A Short Legal History of the Credit Crunch – Part 2 of 4

Quentin Metsys - The MoneylendersWith the Credit Crunch in the finance sector now causing deleterious effects in the ‘real’ economy (see Part 1), concerned Finance Directors (“FDs”) turned to their relationship banks with a view to agreeing how best to muddle through what appeared to be a temporary dip caused by a problem in the arcane world of credit derivatives.

Initial conversations between FD and bank revealed, however, that the old story about nice bankers existing solely to enable talented people to build factories for the benefit of the species, a story drummed into every FD from accounting school, was utterly mythical.  The banks’ balance sheets were full of both holes and ‘toxic’ assets, and they needed to be repaired before any one of the banks went the way of JP Morgan, Bear Stearns, or worse, Lehmans.  From the banks’ point of view it was life or death; find money for the balance sheet or die.  The so-called ‘Masters of the Universe’ summoned their every creative power and scoured their dominions for possibilities of pillage and plunder.

Manufacturing industries stood little chance.  Those industrial executives who had bought into the myth of banking were about to experience the shock of cognitive dissonance.  Not only were the banks going to bleed them dry, but they intended the executives to inflict the wounds themselves, and then the banks would charge them millions for the privilege.  All this, and, once a business could no longer be expected to give any more, the banks were going take over the enterprise, sack these meekly compliant executives, and resell the concern as a viable unit or units; that is, viable, but for the bank induced Credit Crunch.

The leverage the banks had over their borrowers was, as the reader may have guessed from Part 1, the financial covenants.  Two hundred pages long though a standard credit agreement may be, the banks are almost exclusively interested, beyond actual (re-)payment, in the asset to debt ratio and interest payment service ability of the borrower.  Through 2009, with the world economy heading into depression, the fall in asset values rendered borrowers massively overleveraged.  In essence, had the banks sold every asset of the borrower, it would have come nowhere near close to actually repaying the debt owed.  Furthermore, with international trade at a standstill, related industries began to evidence falling cashflow.  One must remember, the borrower’s inability to pay interest is not what the financial covenant as to debt service is designed to detect.  Inability to pay interest is too late for the bank – the financial covenant about debt service is designed to sound an alarm about falling liquidity such that in two financial quarters there could be an inability to pay interest.  As it was, in many cases one or both financial covenants were being breached dramatically, and the alarms were sounding with bank analysts.

A further element of complexity also applies, namely the structure and operation of the revolving credit facility which is common to revenue-based borrowers.  As noted previously, the borrower notionally repays its debt every three months and notionally borrows it again.  The bank matches this with three month funding in the interbank market, a market which no longer existed.  In order to complete the notional “rollover” of funding, the borrower will submit a short rollover notice provided for under the credit agreement.  The notice is usually certified by the FD and the certification as a matter of course confirms that the borrower is not in breach of its financial covenants.  It was the inability of borrowers to make this certification, and thus effect a rollover, which would prove extremely problematic.

By the time the executives of industrial borrowers met with their relationship banks the lawyers on both sides had spelled out what all this meant: in less than three months the borrower would not be able to “rollover”, that is all monies then borrowed would become due and payable in cash at the agent bank.  What had appeared to be a matter of perhaps tweaking interest payments through a rough time had now become a matter of finding in of the order €200m1 within three months and giving it to the bank.  The relationship banks were presumably kind enough to effect some feint attempt at concern for the borrower’s predicament, before they eased back in their chairs.  If there was going to be any rolling over done, the borrower’s executives were going to be doing it.

The banks’ restructuring demands to borrowers at that time have a strikingly familiar feel with hindsight.  ‘Cut!’.  ‘Cut more!’.  ‘You don’t need that many workers.  Sack them.  You don’t need all these assets, so sell them or give them to us as security.’  Yet from the banks’ point of view, matters of industrial management were of little interest; another part of the myth of the banker.  Reciting the dogma of neoliberal texbooks from business school courses was, as with much of the theology of economics, just window dressing for what really mattered and what amounted to racketeering.  The demands of ‘efficiencies’ having been specified, and the FD squeezed to suggest several more cost-cutting measures, the banks then raised the ‘oh so delicate’ question of fees.

Fees for what?  For restructuring advice, per hour, let’s say €200k for the first meeting. One can imagine the palette of colours one would use to paint the borrower’s executives’ faces at this point – the flushed red of indignation tinged, in the centre of the brow, with the cream of surprise.  Then there would be a clarification: restructuring advice and waiver fee.  The waiver fee would be for waiving the egregious breach of financial covenants.  Market practicfor such a fee is a percentage of the total net debt (in the region of 0.15%), so that will be, say, €0.3 million.  Our facial palette would have to mix in quite a lot of blue at this point.  And then of course there are the agency fees and relationship fees, but these would be discussed separately because banks tend to keep these little extras quiet from any funding syndicate that is backing their financing (a matter for Part 3).

Depending on the time of year, the more incautious banker may have added a small reduction for having the fee letters signed on time.  Fees directly influence bonuses.  Not the worthiness of investments.  Not the success of the relationship.  No.  Quantum of fees.  Fee letters signed before 31 December would thus be taken into account in the following February’s bonus round.  To cap it all, the banks would have pointed out that the borrower constituted a much greater risk in light of its covenant breaches, and would have raised the interest rate on the loan to the new market standard – that is, the average assessment of risk in a market which was entering the biggest depression since the inter war years.

By way of example, let us see how these costs stacked up for one business, the shipping company Dryships, Inc, which was lead funded by Scandinavian name Nordeabank (and I apologise for the jargon):

ATHENS, GREECE – (Marketwire – February 9, 2009) – DryShips Inc. (NASDAQ: DRYS) (the “Company” or “DryShips”), a global provider of marine transportation services for drybulk cargoes and off-shore contract drilling oil services, announced today that it has reached preliminary agreement with Nordea Bank Finland Plc to obtain a covenant waiver in connection with the $800.0 million Primelead facility, which was used to partially finance the acquisition of Ocean Rig ASA. As of today, the outstanding loan amount under the facility is $650.0 million.

In accordance with the main terms of the waiver: (i) the Company will pay a restructuring fee of 0.15% on the outstanding loan amount under the facility plus an amount equal to 1.00% per annum on the loan outstanding for the period from January 9, 2009 until the Effective Date of the waiver agreement; (ii) $75.0 million of principal repayment due February 2009 will be postponed until May 2009; (iii) the margin on the facility will increase by 1.00% to 3.125% per annum; and (iv) regular principal payments will resume as of August 2009. In addition, among other things, lender consent will be required for the acquisition of DrillShip Hulls 1837 and 1838, for new cash capital expenditures or commitments and for new acquisitions for cash until the loan has been repaid to below $375.0 million. The waiver agreement Effective Date will not exceed August 12, 2009, at which time the Company expects to be in compliance with the restructured loan covenants. The agreement is preliminary and is subject to formal approvals by the Company and the syndicate banks (Nordea Bank Finland Plc, DnB NOR Bank ASA and HSH Nordbank AG). 2

This regulatory press release is embarrassed enough not to mention a number of other fees which in all likelihood were heading the agent bank’s way for facility, advice, and security services.

It ought to be perfectly apparent by now how exactly the banks proposed to fix their balance sheets:  charging massive fees to fix contracts which they had (however indirectly by the standards of contract law) caused to become broken.  And remember that the borrower in our example has not actually broken any material conditions of the contract.  There is no debt due and owing, the borrower has not fiddled with its security (mortgages etc.), it has not hived assets out of the company into a Cayman Islands trust.  All the borrower has done is to look like it might not be able to pay down interest or debt in the next year.  The ‘might’, unfortunately, has become academic now.  With upto €2m in fees now payable, the cash put aside to meet interest payments had all but disappeared – to suggest a trading company have €x million ‘just lying around’ at the best of times is absurd.  Subsequent meetings therefore had to therefore occur in which the interest payment schedule would be reworked so that the bank fee-induced cashflow crisis would not lead to insolvency.  Amend the interest payment schedule?  Amendment fee.  Take or extend security over all assets.  Needs a security agent (a service provided by the bank).  Security agent fee.  Carry out the reduction of staffing levels and closure of some plants.  These are breaches of minor covenants of the credit agreement: waiver fee.  Further restructuring advice.  Advice fee.  Restructuring becomes public knowledge, loss of faith by suppliers, trade creditors and purchasers, leading to collapse in revenue: breach of now amended financial covenants.  More waiver and amendment fees.  At some point one can imagine that, even if it were ever otherwise, the industrial borrowers in question began to exist for a single and solitary purpose: the incurrence and payment of investment banking fees.

As an indication of how well the fees side of the banking sector were doing, here is a euphemistic excerpt from the Standard Chartered Bank annual report for 2009:

Net fees and commissions income grew $429 million, or 15 per cent, to $3,370 million. In Consumer Banking, whilst demand for Wealth Management products improved steadily through the year, fee income levels were still below those of 2008. Wholesale Banking fee income was higher as a result of strong corporate advisory income and capital market fees, which more than offset reduced custody income.3

In effect this states: “We didn’t make much money from taking deposits (the traditional definition of banking) but this was offset by advising and restructuring businesses for large fees”.

No attempt is made to save the industrial borrower from insolvency.  Insolvency is in the banks’ interest.  Insolvency is not necessarily liquidation, which is not in the banks’ interest (yet).  Insolvency creates conditions which:

  1. practically remove shareholders and management from the equation;
  2. give debtors, especially secured debtors, control of the company;
  3. grants the possibility of reorganising the company as a venture capitalist would into ostensibly profitable chunks which can be sold on; and
  4. generates, you guessed it, insolvency and restructuring fees.

A horse is a useful beast; even dead its carcass may be stripped for meat.

In part 3 we increase the legal complexity in order to examine what was going on behind the scene presented by the quaintly titled ‘relationship’ bank and how this stored up further crises for the future.

Show 3 footnotes

  1. Depending on the total debt borrowed under the contract.  For a medium size industrial business, operating on a multicurrency basis, over €100 million would be a likely debt burden.
  2. http://www.marketwire.com/press-release/DryShips-Announces-Preliminary-Agreement-With-Nordea-Bank-Covenant-Waiver-on-800-Million-NASDAQ-DRYS-947051.htm
  3. http://annualreport.standardchartered.com/business-review/the-group-in-2009.html
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