Warwick Business School

Guy Fraser-SampsonGuy Fraser Sampson23 November 2009

The banking crisis in contextThe banking crisis in context

• History of banking crises, e.g. 1991• Over 700 Savings and Loan institutionsOver 700 Savings and Loan institutions

failedC t th US G t (t )• Cost the US Government (taxpayer) over $120 billion to sort out

• Led to corporate bank debt totally drying up in 1991 on both sides of the Atlanticup in 1991, on both sides of the Atlantic

Some similaritiesSome similarities

S&L f il k d b l i l ti• S&L failure was sparked by legislative changes which allowed them to change the fundamental nature of their business

• A factor was a large increase in property g p p yvalues sparked by passive investment

• Knock-on effect of residential mortgage• Knock-on effect of residential mortgage debt into the banking sectorB k t d l di• Banks stopped lending

• Collapse of corporate bond market

But important differencesBut important differences

• In 1991 there was nothing fundamentally wrong with the banking system

• In 1991 the direct effect of the crisis was confined largely to the US (though big indirect g y ( g geffect elsewhere when international syndication dried up))

• In 1991 there were very few credit derivatives• In 1991 the banks were not over-lent / under-• In 1991 the banks were not over-lent / under-

protected

The Asian Crisis 1997The Asian Crisis 1997

• Catalysts was Thai government’s decision to let the Baht float after they were unable yto defend its peg to the dollar

• Most observers thought Thailand was• Most observers thought Thailand was already effectively bankrupt because of its

flarge foreign debt at high interest levels• Caused mainly by a real estate bubble,Caused mainly by a real estate bubble,

fuelled by debt

SimilaritiesSimilarities

• National bankruptcy Thailand / Iceland• Bankruptcy of hedge funds (LTCM)Bankruptcy of hedge funds (LTCM)• Fear of global banking meltdown• Political fall-out (Suharto in Indonesia)• High unemployment• High unemployment• Prolonged recession / slow recovery• Criticism of role of hedge funds

DifferencesDifferences

At l t i iti ll bl t• At least initially, a currency problem, not a debt problem

• Local problems causing global contagion e.g. Argentina 1999 onwardsg g

• Little long term impact on the banking system in Europe / USsystem in Europe / US

• No significant role for credit derivatives• No major government intervention in

Europe / US

Key Points of present crisisKey Points of present crisis

H i ff t f dit d i ti• Huge gearing effect of credit derivatives• Persistent short-selling by hedge fundsg y g• High leverage in buyout and real estate –

massive leverage in hedge fundsmassive leverage in hedge funds• Partial collapse of banking system

f• Need for massive government intervention to stave off global meltdown

• US sub-prime the catalyst, but proved to be simply the first domino of manyp y y

The three stages of bankingThe three stages of banking

• Caterpillar• Pupa• Butterfly• Butterfly

CaterpillarCaterpillar

• Banks take in depositors’ money• Make loans to business and retailMake loans to business and retail

customersM k th diff b t• Make money on the difference between the interest rates

• Classic banking model, thousands of years oldyears old

• Driven by interest spread

PupaPupaI t t d d d l ffi i t• Interest spread deemed no longer sufficient

• Banks move to charging fees for granting loans• To drive higher fees, banks underwrite whole

funding packages, offer higher risk products ( i ) l d t hi h l ti d(e.g. mezzanine), lend at higher valuations, and take less protection (cov-lite)L t l f b ti dit d i ti• Later, also earn fees by creating credit derivative productsF i d d b h k f l l• Fee income earned used as benchmark for level of individual bonuses (no claw back!)

% Global Buyouts with total debt > 6x EBITDA (S&P)

35

40

25

30

35

20

25

10

15

0

5

02000 2001 2002 2003 2004 2005 2006 2007

ButterflyButterfly

• Banks greedy for more money beyond fees• Begin trading derivative products, including g g p g

those that they have created themselves• Risk may pile on risk, as also extending highRisk may pile on risk, as also extending high

leverage to hedge funds who may be taking the same derivative positionsame derivative position

• Banks are by now more like flies, feeding on their own vomittheir own vomit

• Revenue model now heavily trading driven

Causes / IrritantsCauses / Irritants

R l f Gl St ll A t i US 1999• Repeal of Glass-Steagall Act in US 1999• Dramatic increase in size of buyout funds, y ,

and thus the LBO debt market• Ditto hedge funds and Prime Broker mktDitto hedge funds and Prime Broker mkt• Bonus culture driving deals

/ f• Lax / incompetent regulation of banks• Flight to liquidity in 2008g q y• Problems with valuation

Private Equity factsPrivate Equity facts

• 75% of all the capital ever raised by Private Equity funds has been raised since q y2000

• And 50% since 2005• And 50% since 2005• Assuming 70% gearing, this means that

even in 2006 alone, enough money was raised to require USD1 Trillion of buyoutraised to require USD1 Trillion of buyout debt

Hedge FundsHedge Funds

• As at the end of 2007 hedge funds had about USD 2 Trillion under management gglobally (source: Biz Research)

• Many hedge funds were geared in excess• Many hedge funds were geared in excess of 100x (CCC was 32x). Even if the average was only 10x, this would have made the global Prime Broker market USD g20 Trillion in total

NoteNote …

• In 2008 US GDP was just over $14 Trillion• In 2008 UK GDP was about $2 7 TrillionIn 2008 UK GDP was about $2.7 Trillion• …yet nobody seems to have found these

l l f d bt ilevels of debt excessive• …and they do not include credit a d t ey do ot c ude c ed t

derivativesTh G Li biliti f B l B k• The Gross Liabilities of Barclays Bank are roughly equal to UK GDP

The rise of the LBO marketThe rise of the LBO market

I d S lli More

Great returnsIncreased

institutional appetite

Swelling fund sizes

More LBO firms

Global Buyout Fundraising ($B)

400

500

300

400

200

100

0

990

991

992

993

994

995

996

997

998

999

000

001

002

003

004

005

006

007

008

1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2

Top of the Market (World)?Top of the Market (World)?

• Cov-Lite lending• Blackstone goes publicBlackstone goes public• Blackstone lose $170M in one quarter,

hil St S h t d $3Mwhile Steve Schwartzman spends $3M on his birthday party

• David Rubenstein (Carlyle) buys Magna CartaCarta

• Terra Firma buys EMI

Dire PredictionsDire Predictions …

• In December 2008 Boston Consulting Group issued a study predicting that up to p y p g p30% of European buyout groups could disappear in the next three yearsdisappear in the next three years

• There is regular press speculation that f (buyout firms could go bust (e.g. New York

Times, 8 September)p )

BCG studyBCG study

• Candover is winding up• Hermes direct team taken over byHermes direct team taken over by

BridgepointP i ’ f t i t l t i• Permira’s future is extremely uncertain

• Ditto Alchemytto c e y• PAI and BC Partners have faced revolt /

i t f th i LPresistance from their LPs• LP/GP relationships have souredp

Key DeparturesKey Departures

• Buffini – Permira• Green – ApaxGreen Apax• Moulton – Alchemy• Buffin – Candover

…and many now working with no prospect of carry on current deals, e.g. Hands (Terra Firma / EMI)( )

Is the worst yet to come?Is the worst yet to come?

• Much current bank debt is structured until 2011 or 2012

• Banks have been reluctant to allow LBOs to fall into defaultto fall into default

• Banks reluctant to revalue• Yet most of those 104 buyouts must have

negative equity valuenegative equity value• Restructurings so far look that way

Eye of the storm?Eye of the storm?

S th b k ld b i th f th• So the banks could be in the eye of the storm, with a second wave of crisis yet to come

• Many LBOs to be written downy• Many real estate loans to be written down

What about personal mortgage default?• What about personal mortgage default?• What about consumer credit default?• We may not know the true picture until end

2012

What will happen short term?What will happen short term?Th b t fi hi h i d tl• Those buyout firms which raised money recently will husband it carefully, because they know it might be a long time before they can raise anymight be a long time before they can raise any more

• Anyone who has to raise money before 2011• Anyone who has to raise money before 2011 may have to go into hibernation to survive

• Many (100?) >$1B buyouts will be taken over by• Many (100?) >$1B buyouts will be taken over by the banks

• Some 2005 and 2006 vintage year buyout funds• Some 2005 and 2006 vintage year buyout funds are unlikely to return their capital

But long termBut, long term …B t f d i i ill ( b bl f• Buyout fundraising will recover (probably from 2011 onwards) and continue its upward climb

• The banks will come slowly back into the market• The banks will come slowly back into the market, also from about 2011

• Debt will initially be offered at sensible levelsDebt will initially be offered at sensible levels and on sensible terms

• But as the same drivers will be present, the cycle will repeat itself, though perhaps not so badlyMega buyout returns will continue to struggle• Mega buyout returns will continue to struggle, and be heavily market dependent

Thank YouThank Youhttp://www.guyfs.comp g y

guyfs@yahoo.co.uk