Rising Unemployment Poses the Greatest Threat to Economic Recovery
Prior to the financial crisis of last fall, available credit had reached the pinnacle of historic levels. However, with the implosion of this nation’s financial system, a vast overcorrection has ensued, leaving smaller and mid-sized companies with nowhere to turn. The Wall Street Journal recently reported that loan portfolios at the 15 largest banks contracted 2.8 percent in the second quarter of 2009. The systematic liquidation of our middle-market economy threatens to further shrink the U.S. and global economies and to drive permanent unemployment rates to heights not witnessed in generations.
The implosion of credit markets began as a Wall Street crisis but rapidly spread to Main Street, paving a path of destruction along its way. Credit markets seized and the global economy appeared to stand on the precipice of collapse. Governments rapidly intervened with myriad programs designed to slow the pace of damage. The TARP buttressed struggling financial companies. Liquidity programs were originated to resuscitate moribund credit markets. And new programs, such as the TALF and PPIP, were designed to thaw frozen credit markets and to inspire the private market purchase of so-called toxic assets, respectively.
|“Breaking from historical
unemployment rate currently
at 9.5% is
one to 1.5 percentage
points higher than would
be expected under one
economic rule of thumb,
says Lawrence Summers,
Obama's top economic
adviser.” – The Wall Street
Journal, July 23, 2009
These programs succeeded, to varying degrees, in their respective ambitions to prime the pumps of specific financial markets. Although the grave risk of impending financial collapse may be behind us, the economy remains fragile under the weight of significant pressure. The fall-out from the crisis of last autumn has given way to the new and dangerous threat of extremely high unemployment and permanent job losses, a prospect more frightening than others to most Main Street Americans. Absent an immediate rescue solution, unemployment could peak in excess of 12 percent with underemployment levels approaching 20 percent, exacerbating demand destruction and further economic deterioration.
According to Larry Summers, Director of the White House National Economic Council, the current unemployment rate of 9.5 percent may be one to one-and-a-half percentage points higher than economic conditions would historically warrant. Economists are beginning to ask “Why?”. The evidence points clearly and directly to deficient sources of lending to middle-market companies.
Credit Starvation to MiddleMarket Companies Drives Job Losses
For large companies, credit conditions have tightened, but capital is clearly available. Improvements in commercial paper, equity and high-yield bond and loan markets have allowed large companies to rationalize expenses and operate, despite deep declines in revenues. For very small companies, SBA loans can often be accessed. However, the vast middle-market between the two –- “the tween market” where approximately 40 percent of Americans are employed -- has fallen through the cracks of myriad programs designed to reignite credit markets.
Middle-market companies depend on working capital loans from banks to operate their businesses in the ordinary course -- to finance inventory purchases and to fund payroll and other operating expenses. In every business there are timing differences between the spend of capital to manufacture and deliver a product or service and the payment for those goods or services by customers. For most middle-market companies, access to credit ranges from scarce to none. Battered by a perfect storm of declining revenues and a dearth of credit, companies are liquidating and terminating their work force by the hundreds of thousands each month.
The needs and performance of large companies garner significant attention, but their total labor comprises only a very small percentage of our nation’s total employment. Companies with in more than 500 workers employ approximately 17 percent of America’s workers. Small and mid-sized companies, on the other-hand, employ more than 83 percent. Middle-market companies, those with more than 50 but fewer than 500 workers, employ 39 percent of workers yet account for 44 percent of job losses – more than any other group.
In a normal recession, job losses, while painful, are anticipated and even necessary. Recessions cull the weakest companies, creating room for the strongest and most innovative to thrive. The process of creative destruction is perceived as integral to the successful performance of free market economies. However, this economic collapse is by no means a normal recession. Too many job losses are a result of changes in bank lending strategies and not directly linked to underlying economic forces. Companies that in previous recessions would have achieved work-out solutions and forbearance from banks, or rescue financing from alternative lenders, now alarmingly find themselves without capital and with nowhere to turn but towards layoffs and liquidation. The economy is not in the process of cyclical creative destruction, but rather in the deadly grasp of secular, irreparable economic devastation.
The Solution – SME Rescue Loans
The most direct and rapid solution to stem job losses is to incent private enterprise to originate and monetize rescue-financing loans for struggling smaller and middle-market companies.
The Rescue Loan Program (“RLP”) will access unutilized TARP funds already set aside for PPIP. Treasury originally intended that $75-$100 billion of TARP funds be used for PPIP programs to purchase toxic loan assets from bank balance sheets. Yet, as of today, only $30 billion has been allocated for use in the PPIP Legacy Securities Program. The PPIP Rescue Loan Program will initially use $30 billion for equity and debt investments, leaving available an additional $15-40 billion of the funds originally contemplated for PPIP.
The RLP will be structured based upon similar constructions to those announced in the existing PPIP programs. Pre-selected investment managers will raise a minimum of $150 million in equity capital, which will then be used along with $50 million of equity contributed by the Treasury. Private sector equity capital will serve as the first loss layer to both the loans and equity capital provided by the taxpayer. While the taxpayer will share in the returns, private investors -- not the taxpayers -- will bear the majority of the risk. Additional leverage, of up to four times equity, will then be provided by TARP funds. It will be required that at least $15 million (or 10%) of equity in the Rescue Loan Investment Partnership (RLIP) originates from direct investment by the investment manager’s firm or partnership.
The RLP will be available to companies who have been turned down by banks, whose loans are in default with banks, whose reserves on loans have increased over 10% in the last 12 months companies who require debtor-in-possession financing during bankruptcy restructuring. All loans will need to be senior secured and first in right of payment.
Eligibility requirements for the RLP will be less narrow than other PPIP programs in order to include many talented smaller managers and to encourage small and minority firms to participate. Investment firms, who manage a minimum of $1 billion of gross alternative investment assets, to include distressed debt, distressed lending or distressed private equity will be eligible for application and, provided that criteria are met, 20% of firms chosen will be small or minority-owned. All firms must demonstrate that the capability necessary to originate, monetize and service such loans can be performed in-house.
How the Rescue Loan Program Works
Step 1: Treasury selects investment managers through a competitive application process.
Step 2: Approved managers raise a minimum of $150 million in equity capital (10% from firm).
Step 3: Treasury invests 25% of additional equity capital to result in a 75%/25% ratio of equity.
Step 4: Equity receives leverage of up to 4 to 1.
Step 5: Private capital serves as a first loss layer to the equity provided by the taxpayer.
Step 6: The investment manager will then originate, service and monetize the loan portfolio and the timing of its disposition on an ongoing basis. Eligible asset managers will be approved by and subject to oversight by the Treasury.
In order to most accurately analyze the risk to repayment of government funds, the matrix included on pages 6 and 7 highlights returns to equity under specified default and recovery rates. To help place such risk in perspective, S&P, in May 2009, stated that its preliminary estimate for its 12-month trailing speculative-grade default rate rose to 9.2 percent in June, its highest level so far this year and that they expected “the speculative-grade default rate to escalate to a mean forecast of 14.3 percent by May 2010, but it could reach as high as 18.5 percent if economic conditions are worse than expected,” said the report.
An S&P report dated January 2009 states that recovery rates on senior secured loans have historically had little correlation with its underlying credit ratings of borrowers as senior secured loans are most often structured to offset default risk with high recovery rates. The report further noted that recovery rates on borrowers with ratings at the lower end of the spectrum would likely still provide the same high recovery rates as borrowers with superior ratings. The average recovery rate on senior secured loans during the years 1998 to 2008 was 82%, with future recovery rates anticipated on average to be 78%.
Our sample rescue loan portfolio, on the following page, assumes a default rate of 30 percent, significantly higher than the worst case default rate scenario of 18.5 percent contemplated by S&P. Additionally we assume recovery rates on defaulted loans of 60%, significantly lower than those predicted than S&P. Even using these very conservative assumptions, our model portfolio produces returns to the taxpayer at very low risk
1 “Loans Shrink as Fear Lingers,” The Wall Street Journal, July 27, 2009. http://tinyurl.com/ntvfnc
2 “Job Cuts Outpace GDP Fall,” The Wall Street Journal, July 23, 2009. http://tinyurl.com/myjv6m
3 ADP National Employment Report, June 2009. http://www.adpemploymentreport.com/
4.“Defaults Surged to ‘Massive’ Half-Trillion Dollars,” Bloomberg News, May 13, 2009. http://tinyurl.com/lx9dus
5. “More than A Year into The Credit Crunch, Lenders Confront Diminished Recovery Prospects,” S&P, January 7, 2009. http://tinyurl.com/mc645k