Corporate Defaults At A Six-Year High

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    Default Increase Curbs Bankruptcy Lending as Recoveries Dwindle
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    By Richard Bravo

    July 31 (Bloomberg) --
    Companies on the verge of bankruptcy are finding it harder and more expensive than ever to get loans to help nurse them back to health.

    With corporate defaults at a six-year high, so-called debtor-in-possession financings dropped to about 23 percent of businesses failing to make debt payments so far this year, the lowest since at least 2003, according to a strategist at Bank of America Merrill Lynch. Lenders are charging those entering Chapter 11 reorganization a record 7.25 percentage points over benchmark interest rates, on average, even with borrowing costs for issuers of junk-rated bonds the cheapest since September.

    DIP loans provide funds to continue operating normally while in Chapter 11. Less available financing will give fewer companies this option and drive more into liquidation, said Darin Schmalz, a director on the Fitch Ratings leveraged finance team in Chicago.

    “The playbook is changing,” said Steven Smith, global head of leveraged finance and restructuring at UBS AG in New York. “Very little new capital is flowing into restructuring and Chapter 11 reorganization right now, which is potentially a huge problem. It’s very hard to reorganize companies without new capital.”

    The number of businesses filing for liquidation under Chapter 7 of the bankruptcy code rose 60 percent to 30,035 last year, the most since at least 2000, according to the U.S. Courts Web site.

    Retailers Linens ‘n Things Inc. and Mervyns LLC said last year that they would liquidate rather than reorganize. Richmond, Virginia-based Circuit City Stores Inc. announced it would go out of business in January after seeking court protection in 2008.

    Leveraged Loans

    The worst credit squeeze since the Great Depression has helped increase U.S. companies’ default rate on bonds to 13.2 percent for the last 12 months, the highest since it reached 16.4 percent in 2002, according to Fitch.

    In the leveraged loan market, the trailing 12-month U.S. default rate rose to 8.2 percent at the end of the second quarter, from 2.1 percent a year earlier, according to New York- based Moody’s Investors Service.

    DIP financing helps companies to move through Chapter 11 more successfully, according to a 2000 study written by Sandeep Dahiya of Georgetown University; Kose John of New York University’s Stern School of Business; Manju Puri, now at Duke University’s Fuqua School of Business in Durham, North Carolina; and Gabriel Ramirez, now with Kennesaw State University’s Coles College of Business in Georgia. Those receiving loans are likely to exit reorganization more quickly, they found.

    Delphi Auction

    Creditors of Delphi Corp., the former General Motors Corp. car-parts unit that filed for Chapter 11 in 2005, won an auction for some of the company’s assets by bidding the value of the DIP loans they were owed. On July 30, a court approved the sale of the Troy, Michigan-based company’s assets to the lenders and the automaker.

    Elliott Management Corp. of New York and Greenwich, Connecticut-based Silver Point Capital LP were among investors making the so-called credit bid. Delphi owed about $3.3 billion on the three classes of its bankruptcy loan as of July 21, according to a regulatory filing.

    The two firms will lead a $750 million financing that will be offered through syndication to other lenders, said John Butler Jr., Delphi’s lead bankruptcy lawyer.

    Scott Tagliarino, a spokesman for Elliott, and Silver Point spokesman Todd Fogarty both declined to comment.

    CIT Loans

    The DIP market may also be tested by New York-based CIT Group Inc., which received a $3 billion loan this month to stave off insolvency. The 101-year-old commercial-finance firm has $1 billion in notes maturing in August. CreditSights Inc., a New York-based debt researcher, said July 28 that the company “remains at risk” for filing bankruptcy even if a tender for the debt succeeds.

    The offer is “intended to provide CIT with liquidity necessary to ensure that its important base of small and middle market customers continues to have access to credit,” the company said in a July 20 statement.

    CIT asked owners of the notes to agree to take a loss through a debt tender. If the offer is accepted, the company may start debt-for-equity exchanges, according to a person familiar with the matter.

    Providers of emergency credit to the company include Boston-based hedge fund Baupost Group LLC and Pacific Investment Management Co., which oversees $842 billion in Newport Beach, California.

    Eaton Vance

    The money managers’ decision to lend to CIT at an annual interest rate of at least 13 percent may help protect their investment in its bonds. Businesses such as Eaton Vance Corp. are competing with traditional DIP lenders, including New York- based JPMorgan Chase & Co. and Bank of America Corp. of Charlotte, North Carolina, after financial companies worldwide ran up more than $1.5 trillion in writedowns and credit losses since the start of 2007.

    Boston-based Eaton Vance, the largest manager of investments designed to minimize taxes, is raising $1 billion to invest in DIP loans, the firm said in May. Aladdin Capital Holdings LLC of Stamford, Connecticut, a hedge fund overseeing $15 billion, said in February that it began offering bankruptcy credit to take advantage of “massive dislocation” in the market.

    “You’re seeing disparate groups of hedge funds putting up competing proposals,” said UBS’s Smith. “You’re seeing more interest and a little bit more competition, which is having the impact of improving terms to the debtor.”

    The head of Eaton Vance’s bank-loan group, Scott Page, didn’t return a telephone call for comment. Aladdin’s vice chairman, Neal Neilinger, declined to comment.


    Increased competition isn’t pushing bankruptcy-financing costs down to pre-credit crunch levels, even after yields on speculative-grade bonds relative to benchmarks fell to below “distressed” levels, or 10 percentage points, on July 23.

    The decline marked the narrowest spread since Sept. 25, when the collapse of Lehman Brothers Holdings Inc. led credit markets to freeze, according to Merrill Lynch & Co.’s U.S. High- Yield Master II Index. The gap was 9.33 percentage points as of yesterday.

    The difference between the average cost of DIP loans and benchmark interest rates so far this year compares with 5.3 percentage points in 2008, according to the Bank of America Merrill Lynch report. It never exceeded 4 percentage points before last year.


    While DIP financings have reached a record $16.2 billion this year, many are so-called roll-ups of borrowings that existed before the bankruptcy filings, according to the Bank of America Merrill Lynch report by strategist Jeffrey Rosenberg.

    Roll-ups now account for 64 percent of total bankruptcy loans, up from 36 percent in 2008, Rosenberg wrote. Before last year, the proportion of rolled-up loans never exceeded 10 percent.

    Lenders seek the feature to improve their standing relative to creditors who don’t participate in a debtor-in-possession transaction, Smith said. Doing so gives them a higher priority for getting repaid, creating a new set of “winners and losers.”

    Lyondell Chemical Co., which filed for Chapter 11 on Jan. 6, received a record $8 billion in loans at an interest rate of 10 percentage points over the benchmark after the DIP market had “ceased to operate,” a lawyer representing the Houston-based company, Mark Ellenberg of Cadwalader, Wickersham & Taft LLP, said during a Jan. 7 bankruptcy hearing in New York, according to a transcript.

    40 Percent

    Roll-ups, including commitments from borrowers, made up about 40 percent of the bankruptcy credit, according to Mark Cohen, head of restructuring at Deutsche Bank AG in New York.

    Last week, Lyondell’s DIP roll-up was trading at 83.5 cents on the dollar. The portion of the DIP that wasn’t rolled up was trading at 42 cents on the dollar.

    Susan Moore, a spokeswoman for Lyondell, declined to comment.

    DIP financing may recover as credit markets begin to heal, Cohen said.

    Eddie Bauer Inc., a unit of the Bellevue, Washington-based retailer that filed for Chapter 11 last month, received a $100 million loan costing 4 percentage points more than the London interbank offered rate, the common benchmark for such credits, according to Bloomberg data. Banc of America Securities LLC was the lead arranger of the deal.

    Recovery Rates

    “Market pricing is coming down; new investors are coming in,” Cohen said.

    Still, shrinking bankruptcy financing and rising defaults pushed 12-month recovery rates, or the amount of face value an investor can expect to receive from a loan after default, to 43.9 percent in June, down from 65 percent a year earlier, according to Moody’s. The level is lower than any annual average since the ratings company began compiling the data in 1990.

    “Recovery values tend to drop as bank lending standards tighten,” said John Lonski, chief economist at Moody’s in New York. “If you’re a creditor and you see the value of collateral falling, you are going to tighten credit.”

    To contact the reporter on this story: Richard Bravo in New York at
    Last Updated: July 31, 2009 00:01 EDT
  2. “If you’re a creditor and you see the value of collateral falling, you are going to tighten credit.”

    Basically this is the entire problem in a nutshell. Collateral moves in lockstep, in this case down. One companies fire sale prices is not the next persons bargain, it is the next persons credit freeze.