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The Credit Crunch and the U.S. Economy Steven Rattner March 27, 2008 A Brief Recent Economic and Financial History We begin our story in March 2000, when stock market indices reached all-time highs The dot.com meltdown and accompanying recession inflicted meaningful damage on the U.S. economy and financial system ¾ The U.S. economy went into recession in March 2001, with unemployment rising to 5.5% and cumulative job losses of 1.6 million ¾ Equity markets plunged -- the S&P fell 49% from its 2000 peak and the NASDAQ declined 78% over a similar period ¾ Bankruptcies among highly leveraged companies¹ increased to 8.3% of outstanding debt from a 20-year average of 3.8%. But the damage proved short-lived as the government injected massive stimulus through repeated tax cuts and reductions by the Federal Reserve in its key interest rate from 6% to 1% 1 ¹Companies with high-yield debt in their capital structure. Source: JP Morgan Research The Ensuing Golden Age The economy grew steadily from 2002 through the end of 2007, with real GDP expanding at an annual rate of 2.6% during this period. ¾ Productivity rose at a 3% rate ¾ The unemployment rate fell to 4.4% ¾ Inflation remained low ¾ Consumer spending grew by 5.7% annually 2 Note: Productivity measured as non-farm business output, from the Bureau of Labor Statistics. Consumer spending measured as per capita personal consumption spending from the BEA The Golden Age (cont’d) Stock prices began a steady rise S&P 500 Oct. 9, 2007: Price: 1565.1 1600 1500 1400 15. 7 AG %C R 1300 1200 March 11, 2003: Price: 800.7 1100 1000 900 800 700 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Dec-07 3 Borrowers Were Huge Beneficiaries With capital readily available, the cost of borrowing (relative to Treasuries) fell to record lows and lending grew at a rapid pace Spread to Worst 1000bp $180 JPMorgan Global High-Yield Index 900bp $160 800bp $140 $151.6 $158.2 $120 700bp 600bp New High-Yield Issuances Long-term average (1987 -07)= 542bp $149.1 $147.9 2006 2007 $106.1 $100 $80 $67.8 500bp $60 June 2007: 269 bps 400bp $40 300bp $20 200bp $0 2003 2004 2005 2006 2007 2002 2003 2004 Split B or Lower 2005 Total High Yield Issuance 4 Source: JP Morgan Research Lenders Were Happy to Lend One of the primary drivers of this heightened activity in the debt and LBO markets was the historically low level of corporate bond defaults In 2007 only 10 companies ($3.0 billion in debt) defaulted in the U.S., the lowest figure by number since 1981 and by dollar volume since 1994 D ollar Weighted High- Yield D efault Rate 15.0% 10.0% 5.0% -1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: JP M organ Research 5 Private Equity Boomed Record liquidity in the credit markets fueled historic volume in the buyout market In 2007 low rated debt – often raised to finance leveraged buyouts – swelled to 35% of the total high yield issuances in the U.S. $160 30% ($U S in Billions) $140 25% $120 $100 20% $80 15% $60 10% $40 5% $20 $0 5,000 35% 0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Split B or Lower H igh Yield Issuance Source: JP Morgan research T otal H igh Yield Issuance Announced G lobal M&A Volume 40% 4,500 35% 4,000 (US$ Billions) U.S. Histo rical High Yield Issuance (L ower Rated Issuance % of T otal) $180 30% 3,500 3,000 25% 2,500 20% 2,000 15% 1,500 10% 1,000 500 5% -- 0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 LBO Volume T otal M&A Volume LBO % of T otal M&A Source: Thomson, DeaLogic 6 And So, Of Course, Did Housing As we are now painfully aware, the credit expansion led to a boom in housing prices, which rose far faster than incomes Index Level (scaled to 2000) 250 Housing Price Index vs. Median Household Income 10.7% annual decline in January 2008 200 150 100 50 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 0 S&P/CS H ome Price Index Median H ousehold Income 7 Note: S&P Case/Shiller 20-market home price index The Age of Turmoil: A Quick Summary The unwinding of the credit bubble famously began with the dramatic upsurge in defaults by subprime borrowers, followed in short order by near paralysis in the high yield market, where rising supply overwhelmed demand. During the autumn, these developments spread into the “real” economy, as job losses began to occur in the housing and financial sectors and consumers pulled back on spending as a result of falling home prices and overall nervousness about future economic prospects. Economic forecasters began to gradually raise their estimates of the probability of a recession; today Intrade puts the odds of a recession at 70%. The credit markets are even more dramatically signaling recession. 8 Recent Economic Indicators Point to Recession Some leading economic statistics indicate the potential for a recession ¾ Real GDP growth was 0.6% in the Q4 2007, and was not revised upward. This result was lower than the 1.1% expected by economists, and the weakest GDP growth for the economy since 2002 ¾ The unemployment rate was 4.8% in February 2008, up from 4.4% in March 2007 ¾ New housing construction was down significantly, with Feb. 2008 declining 28% from Feb. 2007 ¾ The Institute for Supply Management indices have largely been below 50 since December, signaling contraction ¾ The Conference Board consumer confidence index has declined significantly since July (down 43%, from 114 to 64.5) ¾ Retail sales declined 0.6% in February Source: BEA, White House Economic Report, The Conference Board, ISM, US Dept. of Housing and Urban Development 9 Investment Grade Spreads vs. Recession The investment grade market is clearly signaling recession. Recession levels (190 bps, 3/17) 200bp Investment G rade Index (CD X IG9 5- yr) 180bp Spread to W orst 160bp Long-term average (1987 - ytd 08)= 73bps 140bp 120bp 100bp 80bp 60bp 40bp 20bp 8 20 0 7 20 0 6 20 0 5 20 0 4 20 0 3 20 0 2 20 0 1 20 0 0 20 0 9 19 9 8 19 9 7 19 9 6 19 9 5 19 9 4 19 9 3 19 9 2 19 9 1 19 9 0 19 9 19 8 9 0bp Source: Goldman Sachs 10 Ambiguous Equity Markets The S&P index has dropped 10% since January 1 and 15% from its peak on October 9th However, the S&P index currently trades at 16.1 times LTM earnings, below its 20 year historic average of 19.3 times S&P 500 LT M P/ E S&P 500 35.0x 1600 1550 30.0x 1500 25.0x 1450 1400 20.0x 1350 15.0x 1300 10.0x 1250 5.0x 1200 08 9/ 7 /2 02 20 0 6 1/ /3 03 /3 03 /3 03 20 0 5 1/ 20 0 4 1/ 20 0 /3 03 03 /3 1/ 1/ 20 0 20 0 1/ /3 03 /3 03 3 2 1 20 0 0 1/ 20 0 9 1/ 03 /3 1/ /3 03 /3 1/ 19 9 19 9 8 20 08 03 3/ 26 / 20 08 26 / 2/ 7 26 / 1/ /2 12 11 /2 6/ 6/ 20 0 20 0 7 7 20 0 6/ /2 10 9/ 26 / 20 07 20 07 26 / 8/ 26 / 20 07 7/ 26 / 6/ Source: Capital IQ 20 08 0.0x 20 07 1150 Source: Standard and Poors 11 Ambiguous Equity Markets (cont’d) When comparing the earnings yield of the S&P 500 index to the yield of the 10-year Treasury (known as the Fed Model) the S&P currently has a higher yield, implying that it is relatively cheap when compared to bonds This barometer of share prices suggests that the stock market is more attractive than at any time over the past 10 years S&P Yield vs. 10-yr T reasury Yield 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 'S&P 500 Earnings Yield 8 00 /2 2/ 29 20 07 07 0/ 09 /3 1/ /3 03 09 /3 0/ 20 20 06 06 20 05 03 /3 0/ /3 09 '10-Year T reasury Yield 1/ 20 20 05 04 0/ 06 /3 0/ /3 09 03 /3 1/ 20 20 04 03 20 03 09 /3 0/ 20 02 1/ /3 03 09 /3 0/ 20 20 02 01 1/ 03 /3 0/ /3 09 03 /3 1/ 20 20 01 00 20 00 0/ /3 /3 1/ 09 Source: Standard and Poors, St. Louis Fed 03 09 /3 0/ 19 20 99 99 19 98 03 /3 1/ 19 0/ /3 09 03 /3 1/ 19 98 0.0% 12 Credit Market Working Through Backlog Following the meltdown in the U.S. mortgage and sub-prime lending markets, liquidity dried up for corporate debt as well, including over $300 billion in previously committed LBO financing Banks and investors have been hard at work since July digesting over $100 billion of the backlog Many of the deals that came to market from the backlog were priced at a discount and continue to trade below par ¾ However, banks have maintained discipline in offloading these loans up to this point Leveraged Loan Backlog High Yield Backlog $120 (US$ Billions) (US$ Billions) $250 $200 $150 Dow n $100 44 % $100 $80 $20 $0 $0 Completed Deals Canceled Deals Current Backlog 32 % $40 $50 Summer '07 Dow n $60 Summer '07 Source: JP Morgan research, Bank of America research Completed Deals Canceled Deals Current Backlog 13 Ramifications for Private Equity The aforementioned factors have led to a dramatic slowdown in private equity activity Announced Buyout Volume H as Stalled Since the Summer Peak 30 $125 25 $100 20 $75 15 $50 10 $25 5 $0 0 Ja n F e - 06 b M -06 ar Ap - 06 M r-0 ay 6 Ju - 06 nJu 06 Au l- 06 g Se - 06 pO 06 c N t- 0 6 ov D -06 ec Ja - 06 n F e - 07 b M -07 ar Ap - 07 M r-0 ay 7 Ju - 07 nJu 07 Au l- 07 g Se - 07 p O -07 c N t- 0 ov 7 D -07 ec Ja - 07 n F e - 08 b08 $150 (# of Deals) (US$ in Billions) $1B+ LBO D eal Volume Source: SDC, CapitalIQ # of $1B+ LBO D eals 14 Ramifications for Private Equity (cont’d) Early 2008 activity suggests a continuation or even an acceleration of this trend Glo bal M&A Volume YT D N ew Issuances YT D $800 $700 (US$ Billions) (US$ Billions) $45 $40 $35 $30 $25 $20 $15 $10 $5 $0 $500 $400 $300 $200 $100 $0 2007 Split B or L ower H igh Yield Issuance Source: JP Morgan research $600 2007 2008 T otal H igh Yield Issuance LBO Volume 2008 T otal M&A Volume Source: Thomson, DeaLogic 15 Widened Credit Market Spreads Credit risk premiums – which by July had compressed to record lows – have widened Arguably, even today’s levels may not be sufficient given: a) higher than historic levels of debt in buyouts, b) uncertain economic outlook in the U.S. and c) housing / general credit market weakness JPMorgan Global High- Yield Index 680bp 5/31/07 = 269bp 510bp 340bp Long-term average (1987 - ytd 08)= 542bp 170bp 3/19/08 = 819bp 06 Ju n06 Au g06 O ct -0 6 D ec -0 6 Fe b07 Ap r07 Ju n07 Au g07 O ct -0 7 D ec -0 7 Fe b08 Ap r- 06 0bp Fe b- Spread to W orst 850bp Source: JP Morgan research 16 Private Equity Default Risk The biggest risk to the debt markets at present is the specter of a significant uptick in default rates Forecasters such as Moody’s expect the global default rate to almost triple over the next year The proliferation of highly leveraged deals “priced to perfection” over the past few years suggest that private equity-sponsored companies may suffer during a period of economic weakness ¾ Financing features available in prior deals (e.g. “covenant-lite” and “PIK-toggle” instruments) may mitigate default risk, or delay an eventual default S&P recently issued a watch list of 74 names, not surprisingly, 50 of which are private equity sponsored companies T otal D ebt / EBIT D A in LBO T ransactions 8.0x 7.0x 6.5x 5.8x 6.0x 5.0x 6.5x 4.9x 5.0x 1995 1996 5.3x 5.8x 5.5x 4.7x 4.8x 4.7x 2001 2002 2003 5.2x 5.3x 2004 2005 4.0x 3.0x 2.0x 1.0x 1997 1998 1999 2000 2006 2007 17 Source: JP Morgan research Near Meltdown in Financial Markets For the most part, the adjustments in the financial markets have been orderly One moment of potential panic occurred in mid-March, when Bear Stearns imploded Bear Stearns Stock Price (3/7-3/20) $80 Lehman Bros. Stock Price (3/7-3/20) $60 $70 $50 $60 $40 $50 $40 $30 $30 $20 $20 $10 $10 $0 8 8 3/ 20 /0 /0 19 3/ /0 18 3/ 17 /0 8 8 8 3/ 17 3/ 3/ 14 /0 /0 8 8 /0 3/ 13 /0 /0 12 3/ 11 3/ 8 8 8 /0 10 3/ 3/ 7/ 08 8 20 3/ 19 /0 /0 8 8 18 3/ 3/ /0 8 /0 8 17 3/ 17 14 /0 8 3/ /0 8 3/ /0 13 3/ 12 /0 8 8 3/ 11 /0 8 3/ /0 10 3/ 3/ 7/ 08 $0 18 Plenty of Volatility The pace of market volatility has quickened, unnerving many participants (while cheering others) Nasdaq Volatility Index (VIX) 35.0 30.0 25.0 20.0 15.0 10.0 3/26/07 4/26/07 5/26/07 6/26/07 7/26/07 8/26/07 9/26/07 10/26/07 11/26/07 12/26/07 1/26/08 2/26/08 19 Source: CapitalIQ Unwinding of Leverage $ bil $1,300 A prominent feature of the adjustment process has been a significant deleveraging throughout the financial system. The problems of KKR Financial and Carlyle Capital are examples of the consequences of this phenomenon. Asset-Backed Commercial Paper Outstanding $ bil $2,300 All Commercial Paper Outstanding $2,200 $1,200 $2,100 $1,100 $2,000 $1,000 $1,900 $900 $1,800 $1,700 $800 $1,600 $700 $1,500 $1,400 $600 3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08 3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08 20 Source: Federal Reserve, 3/22/08 Where Do We Go From Here? Since last summer, the consensus economic forecast for 2008 GDP growth has steadily become more pessimistic 3.5% 3.0% 3.0% Real GDP Growth Forecast 3.0% 2.5% 2.5% 2.5% 2.5% 2.0% 2.0% 2.0% 2.0% 1.5% 1.5% 1.5% 1.0% 1.0% 1.0% 1.0% 1.0% 0.5% 0.0% (0.5%) (0.5%) (1.0%) (1.0%) (1.5%) Q1 = July 2007 Forecast Q2 = Sept. 2007 Forecast Q3 = Nov. 2007 Forecast Q4 = Mar. 2008 Forecast 21 Source: Goldman Sachs But We Should Not Be Overly Pessimistic The probability is that a recession is likely to be shallow ¾ More sophisticated economic policymaking has led to generally benign economic conditions over the past two decades, a phenomenon known to economists as “The Great Moderation” ¾ The last two recessions (1990-91 and 2001-02) were each eight months in duration and relatively mild The U.S. economy remains productive and flexible, and inflationary pressures appear contained The massive interest rate reductions by the Federal Reserve and the recently enacted stimulus package will gradually insert a positive influence on growth The fall in the dollar provides an important push for exports While the possibility of a financial meltdown cannot be ignored, the probability is that the losses from imprudent lending will slowly work through the system Absent any cataclysmic events, the adjustments in markets that are now underway will prove healthy and beneficial 22 23