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The Credit Crunch and the U.S. Economy
Steven Rattner
March 27, 2008
A Brief Recent Economic and Financial History
ƒ
We begin our story in March 2000, when stock market indices reached all-time highs
ƒ
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%.
ƒ
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
ƒ
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)
ƒ
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
ƒ
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
ƒ
ƒ
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
ƒ
Record liquidity in the credit markets fueled historic volume in the buyout market
ƒ
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
ƒ
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
ƒ
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.
ƒ
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.
ƒ
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
ƒ
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
ƒ
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
ƒ
ƒ
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)
ƒ
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
ƒ
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
ƒ
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
ƒ
ƒ
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)
ƒ
$1B+ LBO D eal Volume
Source: SDC, CapitalIQ
# of $1B+ LBO D eals
14
Ramifications for Private Equity (cont’d)
ƒ
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
ƒ Credit risk premiums – which by July had compressed to record lows – have widened
ƒ 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
ƒ The biggest risk to the debt markets at present is the specter of a significant uptick in default rates
ƒ Forecasters such as Moody’s expect the global default rate to almost triple over the next year
ƒ 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
ƒ 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
ƒ
For the most part, the adjustments in the financial markets have been orderly
ƒ
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
ƒ
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
ƒ
A prominent feature of the adjustment process has been a significant deleveraging throughout
the financial system.
ƒ
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?
ƒ
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
ƒ
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
ƒ
The U.S. economy remains productive and flexible, and inflationary pressures appear
contained
ƒ
The massive interest rate reductions by the Federal Reserve and the recently enacted
stimulus package will gradually insert a positive influence on growth
ƒ
The fall in the dollar provides an important push for exports
ƒ
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
ƒ
Absent any cataclysmic events, the adjustments in markets that are now underway will
prove healthy and beneficial
22
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