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.