Marginal Companies with Marginal Business Models are Going to Crack

By: Reggie Middleton | Thu, Jul 30, 2009
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I know the stock market has been on a tear as of late, which did not do well for those of us trying to short shoddy fundamentals. That doesn't help companies burdened with the dubious combination of excessive debt and shoddy business models though. I analyze companies, and I can tell a strong company from a weak one. My analysis may take some time to bear fruit when the government, the media, and the major market players act in concert to suspend null matter that happens to be a decent portion of the S&P 500. Alas, although I can't control stock prices, I can (as the child star in "The Sixth Sense" alludes) "see dead people"!

The problem with the bad business model powered by debt is that you cannot tell it was a bad business model without delving heavily into the books. The companies with these models were able to borrow money and push the borrowings out as earnings which seemed to have easily fooled both the naive retail investor and the lazy institutional investor who never bothered to look at where the "so-called" money was coming from.

Well, the easy money well has dried up, and it will not get refilled any time soon. Hence we see insolvencies, bankruptcies, and "dead people". A prime example of not being able to roll over debt was General Growth Properties where I issued a lot of predictive research before the fact, but it will go way beyond overleveraged development companies.

First let's look at commercial and industrial lending from a historical and comparative perspective using data from the Wells Fargo economics team, who sees green shoots as well except for some distinct factual observations in commercial and industrial (C&I) lending:

In looking at previous recessions (the gray shaded areas), one can easily determine that C&I lending will drop precipitously, even if not particularly after the recession is over.

The drop in C&I also seems to run a very tight correlation to business inventories. Basically destocking softens credit demand, or is it the other way around???

Now, the question is not which came first, the chicken or the egg. It is what is responsible for the drop in credit, suppy or demand destruction. I say both, but listen carefully. Responsible borrowers do not want credit now. They are trying to retrench, both on the corporate and the consumer side. There is a large swath of potential borrowers who are very hungry for loans though. These are the adverse selection crowd. The guys who shouldn't have been lent to in such excesses in the first place, but were before the bust of the shadow banking system (which we will get to soon), and whose existing loans are coming due for rollover and refinance. These are the guys whose business models are predicated on bubble economics and easy credit, who are literally walking zombies, and who will go down, regardless of how high the stock market rallies.

Comparisons to other recessionary periods are not necessarily tantamount to being accurate this time around though. Why, because the majority of corporate and consumer credit, paricularly in the US, no longer exists or is essentially a government entitlement program, ex. consumer and corporate welfare.

Source: NY Federal reserve

The following is an abstract of research from the NY Fed on the "shadow banking system", ex. the securitization market, which for all practical intents and purposes, no longer exists in any significant form.

The current financial crisis has highlighted the growing importance of the "shadow banking system," which grew out of the securitization of assets and the integration of banking with capital market developments. This trend has been most pronounced in the United States, but it has had a profound influence on the global financial system. In a market-based financial system, banking and capital market developments are inseparable: Funding conditions are closely tied to fluctuations in the leverage of market-based financial intermediaries. Growth in the balance sheets of these intermediaries provides a sense of the availability of credit, while contractions of their balance sheets have tended to precede the onset of financial crises. Securitization was intended as a way to transfer credit risk to those better able to absorb losses, but instead it increased the fragility of the entire financial system by allowing banks and other intermediaries to "leverage up" by buying one another's securities. In the new, post-crisis financial system, the role of securitization will likely be held in check by more stringent financial regulation and by the recognition that it is important to prevent excessive leverage and maturity mismatch, both of which can undermine financial stability.

How did we get so dependent on securities to supply us with loans. Well, Wall Street is the answer, mein freund.

When I say the market no longer exists, I really mean it no longer exists...

As excerpted from the Fed paper,"

However, the drying up of credit in the capital markets would have been missed if one paid attention to bank-based lending only. As can be seen from Figure 7, commercial bank lending has picked up pace after the start of the financial crisis, even as market-based providers of credit have contracted rapidly. Banks have traditionally played the role of a buffer for their borrowers in the face of deteriorating market conditions (as during the 1998 crisis) and appear to be playing a similar role in the current crisis."

From the Fed report, "Securitization refers to the practice of parcelling and selling of loans to investors. It was intended as a way to disperse risks associated with bank lending so that deep-pocketed investors who were better able to absorb losses would share the risks. But in reality, securitization worked to concentrate risks in the banking sector. There was a simple reason for this. Banks and other intermediaries wanted to increase their leverage - to become more indebted - so as to spice up their short-term profit. So, rather than dispersing risks evenly throughout the economy, banks and other intermediaries bought each other's securities with borrowed money. As a result, far from dispersing risks, securitization had the perverse effect of concentrating all the risks in the banking system itself."

Armed with the knowledge of what has truly happened to our banking and lending system, it really makes one wonder what will become of the latest actionable intelligence subject forwarded to subscribers (see Technically insolvent Intelligence note 2009-07-29 00:40:46 926.20 Kb):

XXX has a structurally weak balance sheet loaded with a significant amount of debt, negative shareholders' equity and an enormous amount of goodwill (excess costs over fair value of net assets acquired) making the company, technically, an insolvent concern. As of March 31, 2009 the company had total assets of $9.6 bn while tangible assets (deducting only goodwill representing excess costs over fair value of net assets acquired) stood at $8.5 bn. In contrast the company had total debt of about $12.2 bn. Besides this, the company had negative shareholders' equity of $5.4 bn while tangible tangible equity (deducting only goodwill representing excess costs over fair value of net assets acquired) was at negative $6.6 bn. XXX's Altman's Z-score has deteriorated sharply over the past two quarters declining from an already alarming 0.53x in 1Q08 to an abysmal 0.40x in 1Q09 (an Altman's Z-score below 1.81x indicates serious financial trouble and a high chance of bankruptcy with a historical 72% probability of bankruptcy over the next couple of years).

 


 

Reggie Middleton

Author: Reggie Middleton

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