| The Credit Crunch and its Impact on Mezzanine Finance |
We are grinding our way through a generational downturn in the housing market and its attendant impact on the credit and capital markets. While a year ago, the "worst case" estimate on the ultimate credit losses was $250 billion, financial institutions have already written off $500 billion and the final tally may exceed $1 trillion(PIMCO - August 2008 Investment Outlook).
Not surprisingly, given this backdrop, the asset backed markets, which provided an enormous amount of liquidity for the housing and general credit boom, have come to an abrupt halt. The following illustrate this credit halt: 1) In 2008, ABS issuance year to date of $120 billion is 26% of last year's volume, 2) CDO issuance of $17 billion compares to last year's $265 billion, 3) securitized home equity issuance of $303 million contrasts with last year's $215 billion(Source: JP Morgan Chase). The focal point of the losses, however, is in the sub-prime, alt-a, and highly structured mortgage-related products, and these deals have also come to halt. Particularly in the case of highly structured CMOs and CDOs, there is now market-wide recognition that the underlying assumptions and mathematical models employed by securities firms and credit rating agencies to back the aforementioned instruments were flawed. Given this fact, these markets will take some time, possibly years, to recover. As it stands now, Fannie Mae and Freddie Mac are struggling to remain solvent as they deal with between 70-80% of new mortgage originations, while credit cards, car loans, and other asset classes are getting much harder to move off of banks' balance sheets.
On a broad basis, what credit demand that is out there is relying upon a traditional banking system, whose capital ratios and concomitant overall lending ability are under considerable strain. As testament, a recent survey of Senior Loan Officers by the Federal Reserve Board of Governors, conducted in July 2008, shows that loans to small firms are as restricted as they have been in 20 years (see graph below). In middle market mezzanine investing, the overall health of the banking sector is of direct interest, since about 30-40%of the typical (non-LBO) middle market balance sheet capital is provided by bank lenders (1995 Credit survey conducted by NFIB). A dearth of bank capital thus has a direct impact on the operations of small business.
The above reinforces the themes that were touched on in our May newsletter. As banks adjust their portfolios and tighten standards, mezzanine finance is becoming an increasingly critical component of the capital solution, as the gap between bank capital and common equity becomes wider. This gap is already becoming apparent in the middle market, where, for the first quarter of 2008, equity as a percent of the balance sheet is at its highest level since 2000. More markedly, bank capital over the same period for levered transactions under $250M has dropped from a high of over 60% in 2007 down to 36% in the first quarter of 2008 (Allied Capital June 24, 2008 Investor Day Presentation). As common equity increases as a portion of the balance sheet, the dilutive effect on equity returns is compounded by the prospect of slower overall economic growth. This environment makes the judicious use of mezzanine capital an increasingly important factor in maintaining equitable investment returns across the spectrum of middle market investors. |
