A Hole in the Middle of the Recovery

Although the U.S. is far from out of the woods, we have avoided sinking into a depression, prevented a systemic meltdown of the financial system, and taken positive steps to thaw the credit markets and increase lending activity. People may disagree on the size, scope, implementation, or ultimate success of the recovery initiatives, but it is unlikely that many believe the government programs – ranging from propping up automakers to financing the purchase of mortgage-backed securities – are anything but comprehensive. However, the government’s efforts to revive the credit markets have largely excluded a significant driver of the U.S. economy – middle market companies. Mid-size companies, too large for SBA loans but too small to issue bonds or benefit from other government programs, have been largely shut out of the government’s stimulus efforts and the improving debt markets. According to a recent study, nearly a third of middle market companies surveyed are having difficulty accessing credit, and nearly 40% expect the availability of credit to negatively impact their business going forward . In fact, by some measures middle market loan vol1

jobs, or 28% of total U.S. employment3. As a point of reference, large firms with revenues of $1 billion or more account for 29% of employment. The impact of mid-size businesses on GDP is not small either. Companies with $10 - $500 million in revenue generate a combined $6 trillion in annual sales. In addition, companies with less than 500 employees accounted for 70% of net new job creation over the past decade according to the SBA. Admittedly, these figures capture the impact of both small and mid-sized companies. Nonetheless, middle market firms are clearly an important driver of both the current base of employment and job growth. The credit markets have improved substantially since the collapse of Lehman Brothers. The spread on high yield bonds recently dropped to 9.88% above Treasuries, below the 10% ‘distressed’ threshold4. Many large companies have taken advantage of the loosening public debt markets by issuing bonds to replace term loans with near-term maturities. In the first half of 2009, $59.2 billion of high yield bonds were issued in the U.S., a 59% increase from the first half of 20085. However, mid-size firms are generally too small to issue public debt, so these companies have not benefited from the recent liquidity in the high yield market. Middle market loan activity contrasts sharply with the large cap debt markets. Year-overyear, middle market loan issuance fell 49% to $27.7 billion in the first half of 20096. Given that $15.6 billion of middle market loans were scheduled to mature during the first six months of 2009, net new credit issuance was far less than $28 billion7. In the secondary market, the average middle market senior loan continues to trade below 80 cents on the dollar 8.
3 4

ume has fallen by nearly 50% in 2009 . Given the importance

of the middle market to the overall economy, it is difficult to envision a sustained recovery taking place without mid-size companies. No formal definition exists for what constitutes the middle market. Some place cut-offs at revenue of between $20 and $500 million. Still others draw the dividing lines at $5 to $50 million in EBITDA. No matter the exact criteria, these not so small but not quite behemoth companies are a driving force in the U.S. economy. According to U.S. Census data, firms with revenues of $10 to $500 million account for nearly 32 million

Bill Millar, U.S. Middle Market Outlook 2009: Navigating the Credit Crunch (Forbes Insights, 2009)

Thomson Reuters, LoanConnector

CastleGuard Partners, LLC - August 2009

Note: excludes self-employment Merrill Lynch & Co. High Yield index 5 SIFMA, U.S. Corporate Bond Issuance (2009) 6 Thomson Reuters, LoanConnector 7 Ibid 8 Ibid A Hole in the Middle of the Recovery, Page 1 of 5

Why has middle market lending been left behind? First, many middle market lenders utilized collateralized loan obligations (CLOs) to syndicate loan exposure. Although CLOs and other structured products have been demonized in the aftermath of the crisis, these vehicles serve an important role in the credit markets. CLOs allow lenders to generate fresh capital from a broad base of investors and assist in matching the duration of assets and liabilities. In fact, as much as 25% - 50% of all syndicated middle market loan volume may have been sold into CLO vehicles . As the CLO market came to a standstill

Public-Private Investment Program
The Public-Private Investment Program (PPIP) is a $30 billion U.S. Treasury initiative facilitating the removal of troubled legacy residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) that have been clogging banks’ balance sheets. The U.S. Treasury will provide attractive debt financing and invest equity alongside private sector investment managers under the Legacy Securities Program (LSP). Addressing the withering real estate assets that have played such a large role in creating the problems that banks now face is clearly a positive step for the credit markets. However, the companion plan, the Legacy Loan Program (LLP), designed to finance the purchase of troubled loans, has not yet gotten off the ground. Similar to the LSP, this program would attempt to bridge the valuation gap between banks and investors and allow banks to sell loans in order to access fresh capital. The U.S. Treasury and FDIC have stated that this program will be scaled back significantly from its original design. The FDIC’s rationale? “Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system,” according to FDIC Chairman Sheila Bair. While it is true that many of the largest banks have successfully raised capital, the same cannot be said for small and mid-sized institutions. Furthermore, the “toxic” securities that will be addressed by the LSP are only an issue for a relatively small fraction of U.S. banks11. This leads to a bifurcation in the health of the credit markets in which the availability of credit for large companies (primarily served by large financial institutions) has improved significantly, while small and mid-size borrowers struggle to obtain debt financing. There is no question that distressed mortgage-backed securities languishing on banks’ balance sheets are a serious problem that requires attention. If successful, the LSP will improve banks’ liquidity and boost the health of the broader financial system. However, this program will likely have only a modest impact on the extension of credit to middle market companies.

in 2008, a major source of capital for middle market loan origination was cut off. Second, during the up-cycle, GE Capital and other large players consolidated an already significant share of the market. Third, regional banks have been acutely impacted by souring real estate loans10. This weakened capital base has inhibited the capacity of many regional banks to extend new loans. Finally, the middle market has been shut out of the government stimulus that has bolstered other segments of the credit market.

Government Programs
Despite the importance of the middle market to the economy and the dearth of credit available to these companies, the government recovery initiatives have done little to stabilize lending in this market. In fact, the Federal Reserve and the U.S. Treasury have created programs that directly support nearly every segment of the credit markets, ranging from credit card debt to commercial mortgages, except for middle market corporate loans. Admittedly, the government’s actions to stabilize the broader financial system have buoyed every asset class, including middle market loans. The purpose of this article is not to suggest that the government erred in allocating recovery funds to the asset classes it has thus far chosen to support. Rather, the intent is to illustrate how the government recovery efforts have covered a great deal of ground, but have left mid-size companies behind. A brief survey of the major government recovery programs illustrates this point.


Standard & Poor’s LCD 10 Matthias Rieker, Regional Banks’ Loan-Loss Increases Stir Fresh Concerns (Wall Street Journal, 2009) CastleGuard Partners, LLC - August 2009

David Enrich, Liz Rappaport & Jenny Strasburg, Wary Banks Hobble Toxic-Asset Plan (Wall Street Journal, 2009) A Hole in the Middle of the Recovery, Page 2 of 5

Term Asset-Backed Securities Loan Facility
The Term Asset-Backed Securities Loan Facility (TALF) is a $1 trillion initiative intended to resuscitate the securitization market for asset-backed securities (ABS) and CMBS. The N.Y. Federal Reserve provides financing to qualified purchasers of eligible securities. Eligible ABS include securities collateralized by credit card loans, auto loans, student loans, and small business loans guaranteed by the SBA. TALF is largely focused on financing the purchase of newly issued securities (although legacy CMBS were later added to the program). Lenders to these markets securitize loans in order to generate fresh capital for new loans. By facilitating the securitization of loans, the government is hoping to boost the volume of capital flowing into the ABS/CMBS new issuance markets and, in turn, spark increased lending activity. In recent months, spreads have narrowed considerably in both the ABS and CMBS markets (although TALF’s CMBS funding has been fairly small to date)12. A renewed flow of capital into ABS and CMBS is clearly a positive sign for the health of the credit markets. However, the impact of these inflows on asset classes beyond real estate and consumer loans appears to be limited. During the twelve months ending June 1, 2009, commercial and industrial loans outstanding at U.S. commercial banks declined 3.3%, while consumer and real estate loan balances each grew more than 5%13. In fact, the amount of commercial and industrial loans fell each of the first six months of 200914. Only time will tell if these figures reflect a modest extension of credit masked by the natural deleveraging of an overheated economy, or a continued breakdown in the credit markets.

of SBA loans guaranteed by the government to 90% from 75% or 85% (depending on the type of loan), deemed SBA guaranteed loans eligible for TALF financing, reduced loan fees, and allocated $15 billion for the purchase of SBA loans in the secondary market (although this funding has yet to be deployed). While these programs are well intentioned and crucial to the development of small businesses, these efforts do not address the needs of the middle market. In order to be eligible for the SBA program, loans must not exceed $2 million. While adequate for a truly “small” business, this falls far short of the amount of funding required by most middle market companies. A $2 million loan is insufficient to provide basic working capital or capital expenditure financing for most mid-size firms. It is almost as if the government believes companies are either fledgling, single location operations or titans of the S&P 500, and no companies exist in the space between.

Troubled Asset Relief Program
The Troubled Asset Relief Program (TARP) is the umbrella economic recovery program. In fact, TARP provides a significant amount of the funding for PPIP, TALF, and the supplemental SBA programs. TARP’s recovery efforts also include stabilizing the auto industry, providing assistance to homeowners, and propping up a variety of financial institutions large and small. Clearly, middle market lending institutions that received assistance from TARP benefited from this program. Furthermore, the impact of this support extends beyond the individual institution (counterparties, asset classes in which the institution invests, and the broader economy). However, the trickledown effect of the TARP stimulus on mid-market loans is not nearly as powerful as programs designed to directly stimulate a specific asset class (e.g., the TALF program’s impact on ABS). It is unclear why the Fed/Treasury would directly support asset classes such as credit card debt, commercial mortgages, and small business loans but shun credit for mid-sized companies.

Small Business Administration Stimulus Programs
When accused of neglecting mid-sized companies, the government has often cited programs related to the SBA15. Specifically, the U.S. Treasury and SBA have increased the percentage

JP Morgan 13 Federal Reserve, Assets and Liabilities of Commercial Banks in the United States - H.8 (2009)

Potential Solutions
One solution to the anemic lending activity in the middle market is to move forward with the previously announced LLP. The program would provide financing to private invesA Hole in the Middle of the Recovery, Page 3 of 5

Ibid 15 Jonathan Weisman, Small Businesses Have a New Beef With White House (Wall Street Journal, 2009) CastleGuard Partners, LLC - August 2009

tors purchasing portfolios of loans from banks. If the FDIC believes this program is unnecessary because (large) banks have succeeded in raising private capital, then why not limit the program to institutions with less than $5 billion in assets or simply to those still experiencing difficulty raising capital. The LLP has the potential to improve the liquidity of participating institutions and attract capital into the secondary market for corporate loans, just as TALF and the LSP have done for the CMBS market (despite less than $700 million of actual government funding hitting the CMBS market as of July 2009)16.

past 12 months, this provision alone would go a long way towards preventing a populist public relations headache. Second, the government could impose limitations on the leverage of the underlying companies. This would allow the N.Y. Federal Reserve to facilitate access to fresh capital without placing the administration in a compromising political position. If the CLO issuance market returned, even at a modest volume, the availability of loans to middle market companies would be greatly improved. It is important to note that the financing offered by TALF for

TALF is another existing program that could be used to provide support to mid-size companies. Expanding the scope of TALF to provide financing for recently issued CLOs would generate fresh capital for new corporate lending. As CLO issuances have effectively ceased in 2009, lenders have seen a critical source of “dry powder” cut off. $16.4 billion of CLOs backed by investment grade and high yield loans and bonds were issued in the four quarters ending June 30, 2009. This compares to $51.8 billion of such CLOs issued in 2004 – before the credit cycle took off .

newly issued CMBS is very different from every other recovery program. This is not a means of supporting Main Street by encouraging consumer lending, increasing the availability of home mortgages, or even restructuring banks’ balance sheets (only commercial mortgages issued after July 1, 2008 are eligible collateral). Offering financing for recently issued CMBS encourages capital to flow to originators of commercial mortgages in order to allow these firms to fund new mortgages. At the end of the day, this program benefits commercial real estate lenders and investors (such as REITs and real estate private equity funds) – not the average U.S. citizen. Why is the Federal Reserve comfortable supporting investors in shopping malls and office buildings, but not other classes of investors? The government is correct to be concerned about the impact that the halted $700 billion CMBS market will have on the broader economy, particularly as debt issued during the real estate boom begins to mature19. However, the government should also be alarmed about the $450 billion in middle market loans maturing over the next four years20. Meaningful parallels exist between the CMBS and CLO markets. However, the government has chosen to support real estate lending to a much greater extent than corporate lending. Real estate loans may have sparked many of the current problems in the credit markets, but an economic recovery cannot occur without a healthy corporate lending market. Perhaps the most important

The biggest hurdle to the inclusion of CLOs in the TALF program may be the fear of a public relations backlash. The government might step into a firestorm of criticism if detractors viewed the program as “supporting leveraged buyouts,” as debt used to finance LBOs fueled a meaningful portion of the CLO market. However, according to Thomson Reuters 74% of the upcoming middle market debt maturities are nonsponsored (i.e., a private equity firm does not control the borrower)18. Nonetheless, these criticisms could be easily avoided by thoughtfully structuring the program. First, only CLOs with recently originated loans could be eligible for the program. This provision is in line with the original goal of the TALF program and similar to the rules governing TALF funding for ABS. Given the meager level of LBO activity in the
16 17

N.Y. Federal Reserve Securities Industry and Financial Markets Association, Global CDO Data (2009)

19 20

Diana Diquez, 2Q09 Review and 3Q09 Preview: Better times ahead? (Thomson Reuters, 2009) CastleGuard Partners, LLC - August 2009

Hui-yong Yu & Sarah Mulholland Property Bond Sales May Resume With $3 Billion (Bloomberg, 2009) Thomson Reuters, LoanConnector A Hole in the Middle of the Recovery, Page 4 of 5

distinction between the two asset classes is the far greater job losses that would result if companies, as opposed to buildings, cannot refinance their debt. Another potential stimulus to the credit markets would be to temporarily remove the unfavorable tax treatment for debt trading below par. Holders of debt securities that are purchased at a discount must either amortize the discount into interest income annually or pay taxes on the amount of the discount at ordinary income rates as principal is received and when the instrument matures or is sold. The bottom line is that the discount is not taxed at long-term capital gains rates, even when the security is held for more than a year. In contrast, shares of a dividend paying stock purchased at a discount to fundamental value are eligible for long-term capital gains treatment. Changing the taxation of debt bought at a market discount would increase capital flows into this market. While this would not directly drive new loan origination, it would allow banks to receive fresh capital by selling loans and also provide a boost to the legacy and new issuance CLO market. An additional option to improve middle market lending would be to increase the size limit on SBA loans. However, in order to have a meaningful impact on middle market companies, the maximum loan size would need to be increased at least tenfold to $20 million. It is unclear whether the government is willing to provide the SBA with the funding necessary to increase the size and scope of its operations. Furthermore, this may be a less efficient option than encouraging private capital to flow into middle market lending through stimulus programs such as TALF.

Perhaps even more daunting is the prospect of large numbers of mid-size companies unable to refinance maturing debt as a result of diminished lending capacity. The Federal Reserve and U.S. Treasury must take steps to encourage capital to return to middle market lending. Otherwise, the government may see the recovery, which has been building steam, begin to stumble.

The government has been appropriately concerned about the availability of debt capital in the economy and has taken a number of positive steps to restore the credit markets. However, limited support has been extended to middle market companies. It is unlikely that meaningful job creation will occur until middle market companies, which represent nearly a third of U.S. employment, have sufficient access to credit.
CastleGuard Partners, LLC - August 2009

CastleGuard Partners, LLC, based in the Chicago area, is a provider of debt capital to middle market companies. CastleGuard originates new loans, refinances maturating debt, participates in special situations lending, and invests in loans trading in the secondary market. For more information, please visit www.castleguardllc.com
info@castleguardllc.com phone 847-201-3600 fax 847-201-3603 2700 Patriot Blvd, Suite 420 Glenview, IL 60026
A Hole in the Middle of the Recovery, Page 5 of 5

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