A Short Legal History of the Credit Crunch – Part 3 of 4

by Ida Ince | 16 Feb 2011

At whatever time our industrial borrower first took on the credit agreement with which it found itself, in 2009, chained and broken before its financial masters, it is likely it only had a vague inkling that anyone beyond its relationship bank was, or was to be, involved. It is an issue that depends on the size of the borrower – General Motors would have such financing needs that it would have expected only multiple banks to share the risk of such debt¹. This model, called ‘syndicated finance’, was developed in leveraged finance where the risk, due to the high debt to equity ratio, was spread amongst lenders so that no one bank bet the house on one borrower. Debt was sliced up by intercreditor agreements, and debt could be reorganised so that some debt was better protected than other debt from non-repayment on insolvency. These ‘tranches’ of debt were assets (choses in action) in the hands of banks and could be bought and sold on a largely unregulated basis between financial institutions.

The syndicated model, providing as it were a useful means by which the portfolio management approach to risk could be applied, spread quickly beyond its immediate sphere thanks to the ready availability of easy credit following the Dotcom crash of 2000-01: a function of Federal Reserve chair Alan Greenspan fuelling the money supply with low interests rates even when trade-surplus countries flooded the US with their over-supply of US dollars ². Standard ‘investment grade’ credit agreements included within their terms, though amongst the technical boilerplate, provisions permitting the ‘tranching’ up of debt and on-selling to other banks. In the classic case, these new banks were legally the lenders to the borrower, but the borrower only had to deal with one bank, the facility agent, who managed credit, dealt with the borrower’s concerns, and in cases of material problems, asked lenders to vote on solutions pari passu their debt participation.

The favoured model of investment banks such as Lehman Bros. (though not limited to them by any means) was to initiate these deals and almost immediately sell the debt to other finance institutions. In an ideal case, they would not even fund the deals themselves; between signing of the contract and first drawdown of funds by the borrower, the ‘lead bank’ would have novated (i.e. transferred) its obligation to fund entirely to third parties. Fees would be charged for arrangement, both to the borrower and to incoming banks. Other agency and signing fees would also be due. The result was that for a relatively sizeable contract signed in, say 2002, by 2009 a borrower could be dealing with 20 banks, none of whom with which it had signed the original contract.

This is only the first level of complexity. It is best to think of the world of the credit agreement as but one universe among many. The intercreditor agreement, which any savvy borrower would know to exist, would be kept secret from that borrower and would govern matters according to an entirely different legal order. Briefly put, just because in the universe of the credit agreement a borrower must pay Bank A €5m, in the universe of the intercreditor agreement Bank A will not ever see the money, it being considered by the intercreditor agreement as due to Bank B. The facility agent generally operates to mediate between universes, accepting all cash according to one contract and paying it over following the terms of another.

And let us be under no illusion that one intercreditor agreement is enough – financial institutions will if deemed profitable enter into intercreditor agreements of intercreditor agreements, and even (in rare cases) intercreditor agreements of intercreditor agreements of intercreditor agreements. That is four separate legal universes if the reader is counting.

Another degree of complexity involves sub-participation and related mechanisms (such as the total return swap (“TRS”)) which are described as ‘synthetic’, because they aim to create the economic conditions of legal credit-ownership without actually transferring legal title to that credit. Rather, this is achieved through indirect legal or pseudo-legal³ mechanisms. Thus Bank A in effect creates a scenario whereby, say, a private equity institution can act as if it were in the place of Bank A as lender to the borrower. Under sub-participation the participant pays an equivalent amount to the debt to Bank A in exchange for Bank A operating its rights as creditor of the borrower solely for the benefit of the participant.

Under a TRS the same result is achieved with a derivative contract, with Bank A swapping interest payments and debt repayments with the incoming counterparty in exchange for effective cancellation of its risk with respect to the borrower. The counterparty then receives payment if and only if the borrower pays its lender bank. If it does not pay, the counterparty receives nothing; economic risk is thus supposedly transferred to the counterparty. Trust mechanisms are another, though less popular, route to transferring debt risk.

Now the primary a posteriori criticism from regulators is that this model separates the possible risk analysis of the originating bank, which is the one which has sufficient contact with the borrower to assess its assets and long-term revenue streams, from the debt participation of the creditors. It was precisely this dislocation from the borrower(s) that fostered the growth of credit rating agencies as a short cut to due diligence⁴. As the originating bank may not have any exposure to the borrower beyond the first few months (or days), its motivations, even under the most hard bitten economic theory, to make a good job of due diligence of the borrower’s creditworthiness is virtually non-existent. It is at best limited to determining that the borrower is attractive enough to incoming syndicate members.

As an aside, the attractions of cutting corners has increased now that banks know that, if another crash occurs, central banks will be on hand to hand over taxpayer cash in exchange for toxic debt.

Concerns over creditworthiness, however, are not those of the borrower, who is largely unmoved provided it is given the promised millions when it asks. The borrower is much more troubled about who its lenders are, though these worries only arise in the initial stages of the credit agreement’s life in specific cases. For example, a US-based borrower will not want to be a contractual counterparty to an Iranian bank, unless its executives are interested in having long conversations with the FBI⁵.

Where the nature and makeup of the lenders has turned out to be important for every borrower is when things go wrong, such as financial covenants being breached and restructuring being proposed. Part of our industrial executive’s assumption about ‘mythical’ banking was that the relationship bank would help the business muddle through. That image is predicated on one individual at the bank being able to ‘make the call’ and waive certain rights given an intimate knowledge of the borrower’s business and therefore the coherence of the borrower’s claims that in a few months all will be well. The problem, as borrowers only partially found out, was that the image was completely divergent for reality.

Though still speaking to one relationship bank, that bank was now having to deal with 20 other banks, each with its own style, ethos, investment criteria, and proximity to immanent insolvency or nationalisation. I say ‘partially found out’, because, thanks to the variety of other participation mechanisms outlined above, each of those 20 banks may well have had sub-participants, swap counterparties, trust beneficiaries, all with their own views about which way to protect their investment. And it is this set which was not limited just to banks, still within the purview of non-binding codes of banking practice, but was open to private equity, vulture funds, high net worth individuals – anyone with sufficient cash to ‘dabble’ in corporate debt finance. These participants could be counted on for having a largely similar approach to the borrower’s problems, namely a combination of panic and ruthlessness. Boutique finance houses, funded not unlike racing horse syndicates in some cases, i.e. by a small group of ex-CIty traders with a few GBP million to spare, set up shop in backrooms in Luxemburg, Dublin or Mayfair and bet their cash on deals introduced to them in Chelsea bars and restaurants. Whereas, in extremis, banks retained the balance sheet capacity to write-off several million of risky investments, these boutique houses were in no such position and clung desperately to worthless deals, hoping their fallen horse would pick itself up and somehow win the race.

The less well-connected executives at borrowers across the the world were bewildered by the bizarre and uncharacteristic actions of the banks with which they were dealing, actions explicable because these banks were merely carrying out the orders of their hidden principals. Relationship banks attempted to coordinate multiple investment parties, each coordinating their own investors, with a view to agreeing by 51%, 75% or unanimously, the drastic restructuring changes required under the credit agreement. And remember, 75% as a voting minimum in the credit agreement was over-layered by further provisions in the intercreditor agreement(s) and other documents, each of which tightened or relaxed contractual voting rights and stipulations in ways that could only be guessed at by the borrower.

This organised chaos was intensified by the collapse of Lehman Bros. in particular. Lehmans had invested in everything and everywhere, through subsidiaries in places such as London and Luxembourg. Incidentally, the use of these subsidiaries allowed some Lehmans entities such as Lehman Bros. International (Europe) to fall outside of the EU’s directive on the insolvency of credit institutions⁶. This directive tried to bring trans-European Union Member State insolvencies of banks under one umbrella, so that their unravelling could be coordinated centrally and thus relatively speedily. The Lehmans bodies, falling instead under various local insolvency laws, were simply cut loose when their immediate parent operating through London shut its doors. Some Lehmans offices closed immediately; others limped on as zombie entities. It was these dead or undead Lehmans entities which had bought heavily into all sorts of deals.

By way of illustration, let’s take our borrower and its now 20 syndicate banks, plus facility and security agent. To keep things simple, imagine one syndicate bank is a Lehmans entity and it holds 26% of the debt. Now the borrower will need an amendment of an interest payment date, which requires (at least) 75% approval. Who, on behalf of the borrower, will the facility agent call to obtain Lehmans’ vote? The office is empty, its officers retired or now working elsewhere. Calls can be put out to the bankruptcy administrator in New York in the hope of some guidance, but the story goes that the Lehmans bankruptcy administrator is so overwhelmed by such calls that he won’t even consider an asset of less than US$100m. Corporate restructurings became snarled up in attempts to either obtain consents or, better, avoid having to ask.

The multiplicity of legal multiverses, founded on legal and pseudo-legal relations, is a far cry from the contracts of Chitty and Treitel (standard English law textbooks), and is a problem that has only become worse, but whose effects have yet to be felt. The panicked attempts at fixing balance sheets, which increased in intensity through 2008, became the order of the day through the winter 2008/09, with investment bankers being commanded to clean up their portfolios by every possible. Balance sheet cleansing meant in most cases selling assets at fire sale prices into the private equity/venture capital market, thus increasing borrowers’ exposure to the cowboys of banking’s Wild West.

Another option for ‘cleansing’, and this will sadly not surprise anyone, was packaging the assets up into special purpose vehicles and issuing new types of “top-rated” securities.

The difference now was that by far the largest buyers for such securities were central banks, which used acquisition of these assets as a means to pump new cash into the system. Cash which would not go, as intended, into struggling industrial borrowers, but rather straight out of the country and into the People’s Republic of China, which unsurprisingly is now experiencing a credit-inflationary boom the size of the South Sea Bubble⁷.

In Part 4, we will see how the banks’ success in stripping industry by means of restructuring and related fees inspired the tactic’s roll out into the world of state finance.

1
In fact General Motors is a prime example of financialisation in advanced capitalism. In the 1950s it set up the General Motors Acceptances Corporation to provide hire purchase finance for American families seeking to buy its cars. The HP model was so successful that by the 1980s what is now known as GMAC now dwarves GM and has expanded its operations into all forms of corporate and real estate finance.
2
Bloomberg, Greenspan Forgets Where He Put His Asset Bubble: Caroline Baum, 12 March 2009, http://www.bloomberg.com/apps/news?sid=aViiiUp_Lkwo&pid=newsarchive
3
The author regards certain common legal practices in finance as based on dubious beliefs that they are legally valid acts. The hope of banks is that if they are all doing it, no court will dare do other than declare these practices as driving validity on custom and commercial practice. This is especially tenuous a hope where statutes or common law appear to declare similar practices illegal without prior statutory validation (such as insurance, which is illegal but for the UK Merchant Shipping Acts).
4
NY Times, Regulators Push Banks to Limit Reliance on Credit Ratings, Jack Ewing, Published: October 27, 2010 http://www.nytimes.com/2010/10/28/business/global/28basel.html
5
John B. Reynolds, III, Amy E. Worlton and Cari N. Stinebower, “U.S. Dollar Transactions with Iran are Subject to New Restrictions – Tough Policy Decisions Face International Financial Institutions“, Wiley Rein LLP, November 28, 2007
6
The Credit institutions Reorganisation and Winding Up Directive (2001/24/EC). This took lawyers as well as their clients by complete surprise. See the following Clifford Chance briefing note: http://www.lma.eu.com/uploads/files/Clifford%20Chance_update.pdf
7
The Financial Times’ Aplhaville blog has been following China’s problems for some time, briefed by Socété Genérale and Crédit Suisse, see e.g. http://ftalphaville.ft.com/blog/2009/09/23/73556/chinas-looming-credit-crisis/