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A Hole in the Middle of the Recovery

Although the U.S. is far from out of the woods, we have avoid- jobs, or 28% of total U.S. employment3. As a point of refer-
ed sinking into a depression, prevented a systemic meltdown ence, large firms with revenues of $1 billion or more account
of the financial system, and taken positive steps to thaw the for 29% of employment. The impact of mid-size businesses on
credit markets and increase lending activity. People may dis- GDP is not small either. Companies with $10 - $500 million
agree on the size, scope, implementation, or ultimate success of in revenue generate a combined $6 trillion in annual sales. In
the recovery initiatives, but it is unlikely that many believe the addition, companies with less than 500 employees accounted
government programs – ranging from propping up automak- for 70% of net new job creation over the past decade accord-
ers to financing the purchase of mortgage-backed securities – ing to the SBA. Admittedly, these figures capture the impact
are anything but comprehensive. However, the government’s of both small and mid-sized companies. Nonetheless, middle
efforts to revive the credit markets have largely excluded a market firms are clearly an important driver of both the current
significant driver of the U.S. economy – middle market com- base of employment and job growth.
panies. Mid-size companies, too large for SBA loans but too
small to issue bonds or benefit from other government pro- The credit markets have improved substantially since the
grams, have been largely shut out of the government’s stimulus collapse of Lehman Brothers. The spread on high yield bonds
efforts and the improving debt markets. According to a recent recently dropped to 9.88% above Treasuries, below the 10%
study, nearly a third of middle market companies surveyed are ‘distressed’ threshold4. Many large companies have taken
having difficulty accessing credit, and nearly 40% expect the advantage of the loosening public debt markets by issuing
availability of credit to negatively impact their business going bonds to replace term loans with near-term maturities. In
forward . In fact, by some measures middle market loan vol-
the first half of 2009, $59.2 billion of high yield bonds were
ume has fallen by nearly 50% in 2009 . Given the importance
issued in the U.S., a 59% increase from the first half of 20085.
of the middle market to the overall economy, it is difficult However, mid-size firms are generally too small to issue public
to envision a sustained recovery taking place without debt, so these companies have not benefited from the recent
mid-size companies. liquidity in the high yield market. Middle market loan activity
contrasts sharply with the large cap debt markets. Year-over-
No formal definition exists for what constitutes the middle year, middle market loan issuance fell 49% to $27.7 billion
market. Some place cut-offs at revenue of between $20 and in the first half of 20096. Given that $15.6 billion of middle
$500 million. Still others draw the dividing lines at $5 to $50 market loans were scheduled to mature during the first six
million in EBITDA. No matter the exact criteria, these not so months of 2009, net new credit issuance was far less than $28
small but not quite behemoth companies are a driving force in billion7. In the secondary market, the average middle market
the U.S. economy. According to U.S. Census data, firms with senior loan continues to trade below 80 cents on the dollar 8.
revenues of $10 to $500 million account for nearly 32 million 3
Note: excludes self-employment
1 Merrill Lynch & Co. High Yield index
Bill Millar, U.S. Middle Market Outlook 2009: Navigating the Credit 5
SIFMA, U.S. Corporate Bond Issuance (2009)
Crunch (Forbes Insights, 2009) 6
Thomson Reuters, LoanConnector
2 7
Thomson Reuters, LoanConnector Ibid
CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 1 of 5
Why has middle market lending been left behind? First, many Public-Private Investment Program
middle market lenders utilized collateralized loan obligations The Public-Private Investment Program (PPIP) is a $30
(CLOs) to syndicate loan exposure. Although CLOs and other billion U.S. Treasury initiative facilitating the removal of trou-
structured products have been demonized in the aftermath of bled legacy residential mortgage-backed securities (RMBS)
the crisis, these vehicles serve an important role in the credit and commercial mortgage-backed securities (CMBS) that have
markets. CLOs allow lenders to generate fresh capital from been clogging banks’ balance sheets. The U.S. Treasury will
a broad base of investors and assist in matching the duration provide attractive debt financing and invest equity alongside
of assets and liabilities. In fact, as much as 25% - 50% of all private sector investment managers under the Legacy Securi-
syndicated middle market loan volume may have been sold ties Program (LSP). Addressing the withering real estate assets
into CLO vehicles . As the CLO market came to a standstill
that have played such a large role in creating the problems that
in 2008, a major source of capital for middle market loan banks now face is clearly a positive step for the credit mar-
origination was cut off. Second, during the up-cycle, GE kets. However, the companion plan, the Legacy Loan Program
Capital and other large players consolidated an already (LLP), designed to finance the purchase of troubled loans, has
significant share of the market. Third, regional banks have been not yet gotten off the ground. Similar to the LSP, this program
acutely impacted by souring real estate loans10. This weakened would attempt to bridge the valuation gap between banks and
capital base has inhibited the capacity of many regional banks investors and allow banks to sell loans in order to access fresh
to extend new loans. Finally, the middle market has been capital. The U.S. Treasury and FDIC have stated that this pro-
shut out of the government stimulus that has bolstered other gram will be scaled back significantly from its original design.
segments of the credit market. The FDIC’s rationale? “Banks have been able to raise capi-
tal without having to sell bad assets through the LLP, which
Government Programs reflects renewed investor confidence in our banking system,”
Despite the importance of the middle market to the economy according to FDIC Chairman Sheila Bair.
and the dearth of credit available to these companies, the gov-
ernment recovery initiatives have done little to stabilize lending While it is true that many of the largest banks have successfully
in this market. In fact, the Federal Reserve and the U.S. Trea- raised capital, the same cannot be said for small and mid-sized
sury have created programs that directly support nearly every institutions. Furthermore, the “toxic” securities that will be
segment of the credit markets, ranging from credit card debt addressed by the LSP are only an issue for a relatively small
to commercial mortgages, except for middle market corporate fraction of U.S. banks11. This leads to a bifurcation in the
loans. Admittedly, the government’s actions to stabilize the health of the credit markets in which the availability of credit
broader financial system have buoyed every asset class, includ- for large companies (primarily served by large financial insti-
ing middle market loans. The purpose of this article is not to tutions) has improved significantly, while small and mid-size
suggest that the government erred in allocating recovery funds borrowers struggle to obtain debt financing.
to the asset classes it has thus far chosen to support. Rather, the
intent is to illustrate how the government recovery efforts have There is no question that distressed mortgage-backed securities
covered a great deal of ground, but have left mid-size compa- languishing on banks’ balance sheets are a serious problem that
nies behind. A brief survey of the major government recovery requires attention. If successful, the LSP will improve banks’
programs illustrates this point. 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.
Standard & Poor’s LCD
10 11
Matthias Rieker, Regional Banks’ Loan-Loss Increases David Enrich, Liz Rappaport & Jenny Strasburg, Wary Banks Hobble
Stir Fresh Concerns (Wall Street Journal, 2009) Toxic-Asset Plan (Wall Street Journal, 2009)

CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 2 of 5
Term Asset-Backed Securities Loan Facility of SBA loans guaranteed by the government to 90% from 75%
The Term Asset-Backed Securities Loan Facility (TALF) is a or 85% (depending on the type of loan), deemed SBA guaran-
$1 trillion initiative intended to resuscitate the securitization teed loans eligible for TALF financing, reduced loan fees, and
market for asset-backed securities (ABS) and CMBS. The N.Y. allocated $15 billion for the purchase of SBA loans in the sec-
Federal Reserve provides financing to qualified purchasers of ondary market (although this funding has yet to be deployed).
eligible securities. Eligible ABS include securities collateral- While these programs are well intentioned and crucial to the
ized by credit card loans, auto loans, student loans, and small development of small businesses, these efforts do not address
business loans guaranteed by the SBA. TALF is largely focused the needs of the middle market. In order to be eligible for
on financing the purchase of newly issued securities (although the SBA program, loans must not exceed $2 million. While
legacy CMBS were later added to the program). Lenders to adequate for a truly “small” business, this falls far short of the
these markets securitize loans in order to generate fresh capital amount of funding required by most middle market compa-
for new loans. By facilitating the securitization of loans, the nies. A $2 million loan is insufficient to provide basic work-
government is hoping to boost the volume of capital flowing ing capital or capital expenditure financing for most mid-size
into the ABS/CMBS new issuance markets and, in turn, spark firms. It is almost as if the government believes companies are
increased lending activity. either fledgling, single location operations or titans of the S&P
500, and no companies exist in the space between.
In recent months, spreads have narrowed considerably in both
the ABS and CMBS markets (although TALF’s CMBS fund- Troubled Asset Relief Program
ing has been fairly small to date)12. A renewed flow of capital The Troubled Asset Relief Program (TARP) is the umbrella eco-
into ABS and CMBS is clearly a positive sign for the health of nomic recovery program. In fact, TARP provides a significant
the credit markets. However, the impact of these inflows on amount of the funding for PPIP, TALF, and the supplemental
asset classes beyond real estate and consumer loans appears to SBA programs. TARP’s recovery efforts also include stabiliz-
be limited. During the twelve months ending June 1, 2009, ing the auto industry, providing assistance to homeowners, and
commercial and industrial loans outstanding at U.S. commer- propping up a variety of financial institutions large and small.
cial banks declined 3.3%, while consumer and real estate loan Clearly, middle market lending institutions that received assis-
balances each grew more than 5%13. In fact, the amount of tance from TARP benefited from this program. Furthermore,
commercial and industrial loans fell each of the first six months the impact of this support extends beyond the individual in-
of 200914. Only time will tell if these figures reflect a mod- stitution (counterparties, asset classes in which the institution
est extension of credit masked by the natural deleveraging of invests, and the broader economy). However, the trickledown
an overheated economy, or a continued breakdown in the effect of the TARP stimulus on mid-market loans is not nearly
credit markets. as powerful as programs designed to directly stimulate a spe-
cific asset class (e.g., the TALF program’s impact on ABS). It
Small Business Administration Stimulus Programs is unclear why the Fed/Treasury would directly support asset
When accused of neglecting mid-sized companies, the govern- classes such as credit card debt, commercial mortgages, and
ment has often cited programs related to the SBA15. Specifi- small business loans but shun credit for mid-sized companies.
cally, the U.S. Treasury and SBA have increased the percentage
12 Potential Solutions
JP Morgan
Federal Reserve, Assets and Liabilities of Commercial Banks One solution to the anemic lending activity in the middle
in the United States - H.8 (2009)
market is to move forward with the previously announced
Jonathan Weisman, Small Businesses Have a
LLP. The program would provide financing to private inves-
New Beef With White House (Wall Street Journal, 2009)

CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 3 of 5
tors purchasing portfolios of loans from banks. If the FDIC past 12 months, this provision alone would go a long way to-
believes this program is unnecessary because (large) banks have wards preventing a populist public relations headache. Second,
succeeded in raising private capital, then why not limit the the government could impose limitations on the leverage of
program to institutions with less than $5 billion in assets or the underlying companies. This would allow the N.Y. Fed-
simply to those still experiencing difficulty raising capital. The eral Reserve to facilitate access to fresh capital without placing
LLP has the potential to improve the liquidity of participating the administration in a compromising political position. If
institutions and attract capital into the secondary market for the CLO issuance market returned, even at a modest volume,
corporate loans, just as TALF and the LSP have done for the the availability of loans to middle market companies would be
CMBS market (despite less than $700 million of actual gov- greatly improved.
ernment funding hitting the CMBS market as of July 2009)16.
It is important to note that the financing offered by TALF for
TALF is another existing program that could be used to newly issued CMBS is very different from every other recovery
provide support to mid-size companies. Expanding the scope program. This is not a means of supporting Main Street by
of TALF to provide financing for recently issued CLOs would encouraging consumer lending, increasing the availability of
generate fresh capital for new corporate lending. As CLO home mortgages, or even restructuring banks’ balance sheets
issuances have effectively ceased in 2009, lenders have seen (only commercial mortgages issued after July 1, 2008 are eli-
a critical source of “dry powder” cut off. $16.4 billion of gible collateral). Offering financing for recently issued CMBS
CLOs backed by investment grade and high yield loans and encourages capital to flow to originators of commercial mort-
bonds were issued in the four quarters ending June 30, 2009. gages in order to allow these firms to fund new mortgages. At
This compares to $51.8 billion of such CLOs issued in 2004 – the end of the day, this program benefits commercial real estate
before the credit cycle took off . 17
lenders and investors (such as REITs and real estate private eq-
uity funds) – not the average U.S. citizen. Why is the Federal
The biggest hurdle to the inclusion of CLOs in the TALF Reserve comfortable supporting investors in shopping malls
program may be the fear of a public relations backlash. The and office buildings, but not other classes of investors?
government might step into a firestorm of criticism if detrac-
tors viewed the program as “supporting leveraged buyouts,” The government is correct to be concerned about the impact
as debt used to finance LBOs fueled a meaningful portion of that the halted $700 billion CMBS market will have on the
the CLO market. However, according to Thomson Reuters broader economy, particularly as debt issued during the real
74% of the upcoming middle market debt maturities are non- estate boom begins to mature19. However, the government
sponsored (i.e., a private equity firm does not control the bor- should also be alarmed about the $450 billion in middle mar-
rower)18. Nonetheless, these criticisms could be easily avoided ket loans maturing over the next four years20. Meaningful par-
by thoughtfully structuring the program. First, only CLOs allels exist between the CMBS and CLO markets. However,
with recently originated loans could be eligible for the pro- the government has chosen to support real estate lending to a
gram. This provision is in line with the original goal of the much greater extent than corporate lending. Real estate loans
TALF program and similar to the rules governing TALF fund- may have sparked many of the current problems in the credit
ing for ABS. Given the meager level of LBO activity in the markets, but an economic recovery cannot occur without a
healthy corporate lending market. Perhaps the most important
N.Y. Federal Reserve
Securities Industry and Financial Markets Association, Global CDO Data
(2009) Hui-yong Yu & Sarah Mulholland Property Bond Sales May Resume With
18 $3 Billion (Bloomberg, 2009)
Diana Diquez, 2Q09 Review and 3Q09 Preview: Better times ahead?
(Thomson Reuters, 2009) Thomson Reuters, LoanConnector

CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 4 of 5
distinction between the two asset classes is the far greater job Perhaps even more daunting is the prospect of large numbers
losses that would result if companies, as opposed to buildings, of mid-size companies unable to refinance maturing debt as
cannot refinance their debt. a result of diminished lending capacity. The Federal Reserve
and U.S. Treasury must take steps to encourage capital to
Another potential stimulus to the credit markets would be to return to middle market lending. Otherwise, the government
temporarily remove the unfavorable tax treatment for debt may see the recovery, which has been building steam, begin
trading below par. Holders of debt securities that are pur- to stumble.
chased 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 con-
trast, 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 will-
ing 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.

CastleGuard Partners, LLC, based in the Chicago area, is a
The government has been appropriately concerned about
provider of debt capital to middle market companies. CastleGuard
the availability of debt capital in the economy and has tak- originates new loans, refinances maturating debt, participates
en a number of positive steps to restore the credit markets. in special situations lending, and invests in loans trading in the
secondary market.
However, limited support has been extended to middle mar-
ket companies. It is unlikely that meaningful job creation will For more information, please visit
occur until middle market companies, which represent nearly
a third of U.S. employment, have sufficient access to credit. phone 847-201-3600 fax 847-201-3603
2700 Patriot Blvd, Suite 420 Glenview, IL 60026

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