Let the show begin

“You’re not going to see companies restructuring; you’re going to see whole industries. Defaults don’t go up by a little, they jump. And when the dam breaks, it’s broken, and you’ll have many companies that are going to need fixing.”

—Barry Ridings, Lazard, in WSJ Deal Journal Interview, August 2

Each day the volume of articles treating our staggering credit markets seems to increase, and while there is some very real-world pain being inflicted due to the markets’ wobbles (and for that the affected folks have my sympathy), I admit that now is when things start to get interesting.

First, let’s review an interesting piece of information emanating from some of the top law firms in the world. On August 3, The New York Times reported that Cravath, Swaine & Moore, the venerable New York firm, had just hired on one Richard Levin, a bankruptcy law guru. This is interesting for two reasons. First, Mr. Levin is not a ‘Cravath’ lawyer, but was hired away from legal juggernaut Skadden, Arps, Meagher & Flom, making Mr. Levin just the second partner at Cravath to be brought in from the outside…ever. Mr. Levin must be an important guy, you say. And yes, I suppose, he’s pretty top-drawer as bankruptcy lawyers go. Some are better, most not.

That brings us to the second interesting thing here—Cravath has brought in Mr. Levin to begin a bankruptcy group at the absolute bottom of the current cycle. The last few years have been one of the quietest periods ever for corporate bankruptcies. Clearly, the guys at Cravath see the tide beginning to turn. To make the rare decision to hire from the outside—and to do so at the trough of the cycle—would be a pretty good indication that Cravath’s corporate lawyers see a pretty large storm cloud on the horizon, and given their elite status in the world of corporate law, they would be in a position to know. And after all, they could have made this move years ago, but didn’t. They chose now. It could be mere opportunism...or not. We should be mindful of this as we examine other bits of data.

The biggest and brightest signpost of high liquidity in the marketplace has been the leveraged buyout boom. The ease and cheapness of financing is what has fueled ever-larger buyouts, including the biggest buyout on record, last month’s $48.4 billion takeover of Bell Canada by private equity acquirors. As liquidity dries up, so too will the buyouts, or at least, so goes the reasoning. Already, questions have emerged regarding recent large debt offerings, such as the kind used to finance LBOs. For instance, the UK’s Telegraph Media Group reported this weekend on the troubles that Alliance Boots, a recent private-equity target, has had in completing the bank financing needed finish the buyout. The report stated:

The global credit crunch has claimed its latest victim, with banks attempting to finance the takeover of Alliance Boots being forced to shelve the sale of £1bn of second-lien debt after failing to attract buyers.

The latest stumbling block follows last week’s postponement of the £5bn syndication of senior debt because of market turbulence caused by problems in the US sub-prime mortgage market.

The second-lien facility was due to be priced at a hefty discount of 96pc of par, at a spread of 425 basis points over the London Interbank Offered Rate (Libor), which was itself increased from 400 basis points.

The report also cited figures from Barings Capital Management stating that 46 deals have been scrapped since late June, representing over $60 billion in financing that has, quite literally, dried up.

How does this affect stock markets? In the past few months, the effects were mostly localized—financial institutions and those in the housing industry were hit hard, but the Dow Jones Industrial Index and the S&P 500 plugged on toward record numbers in the face of credit woes. In the last few weeks, however, credit troubles have “jumped the track,” dragging the market down considerably. The S&P began this week a mere 1.5% higher than at New Year’s.

One reason could be that certain stocks, particularly in the middle market, might have had a “takeover premium” priced into them, as investors tried to seek out companies that were ripe for a takeover bid. An environment with fewer takeovers, however, would naturally erase this premium from the marketplace. It should noted that many experts view LBOs’ effects on global stock valuations as nugatory, as mentioned today in The New York Times’ Dealbook.

More likely, the recent sell-off of equities is driven by a collection of worrying signs, not one magic bullet. There is evidence that the US economy is grinding to a halt and may already be in recession. Unemployment is nudging upwards; productivity, the linchpin of American growth, is slowing; inflation remains worrisome; corporate investment, often viewed as a proxy for corporate confidence, is decreasing. All of these things, when viewed together, suggest that the sell-off was past due.

But there is something going on here beyond the day-to-day vagaries of the equities markets and their connection to debt, and there is evidence that what we may be seeing is the start of an enormous correction, highlighted by a large spell of bankruptcies. Warren Buffett’s adage about low tide and swimming naked has been repeated ad nauseam over the past week. One can only hope that, as the tide recedes, the banking industry doesn’t get caught in the undertow, because that bailout would no doubt end up on the balance sheets of the American taxpayer…and would do so precisely at a time when Uncle Sam will need to balance fighting inflation (via less liquidity) with providing relief (via greater liquidity).

It has been noted that this cyclic downturn is the first one since the latest revolution in corporate finance. The ability of banks to chop up debt, convert it to paper, and then sell it on in the form of securities has revolutionized finance, but we’ve never seen what happens to all these fancy financing instruments in a distressed marketplace. There is still a great deal of uncertainty concerning who, exactly, will get caught holding the bag when these debt obligations falter. Which brings to mind another adage from the Sage: If, after a few hands of poker, you’re still trying to figure out who’s the patsy, you’re the patsy. It should frighten us at this stage of the game that so many bankers are at the poker table trying to figure out who’s the patsy.