# Staking a claim

## market trends

The dismal impact of 2002 on the credit markets is still being felt, not least in the form of damage awards in the courts and juicy email excerpts from debt analysts and bankers, most notably in the case of WorldCom. Meanwhile, regulators from the SEC to state attorneys general have been finding fault with the financial industry and its capital markets activities.

Following the repeal of Glass-Steagall in 1999, consolidation among financial institutions has been rampant, with the global banking powerhouses convinced that maximum profitability is to be gained from offering one-stop shops for banking services. From bank lines to bond underwritings, from M&A advice to equity IPOs, from secondary market bond trading to funds management, the full range of those services has increasingly been offered under one roof. Many of the banks even flooded the market with dotcom trading platforms to guard their positions and keep out usurpers.

Those universal banks that could best integrate their lending and capital markets activities were well placed to win the lion’s share of mandates; the success of the strategy has been evident in the underwriting league tables in which the commercial banks have steadily gained ground on their narrower investment banking counterparts.

Nonetheless, 2003 has been a year when the advocates of banking ‘supermarkets’ have seen their chickens come home to roost. In the “credit market wars” that erupted in the wake of the Enron default, the commercial banks found themselves struggling to cope with credit risk exposure on many fronts and juggling a range of competing internal interests as they attempted to deal with the problem. The charge of biased research has been the topic that has received most of the headlines to date – and cost the industry most in terms of making financial restitution – but it is hardly the only example of the conflicts of interest that were created once financial specialization gave way to consolidation.

Tension
What is now capturing regulatory and legal attention and is sure to be the subject of future lawsuits/investigations/settlements is the inherent tension that exists within the capital structure of any company. The interests of those sitting on the different rungs of the capital ladder (bank lenders, public debt holders, equity owners) are only broadly aligned at the best of times and never less so than when a company is under duress. At that time, the jostling that takes place as each of these stakeholders tries to best protect their interests can get downright hostile. Even non-stakeholders would find it difficult to claim to be able to judiciously serve all the parties involved.

Given the advantages that are afforded to the lending consortium when the debt renegotiations begin, suggesting that serving all interests can be done off a commercial banking platform looks a lot like inviting the wolf to tend the sheep.

Ultimately the bank’s problem is its bank loan commitment – not investors’ bonds – and the bank’s problem usually comes first. There was ample evidence in the dark days of 2002 when bonds were defaulting in droves that the commercial banks were more than willing to take a hostile position vis-à-vis bondholders, especially if a covenant renegotiation or a refinancing need gave them the opportunity to do so.

That attitude can express itself in many forms. One of the newest versions of this in recent years is lifting protection in the credit default swap (CDS) market – a process that enables the banks to lay off risk in a far less transparent fashion than was previously possible. Most large mainstream institutional investors are prevented from even using such vehicles, let alone executing in size through the handful of banks that dominate that market.

As the CDS dealers turn directly to the cash market to hedge the trade, such activity invariably ends up weighing heavily on traded bond spreads. The sinister side of this is that when banks lift credit protection, it can be a simple risk mitigation exercise or it can be a function of the banks knowing something the overall market isn’t yet aware of by virtue of their privileged position at the renegotiation table. That is often the worry for the CDS-watchers, and those looking to game the market away from the banks can use these signals to inflame the situation for their purposes on the short side.

The other techniques that are employed by banks as they push their way to the head of the capital structure are more blatant and usually more damaging to bondholders’ interests. In 2002 we saw myriad restructurings that delivered tightened covenants and additional bank line terms that started to alert the market to the darker side of structural risks.

The trap doors for the unsecured bondholders included banks rolling in mandatory prepayment provisions on the occurrence of any capital markets transactions, which often came with a reduction in the size of the loan commitment. Too frequently that term was inserted on the back end of the waiver and the same bank, or banks, collared the capital markets transaction mandate.

Other hardball structural moves included inserting prepayment provisions tied to asset sales, and outright pledging of assets or inserting ratings-based springing liens. Too often the asset sale was a good business, thus eroding the position of those left behind, and the lead banks were deriving some incremental fees in the process. Some companies even had to come clean on previously undisclosed ratings-based ‘events of default’. Some banks demonstrated how easy it was to play ‘switch the obligor’ on bondholders without affording ‘equal and ratable’ secured status, revealing again the inherent gaps in high-grade indenture language.

Remember the great Qwest Communications stunt on its coercive debt exchange? It is no surprise the exchange document was closely guarded by its architects on pain of death since it served as a rather damning document for what can be done to bondholders in downside scenarios. It is, at the very least, a template for the structural pounding that can be delivered to bondholders who are vulnerable to indentures from issuing entities more removed from the direct ownership line of the operating assets.

The most damaging scenario for bondholders is the possibility of the banks redrawing the family tree to create further structural subordination. In Qwest’s case, it explicitly talked of haircutting bonds in a veiled threat to cause additional erosion of asset protection under the new entities created to facilitate the exchange. It will be interesting to see if the post-rally bondholders forgive and forget such structural sinkholes in high-grade indentures or look to see better language in the future.

Structurally, it certainly raises more questions than any busy syndicate manager would want to answer. Maybe a warning label on indentures: ‘Buying boilerplate high-grade indentures can be damaging to your health in a down credit cycle.’ Rallies forgive many evils, but some lessons should be taken away for the next bout of volatility.

At the very least, bondholders should take a hard look at their holding company structures, the legal position of the issuing entities in relation to the operating assets, and the alignment of the family tree of borrowers for medium-grade and cusp issuers especially.

Bondholders should also look at their failsafes on the way down the credit ladder, which unfortunately are quite few. People often get ‘new-age’ cross-acceleration boilerplate confused with old-time cross-default language, with the inevitable result that bondholders are unfortunately left on the sidelines while the banks end up in the driver’s seat. It’s a tough situation, but ironically in a credit crisis this actually helps some companies for a while. For example, securitizing the bank lines may be painful to bondholders in terms of ratings, but the fact that the banks have the ability to do this means at least credit will be made available to enable the companies to continue to operate.

Pecking order
Of course it is worth noting that should the medicine not be enough to cure the illness and the company become destined for Chapter 11, then all the banks have done is to ensure that they’re first at the feeding trough while bondholders are left impotently watching as they face subordination down an increasingly flimsy capital structure.

But given that the credit markets have already traversed their darkest hour of this economic cycle and the evidence is growing that the upswing is gaining legs, it might be reasonable to think that the eleventh hour restructurings that gave rise to the most grievous examples of subjugation of bondholder interests are a thing of the past.

The fallen angel volumes aptly capture the stabilization of credit quality. According to Moody’s, in 2001 there was $154 billion of fallen angel volume and in 2002 the total jumped to over$200 billion. To end-August 2003 that tally had dropped to just \$26 billion, a dramatic improvement that suggests that capital structure tension is dissipating. If bondholders have already survived this particular epidemic, is there any need to draw further attention to it?

In the capital markets, bad behavior is not easily forgiven or even forgotten and the litigious environment that exists in the US encourages those who believe themselves to have been financially harmed to actively seek full restitution. Therefore, the subject of integration of investment activity under a commercial banking umbrella is sure to be subject to further discussion on many levels. It is already being raised with reference to the practice of ‘tying’ (see article, pages 30–34).

Regulatory interest
Some time ago Representative John Dingell, the ranking Democrat on the House Energy and Commerce Committee, opened an investigation into practices whereby banks use their lending books as leverage to win more lucrative investment banking business. Dingell maintains that the practice has become a central feature of the strategy of a number of large commercial banks, to the detriment of a broad range of parties.

While the banks are prohibited from explicitly demanding securities business in return for credit lines, many believe the practice has intensified in recent years and has played a large part in the acceleration of the commercial banks in the investment banking industry league tables. The concern about tying is obviously on the climb as on August 25 the Federal Reserve Board requested public comment on the anti-tying restrictions in section 106 of the Bank Holding Company Act.

The Association for Financial Professionals and the Capital Markets Research Center at Georgetown University conducted a survey in late 2001 to assess the degree to which corporate access to short-term credit was contingent upon the use of other banking services. It concluded that cross-selling does occur. Six per cent of survey respondents were “required” to award debt underwriting business to their commercial bank credit providers, with another 21% “strongly encouraged” to do so. One of 10 respondents were “strongly encouraged” to use the equity underwriting and strategic/M&A advisory services of their commercial banks in order to be granted short-term credit. About 20% of respondents reported being “encouraged” to use other services, even if they were not “required” or “strongly encouraged” to do so.

As the legal eagles and regulatory watchdogs continue to upbraid the finance industry for conflicts of interest, the potential in this situation is far too lucrative to be overlooked. The commercial banks are playing both sides here as they ensure that they profit from the distribution of public debt securities but maintain the ability to severely erode the value of those securities with actions taken to protect the value of their loans.

Bondholders should not be too quick to conclude that this situation no longer has teeth with which to bite them. Overall credit quality may be stabilizing but there are still many instances where bondholders can confirm what they already suspect: the banks are playing with a loaded deck.

For the latest data point on that assertion, just look at Moody’s multi-notch downgrade on Union Carbide on the back of lack of disclosure and contingent liability risk surrounding the firm’s asbestos exposure. Union Carbide is just one of many companies hampered by asbestos exposure and the only entities that have a solid footing in extracting information on it are the banks. In the case of Union Carbide, the structural subordination was a bank line from the parent, but is it certainly interesting that no bank lines were in place at a major subsidiary with parent guarantee. Parent company Dow will of course make the case that Union Carbide is a stand-alone company, and that asbestos plaintiffs cannot pierce the ‘corporate veil’.

For bondholders, the lesson lies in drawing a line from this specific event to the more general areas where real threats of structural subordination still lurk. Asbestos-related risk is prime among these and bondholders should become even more sensitized to it as the issue could continue to heat up, particularly if the legislative agenda for asbestos falters, as many predict.

Louise Purtle is credit strategist at CreditSights, an independent credit research provider

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