Slide 1: The world we live in
From Toxic Debt to Toxic Behaviour
Giuseppe Schermi 5th October 2008
Slide 2: Financial Market Outlook
• Consolidation of financial investors
– Commerzbank/Dresdner, Lloyds/HBOS etc
• Back to Banking intermediation
– Wind-down of SPVs
• Mortgage CDOs, Leveraged CLOs, Hedge Funds
• Global Government bail outs, i.e. acquisition of large chunks of ‘toxic’ debt
– US, UK, Ireland, Germany
Slide 3: Mark to Market
• Introduced to privilege transparency over returns’ volatility
– Management Compensation Scheme still based on absolute Market returns
• Unlimited upside in bull market, limited downside in bear market.
Slide 4: Drivers of Market price
1. Risk assessment of underlying asset
– The asset class has become riskier on average
Western Europe LBOs&Recaps: Average Debt to EBITDA Ratios
source: Reuters
7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50
1Q 02 2Q 02 3Q 02 4Q 02 1Q 03 2Q 03 3Q 03 4Q 03 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 1Q 06 2Q 06 3Q 06 4Q 06 1Q 07 2Q 07 3Q 07 4Q 07 1Q 08 2Q 08
Tot. Debt:EBITDA
Sr. Debt:EBITDA
Slide 5: Drivers of Market price
1. Liquidity Premium
– In bull markets, investors attribute a premium to scarcity i.e. less liquid assets are harder to find
• CDS market booming as a consequence of lack of underlying debt paper
Quote from an asset manager:
‘our portfolio is worth a premium over its face value because it is not replicable, we own up to 100% of some debt instruments and there is no market because we won’t sell.’
Slide 6: Drivers of Market price
3. Repricing
– In bull markets, risk premium decreases.
• As a consequence underling assets trade at discount when the market reverts like a government bond price sensitivity to interest rate change. – LevX Senior ca. E+1.75% before Credit Crunch up to ca. E+6.25% currently – Flow-name bids plummet to 84.03, a record low
Old School:
Nominal debt issue at par: 100 Blended Interest Rate: E+2.625% Upfront fees: 1x the spread. implied interest rate: E+3.2%
Slide 7: Consequences on Market price:
• Market exuberance
– Up to1H07: Significant riskier assets, sometimes illiquid held to maturity at significant lower yield
Quote from sell-side:
‘Everything for syndication in Europe is worth 2% more the day after in secondary market’ ‘we track via Intralinks which institution does or does not download due diligence info’ ‘we have received large commitments from funds ahead of the scheduled management presentation’
Slide 8: Consequences on Market price:
• Liquidity Crunch:
– 2H07: Illiquid assets attract no buyers, liquid assets forced to be sold at discount due to excess of supply first mortgage funds, hedge funds to wind down
Slide 9: Consequences on Market price:
• Financial Credit Crunch:
– 2008: in absence of a liquid market, assets are effectively marked down at the last trade, regardless of potential opportunistic behaviours.
• Spill over effect from forced sell pricing to the entire financial investors market.
Slide 10: How toxic is ‘toxic debt’:
• If listed Companies’ debt trades 50% lower than nominal, why Equity is not trading close to zero? • What level of defaults are implied in today pricing?
Slide 11: How toxic is ‘toxic debt’:
• Defaults
– Quote from an old school banker:
• ‘Companies do not default because of their operations, companies default because their liabilities become due and payable but not settled’.
Slide 12: Toxic Behaviour: Debt Acceleration
• What will trigger defaults with certainty?
– Immediate repayment of large chunk of liabilities unmatched by refinancing capability.
• No Companies and no Governments hold sufficient cash on balance sheet to meet their own current and future liabilities immediately.
Slide 13: Toxic Behaviour: Debt Acceleration
• Typical contractual covenants causing acceleration:
1. Financial Ratios 2. Rating downgrades 3. Mark to market thresholds
Slide 14: Toxic Behaviour: Debt Acceleration
• Financial Ratios:
– Typical of LBO market, because of its stringent reporting requirements – Established to provide early warning and negotiation tool to force management taking action to correct performance well before a payment default occur.
– Vicious loop: Rating downgrades typically follow as consequence of a covenant breach, due to uncertainty on debt holder’s behaviour.
Slide 15: Toxic Behaviour: Debt Acceleration
• Rating Downgrades:
– Typical of investment grade market (including securitizated SPVs), due to less information, less financial leverage – Established as a proxy for credit soundness
– Vicious loop: Rating downgrades are not expected to occur frequently for those investments because perceived as ‘sleep-atnight’ credits and wide spread. Hence when they occur, they cause large amount of panic.
Slide 16: Toxic Behaviour: Debt Acceleration
• Mark to Market thresholds:
– Typical of SPVs such hedge funds, who finance themselves on a rollover basis linked to their portfolio market value – Established as a proxy for credit soundness, under the implied assumption the market is efficient
– Vicious loop: in an illiquid bear market, forced sells drive market price further down, leading even more forced sells.
Slide 17: Conclusions
• It is neither Mark to Market nor Ratings to blame for market crisis but the wrong understanding we make of them. Government bail outs increase risk of government defaults due to toxic debt financing, without restoring market confidence. It is fair risk assessment which market needs.
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Slide 18: Conclusions: Good time to buy?
• PE Funds are buying out asset management shops and debt instruments Buffett says ‘holding cash is like saving sex for old age’ Alternative Investment players are piling up cash to invest in secondary and distress opportunities.
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Slide 19: Conclusions
• Top management performance should be based on risk adjusted return, instead of stock performance Sell side performance should be based on risk adjusted return, instead of sales volumes/final take achievement. Asset Managers should not receive performance fees before returning investors money and min return in full
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