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Category Archives: BANKING-ECONOMY

Oct 28th 2008
From The Economist print edition

Will private equity behave any better in this downturn?

It is now 20 years since the mother of all corporate-takeover battles ended, when the private-equity firm, Kohlberg Kravis Roberts (KKR), acquired RJR Nabisco for $25 billion. A new edition of the best-seller about the battle, “Barbarians at the Gate”, by Bryan Burrough and John Helyar, has been published to mark the anniversary. Already widely regarded as one of the best business books of all time, the 2008 edition includes a fascinating extra chapter, updating the story.

Ross Johnson, the former chief executive of RJR Nabisco, is reportedly living a happy semi-retirement in Florida, bearing no ill will to anyone from back then, though it seems he doth protest a little too much that he secured a fantastic deal for the firm’s shareholders. Ted Forstmann, another private-equity legend, who fought hard to block KKR, is “still a little angry”, and the “one thing he wants readers to know” is that “it was he, Ted Forstmann himself, who coined the title of this book”.


Henry Kravis, meanwhile, is “just where we left him, in a conference room in KKR’s 42nd-floor offices at Nine West.” As the authors note, in the past 20 years KKR has enjoyed spectacular growth, with (at the time the book went to press—a couple of important months ago) $52 billion in assets under management, having grown from 32 employees in two offices to 400 professionals in a dozen offices around the world. KKR led a consortium that paid a record $45 billion for TXU, a Texas utility, in 2007—just before the credit crunch brought private-equity deal-making to an abrupt halt.

Of course, the industry’s big change since 1988 is that it has rebranded itself as “private equity”. KKR et al used to be known as leveraged buyout (LBO) firms, before they concluded that advertising their enthusiasm for borrowing was bad for their reputations, getting them called Barbarians and worse. Private-equity firms were supposed to be different from LBO firms. They try to use the best LBO techniques for improving the performance of the firms they buy, but without saddling those firms with the massive debt burdens that were to prove so disastrous for RJR Nabisco and many other acquisitions made after the 1980s’ LBO boom turned to bust. A study by Steven Kaplan and Jeremy Stein of the buy-outs executed at the boom’s peak (1987-88) found that around one-third went bust or needed restructuring by 1991. As Messrs Burrough and Helyar recount, firms such as RJR Nabisco suffered long-term damage to their brand and market share due to aggressive cost-cutting that was driven by the need to pay off debt and interest.

This time was supposed to be different. Yet, as Mr Forstmann tells the two authors, “the so-called junk-bond excesses of the 1980s were minor league compared to what’s been going on in credit markets in the last five years or so.” Already there are signs that the easy credit available until the summer of 2007 proved too tempting to some private-equity firms. So far this year, at least 32 significant private-equity-backed firms have gone bust, according to Ed Altman of New York University’s Stern School.

The main saving grace is the “covenant lite” debt that private-equity firms used this time to make their acquisitions, which has made it much harder for lenders to force firms into bankruptcy when they fail to meet their payments. As Hamilton James, the chief executive of Blackstone Group, a firm that has arguably surpassed KKR in the private-equity firmament, argued earlier this year, “covenant-lite debt structures are not only in private equity’s interest, they’re in everyone’s interest. The only one you might argue is not better off is the senior secured. By keeping the company intact, the private-equity owners are able to fix the problems, and by preserving the employees, the customers and the business, society at large benefits.”

True enough. On the other hand, covenants-lite will mean bigger losses for lenders, which may ultimately hit the private-equity-owned firms, as they will lead to tighter lending conditions and thus to slower economic growth.

Still, the head of one big private-equity firm was bullish this week, telling The Economist that “losses by private-equity this time around will disappoint the prophets of doom.” Indeed, he points out that many big private-equity firms have plenty of equity—raised before the credit crunch—and unused lines of credit from banks. Thus, they are well placed to make huge returns by buying assets at the bottom of the cycle, just as they have done in past downturns.

The new chapter ends with two thoughts. First, given how today’s private-equity industry seems “eerily reminiscent” of the early 1990s, post-RJR Nabisco hangover: “Does anyone on Wall Street ever really learn anything?” Well, we shall see. Second, asserted with more certainty: “Be assured, however, that the Barbarians are out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates.” Indeed, while all eyes are on the financial market meltdown, the gates may already be opening.

International Herald Tribune
U.S. banks likely to hold tight to bailout money
Friday, October 17, 2008

Even as the U.S. government moves to plug holes in American banks, new gaps keep appearing.

As two financial giants, Citigroup and Merrill Lynch, reported fresh multi-billion-dollar losses on Thursday, the industry passed a grim milestone: All of the combined profits that major U.S. banks earned in recent years have vanished.

Since mid-2007, when the credit crisis erupted, the nine largest American banks have written down the value of their troubled assets by a combined $323 billion. With a recession looming, the pain is unlikely to end there. The problems that began with home mortgages, analysts say, are migrating to auto, credit card and commercial real estate loans.

The deepening red ink underscores a crucial question about the U.S. government’s plan: Will lenders deploy their new-found capital quickly, as the Treasury hopes, and unlock the flow of credit through the economy? Or will they hoard the money to protect themselves?

John Thain, the chief executive of Merrill Lynch, said Thursday that banks were unlikely to act swiftly. Executives at other banks privately expressed a similar view.

“We will have the opportunity to redeploy that,” Thain said of the new capital during a telephone call with analysts. “But at least for the next quarter, it’s just going to be a cushion.”

Granted, the banks are in a deep hole. For every dollar the banks earned during the industry’s most prosperous years, they have now wiped out $1.06.

Even with the capital from the government, analysts say, the American banking industry still needs to raise around $275 billion in light of the looming losses.

But Treasury Secretary Henry Paulson Jr. is urging them to use their new capital soon. On Monday, Paulson unveiled plans to provide $125 billion to nine banks on terms that were more favorable than they would have received in the marketplace. The government, however, has offered no written requirements about how or when the banks must use the money.

“There is no express statutory requirement that says you must make this amount of loans,” said John Dugan, the comptroller of the currency. “But the economics work so that it is in their interest to do so.”

Dugan added that he would not examine how the banks use the money, but he said their actions would “be open to the court of public opinion.”

The banks could use the money from the government for any number of things. Some analysts say the banks may use it to acquire weaker competitors. Others say they might use it to avoid painful cost-cutting. And still others say the banks may sit on the capital.

Lenders have been pulling back on credit lines for businesses, mortgages, home-equity loans and credit-card offers, and analysts said that trend was unlikely to be reversed by the government’s money.

“I don’t think that the market wants to see that capital being put to work to leverage the business up again,” said Roger Freeman, an analyst at Barclays Capital, which acquired parts of the now-bankrupt Lehman Brothers last month. “My expectation is it’s quarters off, not months off, before you see that capital being put to work.”

Many banks are still plagued by past excesses. Losses on a variety of different types of loans of all sorts are growing and spreading beyond the country’s borders. Citigroup and Merrill Lynch have each lost money every quarter in the last year, as deteriorating assets wiped out revenue.

Merrill, which is in the process of merging with Bank of America, reported a $5.15 billion loss, dragged down by about $12 billion in write-downs.

Citigroup lost $2.82 billion, as its $13.2 billion in charges related to credit losses more than overwhelmed every bit of revenue that the bank generated. And analysts say Citigroup is likely to face several more quarters of loan losses as the global economy slows.

Every corner of the economy goes through cyclical ups and downs. But the banking downturn has acted with ferocious speed to erase past profits.

In the case of the nine-largest U.S. commercial banks — Citigroup, Merrill Lynch, Bank of America, Morgan Stanley, JPMorgan Chase, Goldman Sachs, Wells Fargo, Washington Mutual and Wachovia — profits from early 2004 until the middle of 2007 were a combined $305 billion. But since July of 2007, those banks have marked down their valuations on loans and other assets by just over that amount.

“The losses now are showing that in some sense the profits reported in earlier years were not real, because they were taking too much risk then,” said Richard Sylla, an economist and financial historian at the Stern School of Business at New York University.

Sylla noted that the average profit of the financial industry in the first decade of this century will be abysmal, despite the fact that there were a handful of record years recorded in the middle.

The ways banks value their investments has already come under scrutiny. Bankers are supposed to be skilled at valuing assets, and many of their sky-high bonuses before the credit crisis were based on the lofty values attached to mortgage securities.

In the future, when Wall Street finds a new profit center, as it surely will, analysts may look back at the losses in this downturn as they question new earnings.

At Citigroup, for instance, the write-downs on mortgages and other loans have eaten away 60 percent of all the profits made by the bank during the boom years. At Morgan Stanley, the cost has reached 70 percent of those profits, and at Merrill Lynch, the tally is 250 percent of the investment bank’s record earnings over those three and half years.

It is those same banks that are in some shape benefiting from the government’s recent capital infusion. Three of the nine — Merrill Lynch, Washington Mutual and Wachovia — are in the process of mergers with others in the group. Two other banks — State Street and Bank of New York Mellon — also received capital from the government this week.

Several of the banks, including Wells Fargo, Morgan Stanley, and Goldman Sachs, declined to comment on how they will spend the government funds once they arrive.

Bank of America said in a statement that the money “will add to our capital, which will increase our capacity to expand our balance sheet and make more loans.” It did not say if it was willing to increase its lending.

Indeed, observers point to the growing well of bank losses, deeper by the quarter, as reason to question whether the government funding will be used as a financial Band-Aid, instead of an engine to move forward.

“It is the government’s responsibility to set the terms and conditions on this money,” said David Walker, the former U.S. comptroller general and now president of the Peter Peterson Foundation. “This is the people’s money. They’re giving it out with no rules.”

Walker noted that the government had yet to put together a board to oversee the Treasury’s actions in implementing the bail-out, as was required by Congress.

Bank executives, meanwhile, said on conference calls this week that it was premature to discuss their plans.

Jamie Dimon, the chairman and chief executive of JPMorgan, said his bank is a stronger position to use the money than some of its competitors.

“It’s clear that the government would like us to use the capital,” Dimon said on a conference call with analysts on Wednesday. “If you are a bank that is filling a hole, you obviously can’t do that.”

And Gary Crittenden, Citigroup’s chief financial officer, on Thursday called the government’s $25 billion investment in Citigroup “incremental to our thinking.” “We now have more capital than we anticipated,” he said in an interview. It will “allow us to opportunistically build what we have not been able to do.”