but for society in general, as it has the potential to create more productive, durable, and valuable companies.

There is a real need to bring a dispassionate analysis to executive compensation and go beyond the superficial caricatures of unbridled greed. Economics can help by shining a light on the purpose of a corporate form of organization and the costs and benefits of comparative mechanisms for aligning executives’ behavior with shareholders and the broader stakeholder community. Keep in mind that well-constructed executive compensation packages are necessary but not sufficient for long-term value creation. 

Recognize the Objective

What is the goal of a corporation? Maximizing the long-term total enterprise value of the firm has long been understood as the chief corporate mission. Simply put, this means expanding the organization’s market reach or improving real productive capacity. Establishing a culture of long-term value creation entails gaining the loyalty and commitment of all constituencies, including employees, suppliers, and the wider community. The key challenge for management is to create the corporate vision, strategy, and tactics to unite and guide all constituents. So much depends on the stock of trust and flow of honest information.

Aligning Interests

A corporation needs to ensure that executive leaders’ incentives are aligned with shareholder interest in long-term value creation. Unlike owner-managers of small firms, executives at large enterprises often have only a small portion of their own equity at stake. However, this disparity leads to a gap in their interest as the “agent” looking after the interest of the “principals” (e.g. shareholders and debtholders). What’s more, they have an information advantage over principals, which can give rise to a serious conflict of interests and accountability problems. The economics of principals and agents helps organize thinking about how the structure of the CEO’s compensation will affect managerial behavior in pursuit of the objectives of the firm’s various stakeholders.

The principal-agent relationship is difficult and costly to maintain effectively over the long run, which means it is critical to take advantage of alternative alignment forces and mechanisms such as government regulation to monitor against fraud and accounting manipulation. In addition, the market for corporate control offers outside active investors and strategic companies a way to act as a disciplinary force against managers who do not maximize the value of their firms and stray too far from their shareholders’ interests. But recent events suggest that this discipline has limitations, especially in the recent era of overvalued equity.

The Role of Corporate Governance

Corporate governance is a mechanism for aligning principal-agent interests and incentives, encouraging accountability. How does it accomplish this? Corporate governance seeks to reconcile the relationships among the CEO, board members, stockholders, and the outside financial community of analysts, bondholders, and other creditors by clearly assigning responsibilities, measuring performance, and rewarding or penalizing managers in line with their impact on the firm’s long-term value creation.

There are some convincing examples that the sine qua non of a well-run, healthy company is effective coordination of the terms of executive compensation with the corporate governance function: rules, monitoring, and other incentives promoting effective relationships among important constituencies. Corporate governance, in theory at least, serves as a kind of “check and balance” for a corporation to ensure that executive compensation packages attract and retain the right people, hasten the departure of the wrong people, and provide incentives for high performance.

Dealing With Short-Termism

A significant part of the problem in executive compensation can be traced to how compensation packages evolved and became more closely tied to short-term stock prices. For example, pay plans have tended to move away from using fixed salaries. Compensation plans are now concentrated in stock options. And deferred stock and stock purchase options, which tend to vest over short time periods, are common. Moreover, options are typically tied to short-run publicly traded stock prices. The table overleaf shows the recent trend of executive compensation increasing in the form of equity.

Of course, CEOs are supposed to be paid for performance, but this shift in the make-up of compensation packages has led to some unexpected consequences: it has skewed managerial decisions to favor the short term and created a marketplace hothouse of overvalued equity. 

The introduction of stock options and restricted stock grants with such features as short-term vesting periods seemed to be the panacea for aligning shareholder and manager interests. Equity compensation soon evolved into the greatest portion of total executive compensation. Simultaneously, its growth facilitated a climate where information became less reliable, although superficially more plentiful, making it increasingly difficult for analysts or investors to make reliable decisions – for example, financial analysts underestimated Microsoft’s quarterly earnings 41 out of 42 times, according to an SEC investigation and cease and desist order in 2002. 

Imagine the CEO of an international engineering and construction company wrestling with whether to bite the bullet and overhaul the firm’s engineering software and invest in an even more costly three-year employee training program. If implemented, the costs of the investment could impact earnings and the company’s share price, affecting the CEO’s various stock options and restricted stock share over the next three years. Delaying the investment may benefit the value of the CEO’s personal stock options, but the longer he waits, the greater the decline in long-term company and shareholder value as his engineers continue to fall behind.

Linking Compensation and Corporate Governance

So, what can this analysis tell us about the present controversy over executive pay packages? Is the controversy symptomatic of a real problem, or an unfortunate matter of timing and appearances? What is clear is that executive compensation and corporate governance are inextricably linked and substantial effort and cost are required to better align incentives and reduce opportunism of all corporate stakeholders – top executives, board chairs and members, stockholders, debtholders – and the financial community.

The seminal idea behind the use of restricted stock grants and stock options was to enhance the performance of managers, or make “pay for performance” a reality in the corporate world. But the situation was still far removed from the ideal of all responsibility and the fruits of performance concentrated in the owner-manager. Granting stock options or restricted stock shares that vested quickly or over short time-horizons contributed nothing toward managers having “skin in the game.” (Private equity, hedge funds, LBOs and other similar entities have largely solved the “skin in the game” problem in the way that managing partners are compensated.)

It soon became clear that grants of stock options and restricted stock were not free of cost to companies and were also failing to have the desired effect of making top management more vested in companies’ long-term goals. In response, a number of corporations began to require CEOs to purchase and hold stock with after-tax dollars or variants with similar effects. Some companies that exchanged cash bonuses, grants of options or restricted stock for their longer-term equivalents include ADC Telecommunications, Arkla, Avon, Baxter, Black & Decker, Clorox, EKCO and General Mills. FTI Consulting will be monitoring the performance of these companies and others that adopt similar compensation strategies over the coming years.

There are other examples of large corporations changing the way in which they incentivize their leading talent. The CEO and COO of fuel wholesaler World Fuel Services have introduced compensation plans with equity grants that vest only after five years or more and the CEO is reported by Forbes.com to have two-thirds of his personal wealth tied up in stock in the company. Meanwhile, energy holding company PG&E Corporation uses an earnings-per-share hurdle to set its bonus for its CEO. To receive the full amount, the CEO must also meet customer and employee satisfaction targets.

The president of upscale retailer Nordstrom, who happens to be a descendant of the company’s founder, receives a portion of pay in performance shares that vest three years after they are granted and only
if total shareholder return is positive and above the average among retail peers. His shareholdings in his company have an approximate worth of $60 million.

Changing Corporate Culture

Building a culture of responsibility and accountability is essential to address issues around executive compensation. Greater transparency and credible, independent checks and balances are the minimum requirements to regain shareholder and broader stakeholder trust. Companies should also put in place a system that identifies potential conflicts of interests and implements countervailing measures. These include:

• Avoid the inherent risk of hiring the same compensation firm for the rank-and-file employees and the CEO or other top managers.
• Implement a set of measures to monitor accounting and other reporting practices that suggest weaknesses in corporate governance.
• Do not provide multi-period compensation packages.
• Carefully monitor CEO and financial analyst relationships.
• Establish an independent compensation committee composed of board members without CEO participation.
• Commission financial analysis of compensation packages with alternative scenarios and expected outcomes in terms of attraction, separation, and incentives.
• Limit to only the CEO and certain top executives the grant of options and deferred stock, and with these, make every effort to establish true estimates of costs to the company and their impact on the CEO and firm value.

As a critical component of corporate governance, executive compensation must constantly strive to align the incentives of top managers with shareholders and broader stakeholders. As the value added by management is difficult and costly to measure, monitor and verify, this is a complex and challenging undertaking for which much is at stake.

Clearly, ensuring effective measurement and monitoring of the value added by top management is complex and costly but, equally, it is essential for protecting stakeholders and increasing long-term total enterprise value of the firm.

According to the 2009 Survey of Credit Underwriting Practices, the U.S. Comptroller of Currency’s annual bank poll, 96% of the banks polled expected credit risk in their middle market loan portfolio to increase over the next year. The same poll had 67% of banks tightening their middle market underwriting standards this year, the most since the poll’s inception.

Middle market lending picked up smartly in the last quarter of 2009 but remains far below the levels of the mid-2000s. With money center banks focused on larger clients and relationship banking, and many regional banks still capital-constrained by poor loan performance, it’s unlikely that middle market lending will return to these volumes any time soon.

One thing is clear: middle market companies seeking bank loans need to be prepared for a limited appetite for leverage, tighter financial covenants, lower advance rates, shorter tenors, and higher spreads than in recent years. Above all, reluctant lenders are looking for another “C” from potential borrowers:

Credibility

While the balance of power between borrowers and lenders has shifted, borrowers should remember that they are far from helpless bystanders. Here are some of the key issues that bank underwriters are most focused on in evaluating a middle market financing:

Collateral Is King – Right now, collateral is crucial and most senior debt will be secured. Companies with tangible assets of determinate and material value are in a far more favorable position than those with fewer tangible assets. Valuing collateral is also a key issue, as real estate and some types of equipment have been severely depressed over the past year. Those seeking financing should go into bank negotiations with a clear understanding of the value of those assets to be pledged, preferably verified by a third-party source.
Remember that assets are only useful as collateral if they can be controlled by a lender in the event of default and subsequently monetized in a timely and cost-effective manner. 

Evidence of Quality Management Is Crucial – Often overlooked, this factor is of paramount importance in the underwriting process. Banks need to be comfortable with a management team’s qualifications and character. Banks are also scrutinizing managerial performance, since in many cases this provides an extreme data point. Management should have answers to the following questions when approaching lenders for financing: How have revenues held up in this downturn? How were costs kept in line with falling sales? How was working capital managed in the face of the recession?

Ensure Your Financial Data Is of the Highest Quality – The integrity of the borrower’s accounting information is critical. Financial statements must be audited, and controls must be strong. Demonstrating the internal control systems in place should be part of a presentation to lenders, as emphasizing the reliability of the company’s financial reporting systems can go a long way in mitigating any skepticism.

Understand the Role of Projections – Lenders generally expect a sluggish economy to impact the financial performance of middle market companies to a greater extent than large firms, negatively affecting cash flow and staying power. For this reason, upbeat projections are greeted skeptically and it is up to the borrower to convince lenders that realistic economic conditions are incorporated. Management should be prepared to provide detailed support for their projections and underlying assumptions. Even if banks accept these projections as reasonable, financing is unlikely to be provided at anything greater than a senior debt-to-EBITDA ratio above three times.

Use Scenario Analysis – Borrowers should have a firm understanding of a worst-case scenario and a detailed plan to deal with it. Many private equity firms started undertaking scenario planning in early 2008. This planning enabled sponsors to reduce the amount of additional equity injected when refinancing. In 2009, one large European private equity firm was able to refinance more than $1.5 billion of debt with additional equity of less than $10 million. Management should follow suit and prepare a line-by-line plan of how costs will be cut and debt will be serviced if sales fail to meet expectations. In the same vein, management should evaluate potential liquidation scenarios as banks will certainly need to understand them thoroughly.

Understand Your Industry – Traditionally, attractive industries for underwriters are those with low cyclicality and low technology/obsolescence risk because cash flows are more predictable. This downturn has spared few industries, but the risk of obsolescence and the intensity of competition continue to be heavily scrutinized in the underwriting process. Additionally, due to the renewed reluctance of banks to underwrite cash-flow loans for middle market borrowers, companies in asset-light industries such as software, technology, and services may find it more difficult to obtain financing, particularly if there is more than one lender. Those seeking financing should have a firm understanding of their industry, and be prepared to make a strong case to lenders on its attractive aspects, while explaining the company’s plan to mitigate risk from its negative elements.

Know Your Business – Attractive borrowers have compelling products and services, a strong brand name, little customer concentration, and highly credible management teams. Even in lean times, bank funding is usually available to high-performing companies with solid track records. Those seeking financing should know their business inside out, and be prepared to present a strong case on how the company stands apart from its competition. Unfortunately, most middle market companies currently in need of refinancing are doing so in the context of weak demand and stagnant revenues. These companies need to demonstrate how well they have been able to reduce costs and rescale their businesses to maintain margins and profitability. Management should also understand and be able to explain the company’s positioning relative to competitors in the event of a normal recovery and a prolonged downturn.

Reconfigure the Capital Structure – Banks are trying to cushion their exposure to the total leverage in a borrower’s capital structure, often requiring principals to have more “skin in the game.” Additionally, many middle market companies seeking refinancing are faced with weaker recent operating performance and more conservative covenant ratios, meaning less debt will be available to them than when the previous financing was put in place. As a result, companies may need a high equity or junior capital contribution to obtain bank debt. Personal guarantees may be required for smaller companies. In this case, the owners’ finances and credit history will be on full display and can be prepared in advance. Make-whole or capital call agreements, particularly in companies with non-public fund-held equity, may be required.

Be Prepared to Concede on Covenants – Banks are demanding tighter covenants. Borrowers should now expect tight covenants regardless of their credit history or relationship with the lender. More frequent reporting and valuation of collateral may also be required. Management should go to lenders with a willingness to accept these restrictions on any issue made in the near future, with the understanding that if the company does outperform these covenants, they can probably refinance their way out of this burden. 

Examine and Reconsider the Use of a Bank’s Other Services – A history of using the bank’s services such as treasury management or merchant services helps the company secure lending in two ways. First, it makes the company more attractive for the future fees these services will generate. Second, it frames the financing as relationship banking, based on a history of proprietary information gained through multifaceted business interactions.

Self-Help Can Help – Companies can make the process of refinancing faster and easier by undertaking their own self-diligence prior to discussions with lenders. As well as knowing their own strengths and weaknesses, companies can also prepare a thorough analysis of their operating performance, financial metrics, and collateral. It may be worth asking an external advisor to assist with this – a good advisor can bring independent analysis, industry knowledge, greater credibility, and additional manpower.

As economic historians debate whether or not Lehman Brothers could have been saved, it’s clear that the global financial markets crisis of 2008 was entirely a self-inflicted wound, which had been years in the making. There were no external factors or shocks to blame. Quite simply, investors collectively lost confidence in the decision-making and risk-taking practices of large financial institutions, private investment capital and large swathes of Corporate America – arguably with good reason.

In the corporate sector, credit quality had never been so poor going into a recession. As we entered the maelstrom a little over a year ago, some 62% of rated U.S. non-financial corporate issuers were considered speculative-grade by Standard & Poor’s (S&P), of which over two-thirds were considered “deeper junk” (B+ or worse) – a significant deterioration in the distribution of credit ratings compared to a decade earlier. The leveraged buyout (LBO) craze of mid-decade contributed greatly to this phenomenon, with some $400 billion of LBO-related loans made in the U.S. between 2005 and 2007, according to Reuters LPC. European borrowers got in on the act too, with the equivalent of some $580 billion of leveraged M&A loans made during this same period, over half of them earmarked for LBO transactions. Already that fallout has begun; S&P recently noted that 42 of 46 European debt defaults of credit-rated or credit-estimated issuers that occurred in the first half of 2009 were LBO deals gone sour.

Today, even after cleansing the pool of rated issuers of hundreds of defaults that have occurred since early 2008, corporate credit quality remains exceptionally weak. Operating and financial challenges for high-risk borrowers still abound. The damage inflicted on a fragile global financial system from the combination of excessive risk-taking, high leverage and sharp economic contraction cannot be repaired in haste, notwithstanding the impressive rally in global credit markets since March 2009. This article will explore how risky borrowers have responded to largely inaccessible credit markets since late 2008 and the challenges that remain firmly in place even as the global economy seems poised for recovery in 2010. 

How are Financial Markets Faring?

Following the near-death experience in capital markets last fall and the precipitous price declines that continued into early 2009, the recovery in global financial markets has been striking. Conversations have moved on from open-ended bailouts, the nationalization of troubled industries and other dire rescue plans to, ultimately, the realization that the collective commitments and bold actions of policymakers in the developed world appear to have prevented the Depression-like scenario that seemed plausible last December. Yet this is no guarantee of smooth sailing in the months and years ahead, and it is certainly not a harbinger of borrower-friendly credit markets. Capital markets have opened up again to investment-grade and near investment-grade corporate issuers, but global fixed-income investors remain highly selective (and demanding) for riskier issuers.

One striking feature of the environment today is the growing divide that has opened up between investment banks and their corporate and retail counterparts. Investment banks – particularly in more traditional business areas such as foreign exchange – are delivering exceptionally good results. This is because a lot of capacity and capital has been withdrawn from the wholesale markets. By contrast, retail and corporate banking continues to struggle with asset quality and a lack of attractive new business.

As might have been expected, the first beneficiaries of government intervention programs have been financial markets. Equities, in particular, have rallied globally, while corporate credit markets have returned to pre-Lehman levels.

What’s Happening on Main Street?

The recession, which officially began in December 2007, is both a by-product of credit tightening and a contributor to its perpetuation; and this recession has been particularly brutal in terms of its impact on U.S. employment and economic activity and the destruction of personal wealth. Real U.S. gross domestic product (GDP) contracted by nearly 6% in the six-month period ended March 2009: its worst two-quarter slump since 1958. Real median household income declined 3.6% in 2008 – erasing gains of the past three years; and household net worth has fallen by 22% from its peak in mid-2007. Consequently, consumers and businesses alike have become exceedingly cautious in their spending and finance decisions of late – largely by choice, but also driven by market-imposed discipline.

Consumer spending, the main driver of U.S. economic activity, remains in deep doldrums. This is hardly surprising, given that three pillars of consumer confidence have crumbled: house prices (down nationally by nearly one-third), the unemployment rate (more than doubling to 9.8% – its highest level in 26 years) and the value of financial assets such as savings accounts and 401(k)s (down by more than 20% since the peak).

There are clear signs that many consumers have downshifted to survival mode. Monthly discretionary spending totals by U.S. consumers have been consistently lower by near double-digit rates or worse (year-on-year) in most product categories outside of consumables.
Despite talk of early recovery, there is virtually no evidence that consumers are willing to open their wallets without steep incentives, such as the ‘Cash for Clunkers’ program. Survey data consistently shows that about three-quarters of all Americans have cut back on personal spending. Credit-card debt outstanding has contracted at a record rate so far in 2009, while the personal savings rate has moved from nearly zero to its highest level in more than two decades – distinct signs that behavioral changes afoot may be more than just temporary adjustments. 

This state of high anxiety within the private sector is not just an American storyline. Consumer-driven demand in much of Continental Europe remains in contraction and massive government intervention has been required to prop up economies in most Western European nations. Despite recent indications that the recession may have ended in Germany and France, the outlook for private consumption in Europe remains poor in 2010.

Clouds are mostly gray in the corporate sector. Operating earnings for the S&P 500 Index have declined 53% from their peak in 2007, considerably worse than the 32% peak-to-trough decline in the 2001 recession and the 25% decline in the 1990-91 recession. Most companies that are meeting or exceeding earnings estimates in 2009 are doing so as a result of aggressive cost-cutting rather than generating top-line growth.

These tough measures are driving employers to shed staff in record numbers, blunting consumer confidence and reinforcing their reluctance to spend. Until there is discernible improvement in consumer sentiment, it is difficult to foresee any meaningful growth in their current timid spending patterns. Yes, a Depression-like scenario may have been avoided, but a period of prolonged economic weakness or anemic growth remains a distinct possibility.

We should remember that while equities are in recovery mode, the default and employment cycles are lagging indicators, which will continue to generate bad news for many months to come.

What are the Prospects for Corporate Borrowers?

Over the past two years, we have also seen a dramatic change in the composition of the lender landscape. There

are now fewer financial institutions, and those that remain are significantly more risk-averse. New paper issuance by collateralized loan obligations (CLOs), structured finance vehicles which provided so much cheap capital during the peak years, has largely dried up. Other non-bank lenders, such as hedge funds and pension funds, which also fed the leveraged loan market, have pulled back in a big way.

Traditional banks, many of which are either capital-challenged or propped up with federal assistance, are significantly more cautious lenders than previously. All told, new leveraged loan activity remains several hundred billion dollars below peak levels (see Chart A), and this decline dwarfs any buoyancy of new issuance activity in high-yield bond markets so far in 2009.

This much is clear. Big changes in the regulation of banks are coming. The effect of events over the past two years has prompted regulators in major countries to revisit rules and consider sweeping changes. The area of change most likely to affect corporate borrowers is that of capital requirements for banks.

Regulators are almost certain to introduce new rules to limit both the risks that many banks retain and the size of their asset base for any given level of capital. The message here is that banks will need to raise fresh capital just to stay where they are in terms of size. Meanwhile, loan underwriting standards are being raised, too. At best, all of this will make refinancing more challenging and expensive; at worst, over-zealous rule-making could lead to severe deleveraging and credit contraction.

Throw in the unfolding collapse of real asset values, and you have a heady cocktail likely to cause a lingering hangover. Declining residential property values, negative home equity and rising foreclosures have dominated business headlines for a while, but there is widespread belief that commercial real estate defaults are the next headline-makers.

Collateral values underlying commercial real estate debt are widely expected to drop by 35%-40% from peak 2007 levels during this down cycle. Transaction activity has plummeted and Commercial Mortgage-Backed Securities (CMBS) markets, previously a major source of real-estate finance, remain dormant, making the prospect of refinancing maturing debt without additional equity incredibly difficult.

A recent article in The New York Times (citing a widely read Deutsche Bank report) noted that “as many as 65% of commercial mortgages maturing over the next few years are unlikely to qualify for refinancing because of the drop in property values and new stricter underwriting standards.” Deutsche Bank Securities expects loss rates from defaulting real estate loans to exceed 10% of outstanding CMBS loan balances, a loss rate that would exceed the real estate crash of the early 1990s.

Until there is some persuasive evidence that the economic recovery has traction and that businesses are finally starting to expand again, markets for commercial real estate are unlikely to improve. Generally speaking, commercial real-estate markets tend to lag behind the economic cycle by at least one year.

A dearth of deal activity and depressed values in the M&A market are also impeding corporate turnarounds. There is little appetite to do deals at what might have once been considered ‘fair value,’ limiting the options of distressed corporates looking to dispose of assets to provide liquidity or refinance debt. Companies that can afford to do so are biding their time until the deal-making environment improves.

It is against this backdrop that hundreds of billions of dollars worth of leveraged corporate debt and commercial property loans will be maturing over the next five years. The ability of borrowers to meet or otherwise satisfy these upcoming obligations will depend on market-place conditions and economic circumstances outside their control, thus prolonging uncertainty in credit markets and corporate turnaround prospects.

Quantifying the Potential Size of the Refinancing Problem

An S&P study published in May showcases the scope of the future debt threat. The study analyzed nearly $4.4 trillion of U.S.-issued rated non-financial corporate debt, which included loans, notes and bonds. About $2 trillion (or 45%) was rated as speculative-grade debt, and $1.3 trillion of this total – or nearly two-thirds – was rated single-B or lower, a common threshold of ‘deep junk.’ Moreover, of the $1.4 trillion of speculative-grade debt scheduled to mature within the next five years, nearly $900 billion is rated single-B or worse. This is especially worrisome, given the ongoing difficulties of low-rated issuers in accessing credit markets despite the 2009 rally, and the materially higher default rates for issuers rated single-B or worse. The current skew of S&P’s ratings distribution of speculative-grade debt towards deep junk is one big reason why the rating agency is projecting an all-time high spec-grade default rate of 14% during this cycle, and a solidly double-digit default rate one year from now. Charts B and C show breakdowns of maturing debt by current rating and by debt type over the next five years.

For many leveraged loans, most maturities in the 2010-2014 time frame represent incredibly borrower-friendly deals originating from 2005-2007. Renewals at previous levels, terms and rates are most unlikely even for compliant, well-performing borrowers. Furthermore, a sizeable slug of these maturing loans represents LBO financings for deals that were aggressively structured and favorably priced.

In many cases, the new math simply won’t work come maturity time. Reuters LPC data indicates that some $230 billion of U.S. LBO-related term loans will mature within five years. This phenomenon is by no means endemic to the U.S.; Western European nations were also caught up in the leveraged buyout craze and the equivalent of $140 billion of LBO-related term loans will likewise be maturing by the end of 2014. 

Access to revolving credit continues to be reined in as traditional lenders seek to cut the size of new facilities, increase pricing spreads, shorten maturities and enhance collateral packages – in short, reduce their exposure to high-risk corporate borrowers. In May, Sears Holdings agreed to a bifurcated extension of its existing $4 billion asset-based revolver that was scheduled to mature in March 2010. Sears could only manage to get its lending syndicate to extend $2.4 billion of the original first lien facility by two years, despite a generous pricing margin increase of over 300 bps, a LIBOR floor, upfront fees and a BB+ rating. Now that’s risk aversion! It’s hard to believe the original ABL revolver was priced at only 88 bps over LIBOR in 2005.

The withdrawal or restriction of a line of credit can drive trade creditors and other critical suppliers to reduce their own exposures, by changing credit terms or placing riskier accounts on limit. This can intensify the pressure on a struggling company’s working capital when they are most likely to need it. In today’s new credit environment, the negotiating advantage has undoubtedly shifted back in favor of lenders, following several years when it was the borrowers that tended to call the shots. While large global companies often have access to alternative financing options or the ability to generate working capital spontaneously, those inhabiting the most precarious end of the borrowing spectrum typically have little choice but to accept more onerous terms and conditions offered by lenders.

Conservative lending practices and capital rationing by banks will disproportionately hurt small and middle-market companies, since the new emphasis on relationship banking and key accounts naturally favors the largest and most diverse clients that generate business volume and can be cross-sold an array of banking services. Middle-market borrowers are already feeling the neglect.

Patching Up the Wounded

Despite the daunting parade of upcoming corporate-debt maturities, there are no outward signs of panic just yet. Scheduled maturities for 2010 are relatively light (Chart B) and most likely to be manageable under current market conditions. However, the refinancing burden will intensify in 2011 and beyond. Concerned senior executives of underperforming businesses may be working hard to create a meaningful earnings recovery by then, but few are banking on it to save the day, judging by their actions of late.

Compelling evidence of highly cautious attitudes about the corporate credit environment can be found by examining the flurry of amends and extends (A&Es) carried out in 2009, often pre-emptive and usually on very costly terms, for debt maturities that were one or two years away. A&Es are essentially short-term deals that allow a company to extend loan maturities.

For borrowers, A&Es can push out maturities that cannot be refinanced outright, or they can grant financial covenant relief or added headroom until operating results improve. Lenders typically get to re-price these loans closer to market spreads, insert tougher loan covenants and extract lucrative fees as well. A&Es account for much of the recent leveraged lending activity, with S&P reporting over 200 rated borrower requests for loan amendments in the first half of 2009.

The problem with the A&E solution, known as ‘forward-start agreements’ in Europe, is that often it just delays the inevitable day of reckoning. It is a leap of faith by borrowers and lenders that the lending environment and operating conditions will be substantially better in the not-too-distant future. It does nothing to remedy the fundamental problem: too much debt. And given the mountains of debt due for refinancing before 2014, there is no assurance that credit markets won’t be just as tight or selective as these revised maturity dates approach.

Similarly, on the bond side, debt-exchange offers – whereby companies offer bondholders the opportunity to exchange maturing bonds for new bonds with a later maturity date and/or equity positions – have figured prominently in restructuring activity this year. Through August, S&P tabulated 74 distressed debt exchanges of rated securities in 2009 – easily more than twice as many as in the whole of 2008. Like A&Es, these transactions are often viewed as short-term fixes that allow distressed borrowers to buy some time to repair their businesses while achieving some degree of near-term financial relief.

This option is only possible because junior creditors often recognize that they are unlikely to see any meaningful recovery under a bankruptcy scenario, given the present economic environment and marketplace conditions. Ironically, it is the distressed borrower that often has the upper hand in these colorful, if not contentious, negotiations with bondholders, by using the prospect of a Chapter 11 filing as a cudgel to get creditors on board with an exchange proposal. Despite these fervent efforts to stave off payment defaults and bankruptcy, history tells us that many companies orchestrating distressed debt exchanges today will eventually file for Chapter 11 relief.

Both A&Es and distressed debt exchanges are practical responses to the scarcity of fresh capital for perceived high-risk borrowers in today’s new lending regime. But what other options are available, and what should companies facing significant maturities in 2011 and 2012 be doing now to prepare for the refinancing that’s just ahead?

The Potential Fallout

For the legions of companies that financed their growth with piles of cheap debt, the double-whammy of a recession and a stringent credit environment is likely to hasten a showdown with lenders or creditors. While A&Es and distressed debt exchanges might paper over the cracks in the short term, by allowing struggling companies to limp along in an uncompetitive fashion, the pain is merely prolonged, and recoveries for creditors may ultimately worsen.

This backdrop is likely to mean heightened levels of bankruptcies well beyond the end of this recession. Once upon a time, a failing business might still have had new money thrown at it. Nowadays investors or lenders are more likely to be throwing in the towel, or at least be looking at other ways to extract value and maximize recoveries – without necessarily saving the enterprise. Turnaround professionals and interim managers will be utilized more extensively as key players lose patience with incumbent executives in floundering organizations.

While deal-making continues to be difficult, there has been a huge upturn in distressed M&A activity. The Deal recently reported that Section 363 sales – the equivalent of auctioning off a failed entity’s business or assets – have almost doubled in 2009. These days especially, it may take a while to get to a Chapter 11 filing, but once there, the timetable really accelerates for some debtors.

Vulnerable sectors going forward will include a raft of consumer-dependent businesses that are asset-intensive, and burdened with debt or other onerous financial obligations. This extends well beyond the retail sector itself and includes airlines, travel and lodging, gaming, consumer finance, media and entertainment and consumer product makers, among others. In the healthcare sector, retirement homes and assisted-living communities are also looking vulnerable as the falling value of residential real estate and retirement accounts is frustrating the ability of potential new customers to take on units in these communities.

Lastly, consider the state of the banking sector. While some Wall Street banks were considered too big to fail, smaller regional banks will end up being too small to rescue. The irony is that many regional banks were conventional lenders that mostly avoided material exposure to toxic paper, risky financial derivatives and other structured investments that embroiled Wall Street. However, sliding values for commercial real estate, a business mainstay of regional banks, will inevitably impair their collateral and erode capital levels. Many believe the knock-on effect on balance sheets could prompt smaller regionals to fall by the wayside. No doubt the best assets of these failed institutions will be snapped up at bargain prices by national money centers and large investment banks – some of which qualified for previous bailout assistance. 

In all of this, antitrust authorities will likely seek to play a more active role, but their voices may ultimately favor measures that restore corporate profitability and the preservation of jobs. It follows that strong companies should have a good opportunity to pursue in-market acquisitions successfully over the next year or two, particularly if the target would otherwise struggle financially, or go bankrupt.

There Are No Magic Bullets

So what can be done? Most important is for companies to address the appropriateness of their capital structure and debt layering long in advance of refinancing dates, bearing in mind both the new tolerances and valuation parameters of capital markets and the expected persistence of weaker operating earnings in light of the recession.

As previously mentioned, a distressed debt exchange, especially one involving a substantial debt-for-equity swap, is a means by which a troubled borrower can reconfigure an unsustainable balance sheet in the absence of new money, and possibly without the need for filing for bankruptcy. But it requires Herculean negotiating efforts with recalcitrant creditor groups which may end up on the courthouse stairs in any event.

Secondly, companies must focus ruthlessly on driving business efficiency. Many have done so admirably during this downturn, with the retail sector coming to mind first. Large U.S. retailers generally surpassed Wall Street’s low earnings expectations in the second quarter, despite slumping sales and gross margin compression. Such results can be achieved through a combination of cost-cutting, vendor and landlord negotiations, reduced capital investment and better inventory management. Senior executives should keep an eagle eye on subtle changes in critical trends that impact their business, and should understand how key performance indicators can be utilized.

Companies with marketable assets might consider selling some of the family silver to pay down debt. While M&A markets are slow, the deal environment is gradually improving. Sometimes such measures are painful, but necessary. Struggling retailer The Talbots sold the J Jill Group – a business segment it could no longer support, given the distress at its namesake chain – in June to a private equity shop for $75 million. Talbot’s purchased the J Jill chain some three years earlier for $500 million in cash. Even if a sale is not possible straight away, companies can start positioning some dispensable businesses or assets for sale as soon as markets improve.

Which Way Now?

We know that refinancing the dozens of billions of high-risk debt slated to mature over the next few years will be a challenge for most, and impossible for many. While there is a good chance that economic conditions may be showing signs of improvement as we move into a new decade, the consensus points to a slow, below average recovery. It is likely to take several years for corporate earnings to return to 2007 levels, for job prospects and personal wealth to recover enough to kick-start consumer spending and for lenders to shake themselves free of the noxious overhang of bad assets and bad practices that they acquired during the halcyon days of the credit boom.
However, some just can’t hold out that long; others will be unable to earn their way out of their financial predicaments. The term ‘jobless recovery’ is already being bandied around with a casualness that belies the grim reality of the expression for many millions of Americans. To make matters worse, federal budget deficits and borrowing needs will remain exorbitant. It’s not exactly a recipe for optimism.

2010 is certain to be a pivotal year for the U.S. and global economies – a ‘show me’ year in the minds of both equity and credit investors who now fully expect to see fresh, indisputable evidence of positive economic growth and solid earnings recovery, and who have already priced such expectations into capital markets. Many economists, though, are less sanguine about any rosy growth scenario as long as stricken consumers stay planted on the sidelines. The interplay between corporate operating performance and credit market conditions will likely be reinforcing: better than expected earnings may further embolden credit investors and ease access to capital, which will in turn bolster corporate results. But it could work the other way too, with vast pockets of economic weakness that persist into 2010 finally causing financial markets to doubt the adequacy or sustainability of a recovery. How the economy unfolds in 2010 may very well determine whether the debt maturity challenge eventually rises to the level of a crisis. We’ll be watching closely.

Dominic DiNapoli is Executive Vice President and Chief Operating Officer of FTI Consulting, responsible for the day-to-day operations of the company’s five business segments.

The essence of the proxy reform proposal is to allow shareholders who own at least 1% of a company’s shares to have their board nominees included in corporate proxy materials. This would apply to companies with a market capitalization exceeding $700 million. A 3% stake would be required for shareholders of midsize companies and a 5% stake for shareholders of smaller companies.

After releasing a detailed proposal in early June, the SEC received more than 500 sets of comments.  The intensity of the response is not a surprise. As one attorney told The Wall Street Journal, ‘It’s the biggest change relating to corporate governance ever proposed by the SEC. Period. It gives activists the ultimate vehicle to express dissatisfaction with a board, the ability to replace board members at the company’s expense.’

The all-out lobbying battle in Washington has pitted the Business Roundtable, U.S. Chamber of Commerce and National Investor Relations Institute against investor groups such as the Council of Institutional Investors and institutional-investing giant Capital Research & Management Co., as well as some large unions. All agree the present proxy system is too complex, but some argue the SEC isn’t attacking the root of the problem, and instead is approaching reform in a piecemeal fashion that doesn’t take into account how the interrelated parts need to work together.

Critics of the SEC proposal argue more time is needed to ensure the technology is in place to support this new style of proxy voting, and to ensure that corporate issuers aren’t hampered with excessive costs of materials printing, mailing and proxy solicitation firm engagement to get out the retail vote.

The real issue behind the proxy access rules is that it has the potential to simplify shareholder activism and reduce the costs associated with it. Lower turnout and support for board members this proxy season paves the way for bad press, hostile shareholders and heightened activism levels at target companies. The SEC’s proposed rules put few limits on shareholder activists who will find it easier to advance their narrow interests at the expense of the broader shareholder goals.

The New York Stock Exchange’s Rule 452, approved in July, provides a preview of how the proxy reform would work in practice, were it to be enacted. It is likely to cause short-term problems since it eliminates ‘Broker Discretionary Voting’ without providing an easy way for retail shareholders to vote. While the intention of removing brokers’ ability to cast votes for shareholders who don’t return voting material unless instructed to do so may be fine, the consequences could have major adverse impacts in practice. Without new technology to lower the cost for retail shareholders to vote, the rule will likely translate into lower voter participation rates. Board members may appear to get much less support than in the past, making them appear to have lost shareholder confidence when, in reality, there were simply fewer voters. This may have the unforeseen consequence of exacerbating the voting impact of the better coordinated activist or opposition group.

It remains an open question as to whether the SEC will approve changes to the proxy process. If it does, it could lead to a shake-up in corporate boardrooms. What’s not clear is whether the shake-up will be for better, or for worse.