The Credit Crunch and the U.S. Economy€¦ · (US$ Billions) Leveraged Loan Backlog $0 $50 $100...
Transcript of The Credit Crunch and the U.S. Economy€¦ · (US$ Billions) Leveraged Loan Backlog $0 $50 $100...
The Credit Crunch and the U.S. EconomySteven Rattner
March 27, 2008
1
We begin our story in March 2000, when stock market indices reached all-time highs
A Brief Recent Economic and Financial History
¹Companies with high-yield debt in their capital structure. Source: JP Morgan Research
The dot.com meltdown and accompanying recession inflicted meaningful damage on the U.S. economy and financial system
But the damage proved short-lived as the government injected massive stimulus through repeated tax cuts and reductions by the Federal Reserve in its key interest rate from 6% to 1%
The U.S. economy went into recession in March 2001, with unemployment rising to 5.5% and cumulative job losses of 1.6 million
Equity markets plunged -- the S&P fell 49% from its 2000 peak and the NASDAQ declined 78% over a similar periodBankruptcies among highly leveraged companies¹ increased to 8.3% of outstanding debt from a 20-year average of 3.8%.
2
The Ensuing Golden Age
The economy grew steadily from 2002 through the end of 2007, with real GDP expanding at an annual rate of 2.6% during this period.
Productivity rose at a 3% rate
The unemployment rate fell to 4.4%
Inflation remained low
Consumer spending grew by 5.7% annually
Note: Productivity measured as non-farm business output, from the Bureau of Labor Statistics. Consumer spending measured as per capita personal consumption spending from the BEA
3
The Golden Age (cont’d)
Stock prices began a steady rise
S&P 500
Dec-07
March 11, 2003: Price: 800.7
Oct. 9, 2007: Price: 1565.1
15.7% CAGR
700
800
900
1000
1100
1200
1300
1400
1500
1600
Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07
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Borrowers Were Huge Beneficiaries
With capital readily available, the cost of borrowing (relative to Treasuries) fell to record lows and lending grew at a rapid pace
Source: JP Morgan Research
JPMorgan Global High-Yield Index
200bp
300bp
400bp
500bp
600bp
700bp
800bp
900bp
1000bp
2003 2004 2005 2006 2007
Spre
ad to
Wor
st
Long-term average (1987 -07)= 542bp
June 2007: 269 bps
$147.9 $149.1
$106.1
$158.2 $151.6
$67.8
New High-Yield Issuances
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
2002 2003 2004 2005 2006 2007
Split B or Lower Total High Yield Issuance
5
Lenders Were Happy to Lend
One of the primary drivers of this heightened activity in the debt and LBO markets was the historically low level of corporate bond defaultsIn 2007 only 10 companies ($3.0 billion in debt) defaulted in the U.S., the lowest figure by number since 1981 and by dollar volume since 1994
D ollar Weighted High-Yield D efault Rate
- -
5.0%
10.0%
15.0%
2007200620052004200320022001200019991998199719961995199419931992199119901989198819871986198519841983198219811980
Source: JP Morgan Research
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Record liquidity in the credit markets fueled historic volume in the buyout marketIn 2007 low rated debt – often raised to finance leveraged buyouts – swelled to 35% of the total high yield issuances in the U.S.
Source: Thomson, DeaLogicSource: JP Morgan research
Private Equity Boomed
U.S. Historical High Yield Issuance
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
2007200620052004200320022001200019991998
($U
S in
Bill
ions
)
0%
5%
10%
15%
20%
25%
30%
35%
(Low
er R
ated
Issu
ance
% o
f Tot
al)
Split B or Lower H igh Yield Issuance T otal H igh Yield Issuance
Announced Global M&A Volume
- -500
1,000
1,5002,0002,5003,0003,500
4,0004,5005,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
(US$
Bill
ions
)
0%
5%
10%
15%
20%
25%
30%
35%
40%
LBO Volume T otal M&A Volume LBO % of T otal M&A
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And So, Of Course, Did Housing
As we are now painfully aware, the credit expansion led to a boom in housing prices, which rose far faster than incomes
Note: S&P Case/Shiller 20-market home price index
Housing Price Index vs. Median Household Income
0
50
100
150
200
250
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Inde
x L
evel
(sca
led
to 2
000)
S&P/CS H ome Price Index Median H ousehold Income
10.7% annual decline in January 2008
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The Age of Turmoil: A Quick Summary
The unwinding of the credit bubble famously began with the dramatic upsurge in defaults by subprime borrowers, followed in short order by near paralysis in the high yield market, where rising supply overwhelmed demand.
During the autumn, these developments spread into the “real” economy, as job losses began to occur in the housing and financial sectors and consumers pulled back on spending as a result of falling home prices and overall nervousness about future economic prospects.
Economic forecasters began to gradually raise their estimates of the probability of a recession; today Intrade puts the odds of a recession at 70%. The credit markets are even more dramatically signaling recession.
9
Recent Economic Indicators Point to Recession
Some leading economic statistics indicate the potential for a recessionReal GDP growth was 0.6% in the Q4 2007, and was not revised upward. This result was lower than the 1.1% expected by economists, and the weakest GDP growth for the economy since 2002The unemployment rate was 4.8% in February 2008, up from 4.4% in March 2007New housing construction was down significantly, with Feb. 2008 declining 28% from Feb. 2007The Institute for Supply Management indices have largely been below 50 since December, signaling contractionThe Conference Board consumer confidence index has declined significantly since July (down 43%, from 114 to 64.5) Retail sales declined 0.6% in February
Source: BEA, White House Economic Report, The Conference Board, ISM, US Dept. of Housing and Urban Development
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Investment Grade Index (CD X IG9 5-yr)
0bp
20bp
40bp
60bp
80bp
100bp
120bp
140bp
160bp
180bp
200bp
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Spre
ad to
Wor
st
Long-term average (1987 - ytd 08)=
73bps
Investment Grade Spreads vs. Recession
Recession levels(190 bps, 3/17)
The investment grade market is clearly signaling recession.
Source: Goldman Sachs
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Ambiguous Equity Markets
The S&P index has dropped 10% since January 1 and 15% from its peak on October 9thHowever, the S&P index currently trades at 16.1 times LTM earnings, below its 20 year historic average of 19.3 times
Source: Capital IQ Source: Standard and Poors
S&P 500
1150
1200
1250
1300
1350
1400
1450
1500
1550
1600
6/26/200
77/26
/2007
8/26/200
79/26
/2007
10/26/2007
11/26/2007
12/26/2007
1/26/200
82/26
/2008
3/26/200
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S&P 500 LT M P/E
0.0x
5.0x
10.0x
15.0x
20.0x
25.0x
30.0x
35.0x
03/31/1998
03/31/1999
03/31/2000
03/31/2001
03/31/2002
03/31/2003
03/31/2004
03/31/2005
03/31/2006
03/31/2007
02/29/08
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Ambiguous Equity Markets (cont’d)
When comparing the earnings yield of the S&P 500 index to the yield of the 10-year Treasury (known as the Fed Model) the S&P currently has a higher yield, implying that it is relatively cheap when compared to bondsThis barometer of share prices suggests that the stock market is more attractive than at any time over the past 10 years
Source: Standard and Poors, St. Louis Fed
S&P Yield vs. 10-yr T reasury Yield
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
03/31/199809 /30/199803 /31/199909 /30/199903 /31/200009 /30/200003 /31/200109 /30/200103 /31/200209 /30/200203 /31/200309 /30/200303 /31/200409 /30/200406 /30/200509 /30/200503 /31/200609 /30/200603 /31/200709 /30/2007
2/29/2008
'S&P 500 Earnings Yield '10-Year T reasury Yield
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High Yield Backlog
$0
$20
$40
$60
$80
$100
$120
Summer '07 Completed Deals
CanceledDeals
CurrentBacklog
(US$
Bill
ions
)
Leveraged Loan Backlog
$0
$50
$100
$150
$200
$250
Summer '07 Completed Deals
CanceledDeals
CurrentBacklog
(US$
Bill
ions
)
Credit Market Working Through Backlog
Following the meltdown in the U.S. mortgage and sub-prime lending markets, liquidity dried up for corporate debt as well, including over $300 billion in previously committed LBO financingBanks and investors have been hard at work since July digesting over $100 billion of the backlogMany of the deals that came to market from the backlog were priced at a discount and continue to trade below par
However, banks have maintained discipline in offloading these loans up to this point
Source: JP Morgan research, Bank of America research
Down 44%
Down 32%
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Ramifications for Private Equity
The aforementioned factors have led to a dramatic slowdown in private equity activity
Source: SDC, CapitalIQ
(US$
in B
illio
ns)
(# of Deals)
Announced Buyout Volume H as Stalled Since the Summer Peak
$0
$25
$50
$75
$100
$125
$150
Jan-0
6Feb
-06M
ar-06
Apr-06
May-06Jun-06Jul- 0
6Aug-0
6Sep
-06Oct-
06Nov-0
6Dec-
06Jan
-07
Feb-07
Mar-
07Apr-0
7M
ay-07Jun-07Jul- 0
7Aug-0
7Sep
-07Oct-
07Nov-0
7Dec-
07Jan
-08
Feb-08
0
5
10
15
20
25
30
$1B+ LBO Deal Volume # of $1B+ LBO D eals
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Early 2008 activity suggests a continuation or even an acceleration of this trend
Ramifications for Private Equity (cont’d)
Source: Thomson, DeaLogicSource: JP Morgan research
Global M&A Volume YT D
$0
$100
$200
$300$400
$500
$600
$700
$800
2007 2008
(US$
Bill
ions
)
LBO Volume T otal M&A Volume
N ew Issuances YT D
$0$5
$10$15$20$25$30$35$40$45
2007 2008
(US$
Bill
ions
)
Split B or Lower H igh Yield Issuance T otal H igh Yield Issuance
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Widened Credit Market Spreads
Credit risk premiums – which by July had compressed to record lows – have widenedArguably, even today’s levels may not be sufficient given: a) higher than historic levels of debt in buyouts, b) uncertain economic outlook in the U.S. and c) housing / general credit market weakness
Source: JP Morgan research
JPMorgan Global High-Yield Index
0bp
170bp
340bp
510bp
680bp
850bp
Feb-06
Apr-06
Jun-
06Aug
-06Oct-
06Dec
-06Feb
-07Apr
-07Ju
n-07
Aug-07
Oct-07
Dec-07
Feb-08
Spre
ad to
Wor
st
5/31/07 = 269bp
3/19/08 = 819bpLong-term average
(1987 - ytd 08)= 542bp
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Private Equity Default Risk
The biggest risk to the debt markets at present is the specter of a significant uptick in default ratesForecasters such as Moody’s expect the global default rate to almost triple over the next yearThe proliferation of highly leveraged deals “priced to perfection” over the past few years suggest that private equity-sponsored companies may suffer during a period of economic weakness
Financing features available in prior deals (e.g. “covenant-lite” and “PIK-toggle” instruments) may mitigate default risk, or delay an eventual default
S&P recently issued a watch list of 74 names, not surprisingly, 50 of which are private equity sponsored companies T otal D ebt / EBIT D A in LBO T ransactions
6.5x5.8x
5.3x5.2x4.7x4.8x4.7x
5.5x5.8x6.5x
5.3x5.0x4.9x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
8.0x
2007200620052004200320022001200019991998199719961995
Source: JP Morgan research
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Near Meltdown in Financial Markets
For the most part, the adjustments in the financial markets have been orderlyOne moment of potential panic occurred in mid-March, when Bear Stearns imploded
$0
$10
$20
$30
$40
$50
$60
$70
$80
3/7/08
3/10/0
83/1
1/08
3/12/0
83/1
3/08
3/14/0
83/1
7/08
3/17/0
83/1
8/08
3/19/0
83/2
0/08
$0
$10
$20
$30
$40
$50
$60
3/7/08
3/10/0
83/1
1/08
3/12/0
83/1
3/08
3/14/0
83/1
7/08
3/17/0
83/1
8/08
3/19/0
83/2
0/08
Bear Stearns Stock Price (3/7-3/20) Lehman Bros. Stock Price (3/7-3/20)
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Plenty of Volatility
The pace of market volatility has quickened, unnerving many participants (while cheering others)
Source: CapitalIQ
Nasdaq Volatility Index (VIX)
10.0
15.0
20.0
25.0
30.0
35.0
3/26/07 4/26/07 5/26/07 6/26/07 7/26/07 8/26/07 9/26/07 10/26/07 11/26/07 12/26/07 1/26/08 2/26/08
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Unwinding of Leverage
A prominent feature of the adjustment process has been a significant deleveraging throughout the financial system.The problems of KKR Financial and Carlyle Capital are examples of the consequences of this phenomenon.
$600
$700
$800
$900
$1,000
$1,100
$1,200
$1,300
3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08$1,400
$1,500
$1,600
$1,700
$1,800
$1,900
$2,000
$2,100
$2,200
$2,300
3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08
Asset-Backed Commercial Paper Outstanding All Commercial Paper Outstanding
Source: Federal Reserve, 3/22/08
$ bil $ bil
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Where Do We Go From Here?
Since last summer, the consensus economic forecast for 2008 GDP growth has steadily become more pessimistic
Source: Goldman Sachs
Rea
l GD
P G
row
th F
orec
ast
= July 2007 Forecast = Sept. 2007 Forecast = Nov. 2007 Forecast = Mar. 2008 Forecast
(0.5%)
(1.0%)
2.5%
2.0%
1.5%
1.0%
2.0% 2.0%
1.5%
1.0%1.0% 1.0%
3.0%3.0%
2.5%2.5%
(1.5%)
(1.0%)
(0.5%)
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Q1 Q2 Q3 Q4
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But We Should Not Be Overly Pessimistic
The probability is that a recession is likely to be shallowMore sophisticated economic policymaking has led to generally benign economic conditions over the past two decades, a phenomenon known to economists as “The Great Moderation”The last two recessions (1990-91 and 2001-02) were each eight months in duration and relatively mild
The U.S. economy remains productive and flexible, and inflationary pressures appear containedThe massive interest rate reductions by the Federal Reserve and the recently enacted stimulus package will gradually insert a positive influence on growthThe fall in the dollar provides an important push for exportsWhile the possibility of a financial meltdown cannot be ignored, the probability is that the losses from imprudent lending will slowly work through the systemAbsent any cataclysmic events, the adjustments in markets that are now underway will prove healthy and beneficial
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