Viewpoint

Now Comes the Great Corporate Deleveraging


After a bleak winter of tumbling stock prices, continual government intervention in financial markets, and contracting debt markets, economic "green shoots" have begun to appear. Stock markets around the globe have rebounded, U.S. financial institutions have received massive injections of private capital, and consumer sentiment has improved over the last few months.

It's nice to see some optimism return to Wall Street and Main Street. But the June 1 General Motors Corp. (GM) bankruptcy filing serves as a stark reminder that the economy remains weak and recovery may be elusive.

Businesses large and small increasingly shifted their capital structures away from equity and towards a greater reliance on debt in the 1980s and 90's. In reaction to the bursting of the dot-com bubble and the recession that followed, the Federal Reserve further primed the pump with a series of interest-rate cuts. According to data from Morgan Stanley (MS), total U.S. debt rose from approximately 150% of gross domestic product in 1980 to over 350% by the end of 2008. As financial institutions increased their leverage significantly above historic norms, obtaining credit was easy for even the riskiest corporate borrowers.

The party ended abruptly in early 2007 as the smallest cracks began to appear in the subprime mortgage market. As 2007 rolled into 2008, credit issues were revealed to be more significant and pervasive than initially imagined. If anyone expected a quick return to pre-2007 credit conditions, those hopes were dramatically dashed on Sept. 15, 2008, when Lehman Brothers filed for bankruptcy.

"junk bond" refinancing: $1 trillion

Since last September, we have seen government intervention in the economy on an unprecedented scale. While massive government aid has allowed financial institutions to remain solvent, the future for many remains uncertain. The release of the stress test results has clarified the capital issues that the banks needed to address.

While the greater transparency afforded by the stress tests has permitted the banks to raise a lot of new capital, it has certainly not eliminated the underlying credit crunch. According to data from Standard & Poor's, approximately $800 billion in U.S. corporate debt matures in 2009. While that is a significant sum, the greater challenge lays ahead.

In order to understand the full extent of the problem, it is crucial to recognize that more than $1 trillion of corporate high-yield debt, often called "junk bonds," will come due between now and 2015. High-yield debt is issued by companies that do not have investment grade credit ratings—essentially the riskiest, most highly leveraged businesses.

You get a sense of the task ahead when you consider that these companies—many struggling to regain their financial footing—will have to somehow repay or refinance this mountain of debt in the coming years.

Banks have far less to lend

All of this must take place during a period in which financial institutions have less lending capacity, just as the U.S. government borrows ever-increasing sums and investment-grade corporate borrowers refinance hundreds of billions of dollars of debt in the ordinary course of business.

It is difficult to assess the reduction in the banks' lending capacity. But economist Tim Bond of Barclays Capital (BCS) has suggested that when the financial crisis has eased, bank capital will likely be reduced by about $170 billion and lending capacity will reduced by at least $1.7 trillion. Although U.S. corporate borrowers rely on banks for about only 30% of their debt capital, the reduction in bank lending capacity reflects the contraction across the broader debt markets.

For an economy that has grown for decades on ever-increasing indebtedness, it is clear that any deleveraging will have a significantly negative impact on all aspects of the economy.

Strong, well-capitalized companies will no doubt take advantage as more leveraged rivals struggle. On a philosophical level this is fine, but given its size, the deleveraging problem will not merely affect individual companies. Rather it will have a pervasive, negative impact on the economy, job creation, and long­-term economic growth. Massive equity injections will be required not to expand these businesses, but simply to keep them alive.

Many companies will disappear

For companies that are particularly highly leveraged or that operate in the hardest hit sectors, equity infusions will be insufficient—or in many cases unavailable—to avert more drastic measures. Most highly leveraged companies will need to sell assets or business units in order to survive. Some will have no choice but to be acquired or seek bankruptcy protection. Given the relative strength of the balance sheets of many Asian and Latin American companies, we are likely to see a new wave of cross-border acquisitions.

The bottom line: The strongest companies will survive and emerge stronger, but many will disappear, at least in their present form.

What are businesses likely to do as the great deleveraging unfolds? As we move beyond the initial stage of the credit crisis, we are likely to see many changes in the way companies manage their capital structures. Returning capital to shareholders, whether through share buybacks or dividends, will decrease and in some cases simply cease. Rather than working on tax-efficient ways to return capital to investors, corporate treasurers will be studying the intricacies of debt-for-equity swaps, sale-­leaseback transactions, and offerings of convertible debt and equity.

Similarly, corporate directors will be following the lead of GM's board as they seek to understand their fiduciary duties when approaching the "zone of insolvency" and the nuances of the bankruptcy code.

While it is likely that the very worst of the economic crisis is behind us, the road ahead will be long and difficult. One need only recall Japan's "lost decade"—zero or negative economic growth from 1989 to 2002 as financial institutions struggled to rid themselves of toxic debt—to recognize that even with massive, sustained government action, deleveraging can be a long and painful process. As the recent stress tests have shown, the sooner we understand the shape and size of the problem, the quicker we will find the way forward.

Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP. .

Frank_aquila
Aquila is a partner in the Mergers & Acquisitions Group of Sullivan & Cromwell LLP.

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