The Credit Crunch and the U.S. Economy Steven Rattner March 27, - - PowerPoint PPT Presentation

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The Credit Crunch and the U.S. Economy

Steven Rattner

March 27, 2008

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• We begin our story in March 2000, when stock market indices reached all-time highs

A Brief Recent Economic and Financial History

¹Companies with high-yield debt in their capital structure. Source: JP Morgan Research

• The dot.com meltdown and accompanying recession inflicted meaningful damage on the

U.S. economy and financial system

• But the damage proved short-lived as the government injected massive stimulus through

repeated tax cuts and reductions by the Federal Reserve in its key interest rate from 6% to 1%

• The U.S. economy went into recession in March 2001, with unemployment rising to

5.5% and cumulative job losses of 1.6 million

• Equity markets plunged -- the S&P fell 49% from its 2000 peak and the NASDAQ

declined 78% over a similar period

• Bankruptcies among highly leveraged companies¹ increased to 8.3% of outstanding

debt from a 20-year average of 3.8%.

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The Ensuing Golden Age

• The economy grew steadily from 2002 through the end of 2007, with real GDP

expanding at an annual rate of 2.6% during this period.

• Productivity rose at a 3% rate
• The unemployment rate fell to 4.4%
• Inflation remained low
• Consumer spending grew by 5.7% annually

Note: Productivity measured as non-farm business output, from the Bureau of Labor Statistics. Consumer spending measured as per capita personal consumption spending from the BEA

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The Golden Age (cont’d)

• Stock prices began a steady rise

S&P 500 Dec-07 March 11, 2003: Price: 800.7

• Oct. 9, 2007:

Price: 1565.1 1 5 . 7 % C A G R 700 800 900 1000 1100 1200 1300 1400 1500 1600 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07

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Borrowers Were Huge Beneficiaries

• With capital readily available, the cost of borrowing (relative to Treasuries) fell to

record lows and lending grew at a rapid pace

Source: JP Morgan Research

JPMorgan Global High-Yield Index 200bp 300bp 400bp 500bp 600bp 700bp 800bp 900bp 1000bp 2003 2004 2005 2006 2007 Spread to Worst

Long-term average (1987 -07)= 542bp June 2007: 269 bps $147.9 $149.1 $106.1 $158.2 $151.6 $67.8 New High-Yield Issuances $0 $20 $40 $60 $80 $100 $120 $140 $160 $180 2002 2003 2004 2005 2006 2007 Split B or Lower Total High Yield Issuance

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Lenders Were Happy to Lend

• One of the primary drivers of this heightened activity in the debt and LBO markets was

the historically low level of corporate bond defaults

• In 2007 only 10 companies ($3.0 billion in debt) defaulted in the U.S., the lowest figure

by number since 1981 and by dollar volume since 1994

D ollar Weighted High-Yield D efault Rate

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5.0% 10.0% 15.0% 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 Source: JP Morgan Research

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• Record liquidity in the credit markets fueled historic volume in the buyout market
• In 2007 low rated debt – often raised to finance leveraged buyouts – swelled to 35% of the

total high yield issuances in the U.S.

Source: Thomson, DeaLogic Source: JP Morgan research

Private Equity Boomed

U.S. Historical High Yield Issuance

$0 $20 $40 $60 $80 $100 $120 $140 $160 $180 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 ($US in Billions) 0% 5% 10% 15% 20% 25% 30% 35% (Lower Rated Issuance % of T otal)

Split B or Lower High Yield Issuance T otal High Yield Issuance Announced Global M&A Volume

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500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 (US$ Billions) 0% 5% 10% 15% 20% 25% 30% 35% 40% LBO Volume Total M&A Volume LBO % of Total M&A

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And So, Of Course, Did Housing

• As we are now painfully aware, the credit expansion led to a boom in housing

prices, which rose far faster than incomes

Note: S&P Case/Shiller 20-market home price index

Housing Price Index vs. Median Household Income 50 100 150 200 250 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Index Level (scaled to 2000) S&P/CS H ome Price Index Median H ousehold Income 10.7% annual decline in January 2008

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The Age of Turmoil: A Quick Summary

• The unwinding of the credit bubble famously began with the dramatic upsurge in

defaults by subprime borrowers, followed in short order by near paralysis in the high yield market, where rising supply overwhelmed demand.

• During the autumn, these developments spread into the “real” economy, as job

losses began to occur in the housing and financial sectors and consumers pulled back on spending as a result of falling home prices and overall nervousness about future economic prospects.

• Economic forecasters began to gradually raise their estimates of the probability of a

recession; today Intrade puts the odds of a recession at 70%. The credit markets are even more dramatically signaling recession.

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Recent Economic Indicators Point to Recession

• Some leading economic statistics indicate the potential for a recession
• Real GDP growth was 0.6% in the Q4 2007, and was not revised upward. This result

was lower than the 1.1% expected by economists, and the weakest GDP growth for the economy since 2002

• The unemployment rate was 4.8% in February 2008, up from 4.4% in March 2007
• New housing construction was down significantly, with Feb. 2008 declining 28% from
• Feb. 2007
• The Institute for Supply Management indices have largely been below 50 since

December, signaling contraction

• The Conference Board consumer confidence index has declined significantly since July

(down 43%, from 114 to 64.5)

• Retail sales declined 0.6% in February

Source: BEA, White House Economic Report, The Conference Board, ISM, US Dept. of Housing and Urban Development

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Investment Grade Index (CD X IG9 5-yr) 0bp 20bp 40bp 60bp 80bp 100bp 120bp 140bp 160bp 180bp 200bp 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Spread to Worst Long-term average (1987 - ytd 08)= 73bps

Investment Grade Spreads vs. Recession

Recession levels (190 bps, 3/17)

• The investment grade market is clearly signaling recession.

Source: Goldman Sachs

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Ambiguous Equity Markets

• The S&P index has dropped 10% since January 1 and 15% from its peak on October 9th
• However, the S&P index currently trades at 16.1 times LTM earnings, below its 20 year

historic average of 19.3 times

Source: Capital IQ Source: Standard and Poors

S&P 500

1150 1200 1250 1300 1350 1400 1450 1500 1550 1600 6 / 2 6 / 2 7 7 / 2 6 / 2 7 8 / 2 6 / 2 7 9 / 2 6 / 2 7 1 / 2 6 / 2 7 1 1 / 2 6 / 2 7 1 2 / 2 6 / 2 7 1 / 2 6 / 2 8 2 / 2 6 / 2 8 3 / 2 6 / 2 8

S&P 500 LTM P/E

0.0x 5.0x 10.0x 15.0x 20.0x 25.0x 30.0x 35.0x 3 / 3 1 / 1 9 9 8 3 / 3 1 / 1 9 9 9 3 / 3 1 / 2 3 / 3 1 / 2 1 3 / 3 1 / 2 2 3 / 3 1 / 2 3 3 / 3 1 / 2 4 3 / 3 1 / 2 5 3 / 3 1 / 2 6 3 / 3 1 / 2 7 2 / 2 9 / 8

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Ambiguous Equity Markets (cont’d)

• When comparing the earnings yield of the S&P 500 index to the yield of the 10-year Treasury (known as the Fed

Model) the S&P currently has a higher yield, implying that it is relatively cheap when compared to bonds

• This barometer of share prices suggests that the stock market is more attractive than at any time over the past 10 years

Source: Standard and Poors, St. Louis Fed

S&P Yield vs. 10-yr Treasury Yield

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 3 / 3 1 / 1 9 9 8 9 / 3 / 1 9 9 8 3 / 3 1 / 1 9 9 9 9 / 3 / 1 9 9 9 3 / 3 1 / 2 9 / 3 / 2 3 / 3 1 / 2 1 9 / 3 / 2 1 3 / 3 1 / 2 2 9 / 3 / 2 2 3 / 3 1 / 2 3 9 / 3 / 2 3 3 / 3 1 / 2 4 9 / 3 / 2 4 6 / 3 / 2 5 9 / 3 / 2 5 3 / 3 1 / 2 6 9 / 3 / 2 6 3 / 3 1 / 2 7 9 / 3 / 2 7 2 / 2 9 / 2 8

'S&P 500 Earnings Yield '10-Year T reasury Yield

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13 High Yield Backlog $0 $20 $40 $60 $80 $100 $120 Summer '07 Completed Deals Canceled Deals Current Backlog (US$ Billions) Leveraged Loan Backlog $0 $50 $100 $150 $200 $250 Summer '07 Completed Deals Canceled Deals Current Backlog (US$ Billions)

Credit Market Working Through Backlog

• Following the meltdown in the U.S. mortgage and sub-prime lending markets, liquidity dried up for

corporate debt as well, including over $300 billion in previously committed LBO financing

• Banks and investors have been hard at work since July digesting over $100 billion of the backlog
• Many of the deals that came to market from the backlog were priced at a discount and continue to

trade below par

• However, banks have maintained discipline in offloading these loans up to this point

Source: JP Morgan research, Bank of America research

Down 44% Down 32%

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Ramifications for Private Equity

• The aforementioned factors have led to a dramatic slowdown in private equity activity

Source: SDC, CapitalIQ

(US$ in Billions) (# of Deals)

Announced Buyout Volume Has Stalled Since the Summer Peak $0 $25 $50 $75 $100 $125 $150 J a n

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5 10 15 20 25 30 $1B+ LBO Deal Volume # of $1B+ LBO Deals

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• Early 2008 activity suggests a continuation or even an acceleration of this trend

Ramifications for Private Equity (cont’d)

Source: Thomson, DeaLogic Source: JP Morgan research

Global M&A Volume YTD $0 $100 $200 $300 $400 $500 $600 $700 $800 2007 2008 (US$ Billions) LBO Volume T otal M&A Volume New Issuances YTD $0 $5 $10 $15 $20 $25 $30 $35 $40 $45 2007 2008 (US$ Billions)

Split B or Lower High Yield Issuance T otal High Yield Issuance

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Widened Credit Market Spreads

• Credit risk premiums – which by July had compressed to record lows – have widened
• Arguably, even today’s levels may not be sufficient given: a) higher than historic levels of

debt in buyouts, b) uncertain economic outlook in the U.S. and c) housing / general credit market weakness

Source: JP Morgan research

JPMorgan Global High-Yield Index 0bp 170bp 340bp 510bp 680bp 850bp Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Spread to Worst 5/31/07 = 269bp 3/19/08 = 819bp Long-term average (1987 - ytd 08)= 542bp

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Private Equity Default Risk

The biggest risk to the debt markets at present is the specter of a significant uptick in default rates Forecasters such as Moody’s expect the global default rate to almost triple over the next year The proliferation of highly leveraged deals “priced to perfection” over the past few years suggest that private equity-sponsored companies may suffer during a period of economic weakness Financing features available in prior deals (e.g. “covenant-lite” and “PIK-toggle” instruments) may mitigate default risk, or delay an eventual default S&P recently issued a watch list of 74 names, not surprisingly, 50 of which are private equity sponsored companies

T otal D ebt / EBITD A in LBO T ransactions 6.5x 5.8x 5.3x 5.2x 4.7x 4.8x 4.7x 5.5x 5.8x 6.5x 5.3x 5.0x 4.9x 1.0x 2.0x 3.0x 4.0x 5.0x 6.0x 7.0x 8.0x 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

Source: JP Morgan research

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Near Meltdown in Financial Markets

• For the most part, the adjustments in the financial markets have been orderly
• One moment of potential panic occurred in mid-March, when Bear Stearns

imploded

$0 $10 $20 $30 $40 $50 $60 $70 $80 3 / 7 / 8 3 / 1 / 8 3 / 1 1 / 8 3 / 1 2 / 8 3 / 1 3 / 8 3 / 1 4 / 8 3 / 1 7 / 8 3 / 1 7 / 8 3 / 1 8 / 8 3 / 1 9 / 8 3 / 2 / 8 $0 $10 $20 $30 $40 $50 $60 3/7/08 3/10/08 3/11/08 3/12/08 3/13/08 3/14/08 3/17/08 3/17/08 3/18/08 3/19/08 3/20/08

Bear Stearns Stock Price (3/7-3/20) Lehman Bros. Stock Price (3/7-3/20)

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Plenty of Volatility

• The pace of market volatility has quickened, unnerving many participants (while

cheering others)

Source: CapitalIQ

Nasdaq Volatility Index (VIX) 10.0 15.0 20.0 25.0 30.0 35.0 3/26/07 4/26/07 5/26/07 6/26/07 7/26/07 8/26/07 9/26/07 10/26/07 11/26/07 12/26/07 1/26/08 2/26/08

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Unwinding of Leverage

• A prominent feature of the adjustment process has been a significant deleveraging throughout

the financial system.

• The problems of KKR Financial and Carlyle Capital are examples of the consequences of this

phenomenon.

$600 $700 $800 $900 $1,000 $1,100 $1,200 $1,300 3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08 $1,400 $1,500 $1,600 $1,700 $1,800 $1,900 $2,000 $2,100 $2,200 $2,300 3/22/06 7/22/06 11/22/06 3/22/07 7/22/07 11/22/07 3/22/08

Asset-Backed Commercial Paper Outstanding All Commercial Paper Outstanding

Source: Federal Reserve, 3/22/08

$ bil $ bil

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Where Do We Go From Here?

• Since last summer, the consensus economic forecast for 2008 GDP growth has

steadily become more pessimistic

Source: Goldman Sachs

Real GDP Growth Forecast = July 2007 Forecast = Sept. 2007 Forecast = Nov. 2007 Forecast = Mar. 2008 Forecast

(0.5%) (1.0%) 2.5% 2.0% 1.5% 1.0% 2.0% 2.0% 1.5% 1.0% 1.0% 1.0% 3.0% 3.0% 2.5% 2.5% (1.5%) (1.0%) (0.5%) 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% Q1 Q2 Q3 Q4

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But We Should Not Be Overly Pessimistic

• The probability is that a recession is likely to be shallow
• More sophisticated economic policymaking has led to generally benign economic

conditions over the past two decades, a phenomenon known to economists as “The Great Moderation”

• The last two recessions (1990-91 and 2001-02) were each eight months in duration

and relatively mild

• The U.S. economy remains productive and flexible, and inflationary pressures appear

contained

• The massive interest rate reductions by the Federal Reserve and the recently enacted

stimulus package will gradually insert a positive influence on growth

• The fall in the dollar provides an important push for exports
• While the possibility of a financial meltdown cannot be ignored, the probability is that the

losses from imprudent lending will slowly work through the system

• Absent any cataclysmic events, the adjustments in markets that are now underway will

prove healthy and beneficial

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