Preview:X 430.611 Credit: commercial, personal, and global

X 430.611 CREDIT: COMMERCIAL, PERSONAL, AND GLOBAL

Joe El Rady

X 430.611 will provide students: An overview of the macroeconomics of credit. Details of firm level economics , finance, and accounting

of leverage. Knowledge about various credit instruments, their

behavior, and pricing. Focus on both credit markets (primary as well as

secondary) and firm-level credit decisions. Examination of consumer credit both from the standpoint

of markets and individual level credit decisions. Analysis of bubbles, bank runs, liquidity crises and

default (both corporate and consumer/individual).

The following slides present a sampling of class content.

Class Content

Why is Credit Important?

The Importance of Credit

5

Credit – Why Is It Important? Firm has ability to lend / invest. Opportunity to generate income and

create long-term value for the firm. Business dependent on credit –

Trade, Operations, Capital Raising, M&A and Restructuring.

Bank DebtOther Loans

Bonds

Mezzanine

Preferred Equity

Common Equity

What is Capital Structure?

7

Capital Structure Overview

Key Considerations

Senior Bank Debt

(Asset-Based)

Senior Bank Debt

(Cash Flow) Senior NotesSecond Lien

NotesSubordinated

NotesConvertible

DebtPrivate Equity

Cost of Funds L + (250-325)

L + (375-650) LIBOR

Floor

T + (175-450)

9-15% Floating

14-19% 20-25% 22-35%

Dilution None None None None Limited Meaningful Substantial

Leveragability (Multiple of

EBITDA)

Asset Value Approach

2.0-4.0x 2.5-5.0x 2.75-5.0x 2.5-5.5x 5.0-7.0x N.M.

Maturity 1-6 years 4-7 years 5-8 years 4-7 years 5-7 years 7-10 years N.M.

Covenant Flexibility

Flexible Restrictive Restrictive Restrictive Flexible Minimal N/A

Interest Rate Risk Yes Yes No Yes None None None

Collateral Yes Yes No Yes No No No

Prepayment Penalty

Varies No Make-Whole Yes Yes Minimal N/A

Timing to Close 10-14 weeks 10-14 weeks 10-14 weeks 10-14 weeks 14-18 weeks 16-20 weeks 18-22 weeks

Investors Banks, Commercial

Finance Companies

Banks, Hedge Funds,

Finance Companies

Insurance Companies

Banks, Special

Situation Funds, Hedge

Funds

Insurance Companies,

Funds

Hedge Funds and Private

Equity Funds

Hedge Funds and Private

Equity Funds

How are different credit instruments prioritized in capital structure?

9

Who provides the various credit instruments in the capital structure?

Banks (BofA, Wells Fargo, Citibank, JP Morgan) Senior, Second Lien, Limited Mezzanine Focus: Relationship focused, preservation of principal, cross-selling of services

Financial Services Firms (G.E., CIT) Senior, Second Lien, Mezzanine and Minority Equity Focus: Relationship minded but transaction oriented; focus on lending

Second Lien Funds (Canyon Capital, Contrarian Capital) Second Lien and Limited Mezzanine Focus: Transaction oriented

Mezzanine Funds (Caltius Mezzanine, Key Mezzanine, Blackstone Mezzanine) Mezzanine and Minority Equity Focus: Relationship minded but transaction oriented

Hedge Funds (Cerberus, Silver Point, Fortress) Senior, Second Lien, Mezzanine, Structured Equity, Minority Equity and Control Equity Focus: Transaction oriented

Private Equity Funds (Centre Partners, Kirtland Capital, Summit Partners) Minority and Control Equity Focus: Relationship minded

10

How do the broad categories of loans differ? Asset Based

Extend credit based on underlying value of assets % of Receivables and inventory % of Net “Orderly Liquidation Value” of equipment Potential advance against intangibles Multiple of cash flow and P&L performance of secondary importance

Cash Flow Based on multiple of cash flow – EBITDA Influenced by (i) level of free cash flow, (ii) stability and

predictability of cash flow, (iii) nature of business and industry, (iv) cyclicality, (v) enterprise value, (vi) size of company

Greater perceived risk than ABL given that cash flow can evaporate Enterprise Value

Approach is closely aligned to cash flow Level of debt is geared to enterprise value and level of equity

cushion required Ability to potentially provide more capital than cash flow approach

Key Questions and Characteristics of the Money Market

The Money Market

How do we determine the Federal Funds Rate?

How do we determine short term interest rates?

How do we determine yield spreads?

How do we determine the TED Spread?

What is Commercial Paper and why do Corporations use it?

What are bankers acceptances?

An Overview of the Syndicated Loan Market

The Syndicated Loan Market

What is the syndicated loan market?

What is the syndicated loan market? What is a loan? How do we define different loan

segments? How large is the loan market? What are the differences between

loans and bonds? How do the primary and secondary

markets differ?

What is a syndicated loan? Large loan that is sold in pieces to

lenders Floating rate, senior debt in

borrower’s capital structure Senior, secured debt sold to non-

bank investors Senior debt which moves in tandem

with the bond market

Syndicated loan issuance is more than US$1.6 Trillion

US Syndicated Loan Market is larger than US High Yield Bond Market

What is a Syndicated Loan? Generally a senior debt instrument Dominant types include revolvers, term loans

Revolvers can be undrawn, partially drawn or fully drawn

Term loans usually are fully drawn at close Generally syndicated by a lead bank to a group of

banks and/or institutional investors Usually floating rate Tenor can range from several months to 10+

years Generally have more covenants than a bond issue FOUR KEY LOAN MARKET SEGMENTS

There are four key large corporate loan market segments

What is syndication?

Generally syndicated–broken into pieces and sold to lenders

Lead arranger–arranges loan and theoretically holds the biggest piece

Syndicates remainder

How is Credit Priced?

Credit Pricing

Investment returns compensate risks

What is Risk? How is Risk related

to Return? What is the risk –

return tradeoff? How is Risk

measured? How is Risk

calculated? Risk

Retu

rn

Risk measures the precise probability and impact of specific outcomes Risk measures both the likelihood of a hazardous

event and the harm of that event

Event ofAmt Event of ProbRisk Does a “risk free” investment exist? How is risk compensated?

How is risk measured or calculated in finance? Financial risk is defined as the statistically

unexpected variability or volatility of returns (an outcome different from the expectation)

In statistics the expectation is called the “Mean”

The variability about the expectation is called the “Standard Deviation”

In life, science, math and the universe all data exhibit a central tendency. The distance from the center defines the variability

Corporate Bonds and their issuers have credit ratings

Quality Moody’s S&P

Investment Grade

Highest Aaa AAA

High Aa AA

Tier-1 Medium A-1, A A

Tier-2 Medium Baa-1, Baa BBB

Noninvestment Grade (Junk)

Speculative Ba BB

Extremely Speculative

B, Caa B, CCC, CC

In Default Ca, C D

What is a Corporate Credit Rating?

What is the relationship between default risk and ratings?

Bonds and the Bond Market

Bonds

Bond Characteristics

10-37

Bond Basics

Two basic yield measures for a bond are its coupon rate and its current yield.

value Par

coupon Annualrate Coupon

How do we price bonds?

10-39

Premium and Discount Bonds

Premium bonds: price > par valueYTM < coupon rate

Discount bonds: price < par valueYTM > coupon rate

Par bonds: price = par valueYTM = coupon rate

10-40

Relationships among Yield Measures

for premium bonds: coupon rate > current yield > YTM

for discount bonds:coupon rate < current yield < YTM

for par value bonds:coupon rate = current yield = YTM

10-41

Interest Rate Risk and Maturity

10-42

Duration

Bondholders know that the price of their bonds change when interest rates change. But, How big is this change? How is this change in price estimated?

Macaulay Duration, or Duration, is the name of concept that helps bondholders measure the sensitivity of a bond price to changes in bond yields.

2YTM1

YTMin ChangeDurationPrice Bond in Change Pct.

Duration Basics

Duration measures how long, in years, it takes for the price of the bond to be repaid by its internal cash flows.

10-44

Properties of Duration

Debt and Public Policy

Credit in the Macroeconomy

Bank Runs, Liquidity Crises, Bubbles

The Dark Side of Debt

How does debt fuel consumption, increase asset prices, and inflate bubbles?

How does excessive leverage distort the economy?

Leverage!1. Reversal of Glass-Steagall in 1999 set off a

leverage race on Wall Street

2. Leverage outside the banking system largely unregulated / misunderstood

3. Explosion of credit markets allowed each segment of risk to be isolated… and further leveraged

4. Tiering of risk allowed for multiple layers of leverage with limited transparency

5. Investors became complacent while regulators became overwhelmed

Extent of Leverage is a Differentiating Feature of this Particular Cycle

Government Debt 1

Federal and Consumer

Debt as % of GDP 2

$0$1,000

$2,000

$3,000

$4,000$5,000

$6,000

$7,000

$8,000$9,000

$10,000

193819

4219

4619

5019

5419

5819

6219

6619

7019

7419

7819

8219

8619

9019

9419

9820

0220

06

Fed

era

l D

eb

t ($

bil)

0%

50%

100%

150%

200%

250%

300%

1943

1947

1951

1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

Perc

en

t of

GD

P

Total Consumer Debt Total Federal Debt

(1) Office of Management and Budget, Budget of the United States, FY 2007(2) U.S. Chamber of Commerce as of 8/27/08

Bank Leverage 2

%

Extent of Leverage is a Differentiating Feature of this Particular Cycle

Share of Intermediation Through

Banks & Securities Markets 1

(1) Morgan Stanley. “Levered Losses: Lessons Learned from the Mortgage Market Meltdown” 2/08(2) SNL Financial. Data as of 7/31/08

20%

25%

30%

35%

40%

45%

50%

55%

60%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Intermediated Through Securities MarketsIntermediated Through Depository Institutions

0

1

2

3

4

5

6

7%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Reserves/Loans TCE/TA

6.4%

1.8%

1.2%

5.2%

Total Assets of Top 5 Brokers 1

($ tril)

6% CAGR 16%

CAG

R

(1) SNL Financial. Top brokers traded on the NYSE and NASDAQ(2) Source: Lehman Brothers. Data provided 8/28/08

Global Issuance of Structured Finance Products 2

Extent of Leverage is a Differentiating Feature of this Particular Cycle

-

100

200

300

400

500

600

700

800

900

1,000

1995

Q1

1996

Q1

1997

Q1

1998

Q1

1999

Q1

2000

Q1

2001

Q1

2002

Q1

2003

Q1

2004

Q1

2005

Q1

2006

Q1

2007

Q1

2008

Q1

(in $ bil)

Total CDO Total ABS

Anecdotes of Leverage ~$2.3 tril in “AAA” guarantees supported by six

monolines with less than $20 bil in equity (0.8%)(1)

In June 2007, financials made up 20.9% of S&P 500 Implies that approximately 30% of every dollar earned by an

S&P 500 company was earned by a financial services firm

Total assets of the top 5 brokerage houses in the U.S. equaled approximately 35% of the total U.S. annual GDP. Balance sheets were levered on average 30:1(3)

In 1998, failure of Long Term Capital brought markets to their knees, based on a loss of $4.6 bil.(4) To-date system has incurred approximately 75x(5) this amount. Industry’s capital base increased by only 2.5x that during this time(6)

(1) Pershing Square Capital Management. “How to Save the Bond Insurers,” 11/07(2) Company Reports. Data as of Q4 2007(3) SNL Financial. Data as of Q4 2007(4) Financial Times. “Bank bailout shows need to intervene,” 6/08(5) Loss estimate to-date of $460 bil provided by Goldman Sachs. Data provided on 8/28/08.

Inflation data provided by the U.S. department of Labor.(6) SNL Financial. As measured by tangible capital base of top 25 U.S. financial institutions (excluding insurance companies, from 1998 to Q2 2008)

Mortgages

Mortgages

Mortgages

Cash

Cash

Cash & Fees

AAACashCash

AA Below

Notes

Cash

10 to 1

50 to 1 (Warehouse)

50 to 1

15 to 1

30 to 1

Consumer

Loan Origination

Wall Street

Structured ABSRatings Agencies

70%FNMAFHLMC

30% BankInsurance

CompaniesCDOs

AAA’s, AA, A, BBB, BB

Equity

Wall Street

Source: Wachovia Securities, “Lifestyles of the Rich and Living Rich,A Tale of Two Consumers,” 2005

400 to 1Leverage

The Leverage GameNotwithstanding the existing underlying leverage, banks could lever AAA securities by over 100:1!

Risk vs. Information

Originator

Warehouse Provider

Senior Bonds

Mezzanine Bonds

Sub Bonds

Residual NotesCDO Equity

Performance Risk

Un

derl

yin

g C

olla

tera

l K

now

led

ge

Least Most

Least

Most

Efficien

t Fro

ntier

Source: Wachovia Securities, “Lifestyles of the Rich and Living Rich,A Tale of Two Consumers,” 2005

Those who knew the most held the least amount of the risk…

…while those who knew the least ended up holding the most risk

Hedging, Insuring, Mitigating Risk

Credit Derivatives

What is securitization?

What is a Collateralized Loan Obligation?

What is a Total Return Swap?

What is the role of options in the credit markets?

How are Interest Rate Swaps traded?

How are Options priced?

How are Fixed Rate Notes priced?

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