In June of 2007, Harvey gave the keynote address at the International Institute of Insolvency.  In the address, Harvey asked the question, “Is the market headed for disaster?”  He also says, “When the bubble bursts, those left holding today’s version of tulip bulbs may be left scratching their heads and pining for the past.”  Little did Harvey (or anyone else) suspect that 15 months later, the collapse of Lehman Brothers would trigger a worldwide financial crisis.

Introduction 

It is a great honor for me to have the opportunity to address this renowned institute.  My subject, chapter 11 in transition – from boom to bust and into the future, is an awesome task to undertake.  Fortunately, I have been around long enough to observe the boom, or rather several booms, with minor busts… and now, a major decline in business reorganizations under chapter 11 of the United States Bankruptcy Code.

I have often said that if one lives long enough, one will see everything repeat itself.  The nomenclature may be different, but the basics are the same.  However, one observation as to the current environment and the economic changes which have occurred since 2003 is that everything is moving faster.  Technology has changed the dynamics of restructurings and reorganizations with access to greater information and, thus, greater transparency, a transparency that is used by many more sophisticated persons and institutions in dealing with economic distress.

It is within that context that I have attempted to deal with my subject.

Chapter 11 in Transition…From Boom to Bust. 

When I entered the legal world in the 1960s, bankruptcy was a small, arcane, undesired practice area.  After the Second World War, the volume of bankruptcies and particularly old Chapter XI cases was very minor.  Credit was relatively tight.  Major law firms and accounting firms shunned the area of bankruptcy.  The stigma of bankruptcy was very much to be avoided.  From a professional point of view, practice under the Bankruptcy Act was subject to the spirit of economy that mandated lower fees and compensation for professionals than could otherwise be earned in the private sector.  Some people ended up in bankruptcy practice, like myself, by accident.  It certainly was not a boom period.  So, what happened?

Starting in the early to mid 1960s, the United States underwent a rapid economic change.  The concept of public ownership became the rage and “going public” became the desire of many growing businesses.  It was accompanied with the opening of the credit markets and the concept of leverage.  As leverage increased, the need for fiscal discipline increased and businesses became more sensitive to maintaining sufficient cash flow to service debt.

However, all cycles do end and as the 1960s migrated into the 1970s, debt leverage became a critical factor.  It was then that that some of us discovered all of the seemingly great attributes of business reorganizations under the Bankruptcy Act.

The boom began.  It passed through different sectors of the economy:  real estate, retailing, manufacturing and service industries until it culminated in 1975 with the first billion dollar Chapter XI case of the W. T. Grant Company, one of the largest U.S. retailers that was once considered the Tiffany of retailers.  Suddenly the practice of bankruptcy law appeared more alluring.  The cases got bigger.  The fees got bigger.  The stigma eroded and under the leadership of some individuals, bankruptcy reorganization became a strategic and tactical tool.  It began to attract the best and the brightest.

Although it had cyclical ups and downs, it basically maintained boom characteristics through the first half of the 1990s, with a brief slowdown and then a major boom.  Starting in 2001 with the onset of cases like Enron, Global Crossing, and WorldCom, the boom reached its apex.  It was the golden age.  Professionals rushed to join in the boom years and the bankruptcy court had difficulty handling the onrush of cases.

The winter of our discontent began in 2003 and has continued almost to date.  We have gone through and appear to be continuing the longest stretch of concerted growth in decades.  Query:  Will the winter of our discontent continue?  Will the slump in U.S. domestic growth result in a resurgence of restructurings and business reorganizations?  Will the decline of the Chinese stock market spark a conflagration that will revitalize the global bankruptcy practice?

To answer these questions, we have to evaluate the current economic situation.

In 1881, Ian McLeod published his treatise, The Elements of Economics.  He said:

If we were asked, who made the discovery which has most deeply affected the fortunes of the human race, we think after full consideration, we might safely answer – the man who first discovered that a debt is a saleable commodity.

The current marketplace validates McLeod’s answer.  The debt market and, if you can find it, the distressed debt market are overheated and full of risks.  Indeed, defaulted debt in some cases is trading in the mid-90s.  Private equity firms, hedge funds and investment banks are acting as if the good times will continue ad infinitum.  The dramatic change in the world of restructuring and distressed investing may in large measure be related back to the words:

Inflated Liquidity

Private Equity Firms

Hedge Funds

Second Liens, and now,

Third Liens.

The combination of the foregoing and certain other factors have produced the huge amount of issued high risk debt combined with lowest default rates in the history of U.S. financial markets.  The result has been what many have described as the most robust resilient economy that has ever existed, allegedly an economy that is impervious to a recession or crash.  It is an economy built upon abundant liquidity.  It seems that there is a liquidity solution for even the most troubled of companies.  It is a market redundant with investors competing with each other for places to invest their money and realize reasonable or hoped-for substantial returns.

History reveals many disastrous economic bubbles, illustrated by the tulip bubble of the 17th Century, the South Sea bubble of the 18th Century, as well as the dot.com companies of the late 20th Century, companies that floated public issues with no revenues, a situation that may be repeated as one reviews the more recent U.S. IPOs of companies showing no profits.  Today we face explosive debt with limited contractual lender protections.  When the bubble bursts, those left holding today’s version of tulip bulbs may be left scratching their heads and pining for the past.

The Current Environment—Liquidity and Deals Galore (But Watch Out for the Risk) 

Leveraged Loans:  Volume in the Leveraged Loan Market Continues to Soar and Break Records

The volume of newly issued leveraged loans is growing exponentially.  In the first quarter of 2007, a record $183 billion in leveraged loans was issued.  This is more than 20% higher than the $148 billion in the previous quarter, and more than three times (or 366%) the amount issued just three years ago in the first quarter of 2004.

Just as telling is that the quality of new issue loans has decreased over time.  The total amount of below investment grade debt has materially increased since 2000.  The par amount of outstanding leveraged loans has more than doubled in the last few years and now stands at over half a trillion dollars.

The European leveraged loan market also has achieved phenomenal growth over the past five years, with total transaction volume increasing from 80 billion Euros in 2002 to 200 billion Euros by the end of 2006.  And it appears that this year will be a record as well.  Europe’s share of the leveraged loan market has grown from 20% in 2000 to 33% today.

Asia is just starting to get into the leveraged loan craze.  Dozens of top bankers are heading to Asia from the U.S. and Europe to boost the leveraged finance business there.  They see Asia as the next big market.

Almost half (50%) the loans made this year worldwide were rated below investment grade, up from 20% in 2004.

Growth of Investors in the Loan Market

In a little over ten years, the players in the loan market have done almost a 180 degree shift.  In 1995, banks represented over 70% of the investors in loans.  Today, that number stands at under 13%.  Conversely, in 1995, CLO’s, hedge funds, and other such funds represented just over 16% of the investors in loans.  Today, that number stands at over 77%.

The number of institutional investors has grown exponentially.  Today, there are over 254 institutional investors, almost ten times the 32 that existed in 1995.  And these investors are return-driven, rather than interest-driven.

Leverage multiples have reached levels that many banks believe excessive.  Nonetheless, it hasn’t discouraged them from lending in the past few years.  But banks have become adept at passing on potential problems by selling down through the syndication of loans.

Second Lien Loans 

As investors compete for opportunities to invest their money, they are forced to engage in riskier investments – second, and now third lien loans.  The volume and number of second lien loans have increased from almost non-existent in 2002 to a market of almost 200 loans totaling almost $29 billion in 2006.  And the first quarter 2007 numbers suggest that 2007 will likely see even more second lien loans.

While the number and volume of second-lien loans is increasing, the reward for taking the risk of making a second lien loan is decreasing.  In 2003, when second-lien loans were relatively new, investors were rewarded handsomely for the risk in making them — with an average spread of 738 basis points.  The spread has gone down every year since then.  The average spread on second lien loans in the first quarter of 2007 was almost 200 basis points less than in 2003 — at 559 basis points.  This is pure supply and demand economics.  As the supply of investors willing to make second lien loans increased, the price (the reward to the supplier) decreased.

Most second-lien investors are not traditional lenders, but risk-seeking (or at least not risk adverse) CLO’s and hedge fund-types.

Increase in Riskiest Loans

As the boom in second lien loans demonstrates, investors are willing to take greater risks in making loans.  This is so increasingly true that in the first quarter of 2007 alone, more than $7 billion in new loans were rated CCC or below.  This surpassed the record high set in 2006, which itself more than doubled the previous record set the year before.  In contrast, less than $500 million CCC loans were made just five years ago in 2002.

Covenant Lite Loans

Covenant-lite loans, another fairly new, innovative type of lending, have also increased exponentially.  Covenant lite loans are first lien term loans that lack the typical financial covenants traditionally found in loans.  The volume of covenant-lite loans in the first quarter of 2007 was over $48 billion, more than double the already staggering $23.6 billion in 2006 and much more than the volume of the prior 10 years combined.

The share of institutional loans that are covenant lite went from 1.3% in 2005 to 7.4% last year to 35% as of the end of the first quarter of 2007.  On May 31, 2007, a new milestone for covenant-lite loans was disclosed in connection with KKR’s proposed acquisition of First Data Corporation for approximately $27 billion, of which $16 billion will be covenant-lite loans.  That $16 billion almost equals the $16.6 of covenant-lite loans made in the entire month of April, 2007.

Increasing Leverage Levels

Is it déjà vu all over again?  Are we beginning to see leverage ratios eerily similar to those of the late 90’s that preceded the downturn of the early part of this decade?  For LBO loans of issuers with $50 million or more of EBIDTA, the average debt multiple in the first quarter of 2007 was 5.7x, the exact same amount as in 1997.  This compares with the low of 4.0x in 2001.   Similarly, the average coverage ratio (EBITDA – Capex)/(Cash Interest) of large LBO loans was down to 1.6x in the first quarter of 2007 from a high of 2.6x in 2004 and almost down to the low levels of 1996-1997.  The percentage of leveraged financing used for M&A in the U.S. hit 57% in 2006, its highest level in seven years.  While that may pale next to the 68% seen in 1999 and the 71% recorded in 1998, the sheer volume of last year’s M&A related leveraged financing is astounding.

Junk Bonds

It is not just leveraged loans that are the risky landing place for investors’ hungry capital, but also unsecured high yield bonds.  Thirty years ago, the high-yield bond market consisted almost entirely of “fallen angels” – investment grade bonds whose ratings were cut as issuing companies’ fortunes declined.  It was a tiny market with less than $10 billion of such bonds outstanding in the United States in 1978, the year that Congress enacted the Bankruptcy Reform Act.  The high-yield market has since enjoyed spectacular growth.  There is $1.1 trillion in high-yield bonds outstanding in the U.S.  The market is not dominated by fallen angels, but by newly issued non-investment grade securities (bonds receiving ratings from Standard & Poor’s and Fitch of below BBB-, or Moody’s ratings of below Baa3).

This junk bond craze is not limited to the United States.  New issuances of junk bonds in Europe in the first quarter of 2007 totaled 12.7 billion Euros, compared with 7.1 billion Euros in the same period of 2006.

A recent issue of Grant’s Interest One Rate Observer stated that the only thing missing from the risks section of bond offerings these days is the disclaimer:

“Bond investors have lost their minds!”

Default Rates

Even as risk increases, defaults are decreasing.   In 2001, 138 bond issuers with bonds totaling $56 million defaulted.  That number decreased to 18 issuers with bonds totaling $7 billion defaulting in 2006.  The downward trend continued in the first quarter of 2007.  In that period, only one issuer defaulted, for a total of only $130 million in defaulted bond debt.   More bonds are being upgraded than downgraded in recent times.

Deals, Deals, and More Deals

It’s not just loans that are big.  The deals are huge.

1.               General Statistics

In 2006, there were over 36,000 worldwide mergers and buyouts worth $3.6 trillion.  More than half of that market value and most of the debt from those mergers involved “leveraged” takeovers.

2006 saw nine of the 10 largest U.S. leveraged buyouts ever.  2007 appears to be more of the same.

As of mid-May, $366 billion of LBOs have been announced this year, a rate that appears headed to eclipse last year’s record of $701.5 billion.

Funds are paying more to take companies private than they did in 2006.  Transaction multiples for the 32 U.S. public-to-private deals in the first quarter of 2007 were nearly 11x EBITDA, compared to the already-high 10.7x for deals announced in 2006.

In May of 2007 alone, buyout groups in the United States had their busiest month on record launching over $100 billion of new bids in that month alone.

2.               The Deals are Riskier

The deals are riskier and more highly leveraged than we have seen in the past.  In 2006, 41% of all large LBOs boasted a pro-forma debt multiple of 6 times or higher, up from 25% in 2005 and 9% in 2004.  It is the highest reading since 1997, when 44% of all large LBOs were structured as aggressively.  In the fourth quarter of 2006, the share held by these 6 times deals expanded even further, to 50%.

In Europe, companies acquired by buyout firms had debt equal to 6.2x EBITDA in the first quarter of this year.  That is up from 5.1 times in 2004 and 4.8 in 2003.

3.               The Private Equity Bubble

Leveraged loans are fueling the private equity bubble.  The high water mark was Blackstone’s acquisition of Equity Office Properties Trust and the battle that occurred between Blackstone and the Vornado Group, which pushed the price for that deal to almost $40 billion inclusive of assumed debt.  That was recently surpassed by the $45 billion agreement to buyout Texas energy giant TXU by investors led by Kohlberg Kravis Roberts and the Texas Pacific Group.

Total private equity investment in Europe nearly doubled last year to 21.9 billion Euros from 11.7 billion Euros in 2006.  U.S. private equity players are moving into Europe.  U.S. private equity giant Carlyle Group recently announced it plans to float a major new fund in Europe.  It is doing so while all of Britain’s major banks are selling off billions of dollars of bank loans and mortgage debt in the capital markets, to debt traders, hedge funds, and other institutional investors.

According to a Wall Street Journal article, the modus operandi of private equity firms is that they buy companies, slim them down with big layoffs, then load the companies up with debt to pay their high management fees and dividends.  Once they’ve taken their cut, they quickly flip the business back into the stock market or to another purchaser.

The abundant liquidity environment that has spurred the private equity bubble also appears to have saved many “walking wounded” companies that have been rescued by anxious investors willing to refinance.

What Does This All Mean?

When will the credit markets buckle and how badly will they have to buckle to absorb all of the distressed capital out there?  Will second liens contribute to the next wave of defaults?  What about the covenant-lite loans, which have not been around long enough for us to truly understand their impact when things go sour?  There are reasons to believe that when the defaults do come, as expected, the results will not be pretty for the holders of the high-yield debt:

  • Fitch (in Bloomberg) estimates that as companies add more senior secured loans, which rank ahead of junk bonds, the average recovery rate for unsecured bonds may fall by as much as 10% from its recent historical average of 40 cents on the dollar. A Fitch analyst notes that the structural risks are rising; but are being masked by the low default rate.
  • Stuart Gilson, a professor of finance at the Harvard Business School, recently noted, “There’s been more money than good deals, and the money has been papering over real business problems. When the money runs out and the situation turns to crisis, the types of default we’re going to see could be more serious than in the past.”

What Does the Future Have in Store for Chapter 11 and the Economy? Introduction:  What Happens if There Is a Crash?

Chapter 11 is not a receptive forum for a debtor.  The changes in the bankruptcy law, which culminated in the 2005 amendments, make bankruptcy unappealing to most debtor organizations.  It is a tremendously expensive, and there has been a significant diminishment in the control that was exercised by a debtor in possession.  Consider the provocative statement of Professor Douglas Baird of the University of Chicago Law School:

To the extent we understand the law of corporate reorganizations as providing a collective forum in which creditors and their common debtor fashion a future for a firm that would otherwise be torn apart by financial distress, we may safely conclude that its era has come to an end.

Today, chapter 11 is not a process in which a debtor and creditors work together to rehabilitate a debtor.  In most instances that process has come to an end.  Chapter 11 has been decreasing in popularity as a solution to a company’s problems, and the decline is even more profound for public companies.  During the ten year period (1994-2003), the total number of bankruptcy cases filed increased by an average of 9% per year.  However, during the same period, the number of chapter 11 cases filed decreased by an average of 4% per year.  Stated differently, in 1994, 1.77% of total bankruptcy cases filed were chapter 11 cases.  In 2003, that figure was .57%.

In 2006, business-related chapter 11 bankruptcies continued to slide, with only 5,163 being filed that year, down from 6,800 in 2005, and more than 9,000 in every year from 2000 through 2004. While there was a slight increase in the last quarter of 2006, it was minimal.

As to chapter 11 for public companies, in 2001 approximately 257 public companies commenced bankruptcy cases with liabilities in excess of $225 billion.  In 2002, there were approximately 195 public companies with petition-date liabilities in excess of $350 billion that commenced chapter 11 cases.  Since that peak in 2002, the number of public companies and the amount of liabilities subjected to chapter 11 has steadily moved downward, to the point that of the over 5,000 chapter 11 cases filed during 2006, only 60 were public companies, as compared to 257 public companies in 2001.  Many of the other cases were efforts to use chapter 11 to prevent evictions or otherwise enjoin creditors.

The statistics illustrate the eroding use of chapter 11 as a debtor relief vehicle.

Why has chapter 11 failed?  The answer is multi-faceted.

In the legislative process that occurred from 1973 to the passage of the Bankruptcy Reform Act of 1978, the goal of rehabilitation of distressed debtors was the primary rationale to support the need for business reorganization reform legislation.  Subsequent to the enactment of the Bankruptcy Reform Act, and during the mid to late 1980s, a new and often conflicting theme began to emerge in response to the belief of special interest groups that chapter 11 cases were weighted in favor of debtors.  This theme emphasized as a prime objective of chapter 11 the maximization of creditor recoveries.  While it could be argued that the objectives are not mutually exclusive, the effort to give primacy to creditor recoveries has given rise to confusion in the chapter 11 process.

Today, chapter 11 more often than not is a means to validate and sterilize the sale of a debtor’s assets.  This is accomplished by the use of section 363(b) of the Bankruptcy Code to affect a speedy sale of all or substantially all of the debtor’s assets and expedite distributions, essentially, to secured creditors.  The process gives buyers the benefit of asset sales that are blessed by a court and, often, are free and clear of liens and encumbrances under section 363(f) of the Bankruptcy Code.

The chapter 11 process, as contemplated in 1978, has been overwhelmed by marginalization of the debtor in possession, expansion of creditor (particularly secured creditor) control, the increasing imposition of creditor designated chief restructuring officers (“CROs”), claims trading, more complex debt and organizational structures, short-term profit motivation, and, of course, greed gratified by claims trading, acquisitions and litigation.  Gordon Gekko is alive and well in the public and private markets, as well as in the benign environment of restructuring.  As a consequence, the objective of a successful rehabilitation, the preservation of going concern value and the emergence of a rehabilitated stand-alone debtor has been eclipsed in most cases.

It is interesting to note that the number of reported insolvency cases in the rest of the world has also decreased.  For example, the number of corporate insolvencies in Western Europe reached a peak in 2004, but declined in 2005 and 2006.  Similarly, the number of corporate insolvencies in Japan decreased in 2006.  Some of the Eastern European EU countries saw an increase in the number of insolvencies in 2006, but those are generally attributed to specific problems in particular countries, such as Hungary (which has an unusually high deficit in both the balance of current payments and the state budget).

As one would expect, those countries with debtor-friendly insolvency laws, such as the “procedure de redressment judicaire” in France, in general saw a greater number of business failures than those countries with laws that are perceived as being friendly to creditors, such as Britain’s “administrative receivership.”  As U.S. chapter 11 is becoming more creditor-friendly, or shall I dare say beholden to the strong creditor lobby interests, chapter 11 is being seen and will be seen by companies as less of an attractive option.

The Past

1.       The Bankruptcy Reform Act of 1978

The enactment of the Bankruptcy Reform Act of 1978 was generally supported by the academic community and, importantly, by the banking industry.  Representatives of that industry testified before Congress urging the need for a statute that would allow for the rehabilitation of distressed debtor entities.  The banking industry lobbied earnestly for the enactment of chapter 11.

The period up to the effective date of the Bankruptcy Reform Act witnessed the strained reorganization efforts of many large public corporations under the inadequate provisions of former Chapters X and XI that had been enacted as part of the debtor relief provisions of the Chandler Act of 1938.  After the effective date of the Bankruptcy Reform Act and for a period of years, debtor led chapter 11 reorganizations may be said to have flourished.  It may have been the golden age of debtor rehabilitation.

The Bankruptcy Code was viewed as very flexible legislation intended to meet the needs of economic distress and default, and serve the interests of all those affected by business failure, including the debtor, creditors, employees, the communities in which the debtors operated and the public in general.  The reorganization provisions of the Bankruptcy Code were adopted to deal with the reluctant debtor by providing inducements to initiate formal reorganization cases before its assets had been dissipated and the possibility of reorganization minimized, as had occurred under the former Bankruptcy Act.  To achieve that objective, Congress enacted the administrative provisions that provided protections for the debtor, including the automatic stay; the ability to use, sell or lease property, including the cash collateral and other collateral security of a secured creditor; the ability to assume or reject executory contracts and unexpired leases of non-residential real property; and, importantly, the ability to obtain credit and offer to lenders material enhancements for lending to a debtor in possession.

Of monumental significance was the adoption of the debtor in possession (“DIP”) concept.  The debtor in possession is not required to be disinterested and, ironically, may include persons that caused or were responsible for the plight of the debtor, a circumstance that has amazed foreign creditors and investors.

In 1978 Congress intended that the debtor in possession would be the driving force of a chapter 11 reorganization.  Supported by a sympathetic bankruptcy court, the debtor/debtor in possession did become the leading actor in the chapter 11 reorganization scenario during the 1980s, to a point that it created a backlash from creditors.  The hue and cry went out that bankruptcy judges were debtor-oriented and every benefit of the doubt went to the debtor.  It was argued that the logo of the bankruptcy court was, “reorganization über alles.”

However, that situation did not prevail for very long.  The drive to make chapter 11 more inviting to distressed debtors was inadequate to eliminate all special interest legislation.  Despite valiant efforts by the reformers, section 1110 of the Bankruptcy Code carried forward from the former Bankruptcy Act, special protections for sellers, financiers and lessors of certain types of equipment relating to aircraft, railroads and vessels.  Using that piece of special interest legislation as a foundation, other creditor groups pressed Congress for legislative containment of the bankruptcy court and the debtor in possession’s powers.  Congress has been generous in responding to the “needs” of these special interest groups.

As a consequence, the clawback of debtor protection provisions began.  Virtually every group with an effective lobbyist has come forward and worked its magic on Congress for a statutory provision that benefited its special interests.  These include personal property equipment lessors, commercial property owners, shopping center owners and lessors, fisheries, grain elevators, financial institutions, government agencies, unions, and retirees, to name just a few.

2.       BAPCPA

Perhaps the biggest special interest victory is the ill-conceived Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which has effectively repealed the fresh start principle for individuals.  The BAPCPA was enacted after four or more years of intensive and expensive lobbying by the credit card industry, estimated at $50 to $60 million.  While it is primarily directed at consumer bankruptcies, the BAPCPA contains provisions relating to chapter 11 reorganizations, and affects the delicate balance between interests of debtors and creditors that are the essence of reorganization.  Among them are the mandatory cap on a debtor’s exclusive period to file a plan of reorganization, enhanced protections for reclamation and trade creditors; a mandatory cap on the period to assume or reject unexpired leases of non-residential real property; expanded protection of utilities; mandatory appointment of a chapter 11 trustee in certain circumstances, and relaxation of the ability to recover preferences, among others.

The BAPCPA fulfilled a long-standing desire on the part of special interest groups to limit the discretion of the bankruptcy court and thereby reduce the flexibility of the court to meet the needs of rehabilitation and reorganization of a debtor.  Complementing the extended adoption of special interest legislation has been the rise of the coercive debtor in possession financing.  To understand this phenomenon, once again we must go back into history.

3.         Events Leading Up to Bankruptcy Act of 1978

The Bankruptcy Reform Act was considered and enacted in a very different economic world.  In the 1970s, and most of the 1980s, the full impact of globalization had not yet been felt.  Almost all of the debt carried by business debtors was unsecured.  The adoption of the Uniform Commercial Code was not yet universal.  U.S. businesses, for the most part, were based upon local or national economies.

In the beginning of the 1970s, business debtors relied primarily upon long-standing relationships with vendors and suppliers.  Access to bank credit for many businesses was limited.  In those few cases in the early 1970s that involved a bank creditor, it was usually one bank which had a very recent relationship with the business debtor.  Secured lending was done primarily by asset-based lenders such as factors and commercial finance firms.  In the early years, public debt was a relatively rare factor in restructurings and reorganizations.

Manufacturing and production of goods and commodities were basic elements of the U.S. economy.  Distressed debtors had multiple choices of vendors and suppliers to offset a particular supplier rejection.  It was a simple world that began to get complicated as the economy expanded and the going-public binge erupted in the late 1960s and 1970s.

Business needed capital to expand and financial institutions likewise wanted to grow and become financial empires offering more and more credit support.  It almost had the makings of a perfect storm.  The financial institutions wanted to lend and businesses needed access to credit to grow.  As a result, when the economy softened in the early 1970s, for the first time in old chapter XI cases, bank and insurance company creditors began to appear.  First as individual creditors and soon as syndicates, but almost always as unsecured creditors.

Soon thereafter, a new creditor group began to demand representation, the public bond holders, first in the person of the indenture trustee and then as individual bond holders.  These changes in the creditor constituency, initially, did not materially alter the dynamics of the chapter XI proceeding or the processing of chapter 11 cases under the new Bankruptcy Code.  But, changes were beginning to be apparent.

The Present

The financial institutions have gotten smarter.  They found the Uniform Commercial Code and demanded and got collateral security for their loans.  Public bond holders had learned to mouth the words, “equitable subordination,” “breach of fiduciary duties,” and “fraudulent transfers.”  The threat of litigation by junior creditors has become standard operating practice in chapter 11 cases as a means to coerce secured or senior creditors to reach accommodations with unsecured or junior creditors.  But as before, the creditors, banks, insurance companies and trade creditors initially all stayed the course.  The exceptions appeared in the chapter 11 cases such as Baldwin United, Revere Copper & Brass, and Storage Technology Corporation, where something new was happening.

In those cases, major claims were changing hands and transferees without any prior relationship with the debtor were emerging.  They were characterized as “distressed debt traders.”  The discovery that vast profits could be made by buying distressed debt began to resonate with Wall Street.  You could buy claims at a steep discount from frustrated creditors and, hopefully, within a relatively short period, realize double digit returns.  The trading of distressed debt claims became a cottage industry.  It started slowly and after the 1991 amendment of the Bankruptcy Rules that enhanced the free trading of claims and the subsequent obligation imposed upon financial institutions to liquefy bad loans, claims trading grew exponentially to the point that in many reorganization cases, a substantial portion of the creditor body changed from month to month.

Claims trading had dramatically changed the dynamics of the reorganization process.  Distressed debt traders have different motivations and objectives than the old line relationship banks and trade creditors.  Quick and significant return on investment was the imperative to the traders.

The explosion of distressed debt trading marked the end of the relationships that had been a major support structure of the reorganization paradigm of 1978.  The situation was further aggravated as the financial institutions became secured creditors with elaborate loan and security agreements.  They became more aggressive and disinclined to share their collateral security with others.  The potential exercise of remedial rights of secured creditors and expedited creditor recoveries assumed predominance as we marched into the 1990s and the 21st Century.

It was in this context that the use of DIP financing became a vehicle to achieve the goal of expedited returns to the holders of secured claims and achieve the demise of stand-alone rehabilitations.  As the lenders’ liens captured all of the assets of a debtor, it literally had no place to go to obtain post-chapter 11 financing other than to the holders of the existing secured loans.  Given their economic leverage, the pre-chapter 11 lenders or their successors have used the granting of DIP financing as the means to exert substantial control over the debtor and chapter 11 case.  Negotiations over DIP agreements tend to be one-sided, with lenders structuring such agreements to enhance influence and control.

These provisions substitute the judgment and decision-making of the debtor in possession, who is supposed to serve as an independent fiduciary, and replace it with a self-interested creditor who uses the process to protect its interests.  Effectively, the debtor in possession is neutered.  Likewise, certain of the imposed conditions limit the role of the bankruptcy court.

Globalization and the changing economy also added to the factors that have left a reorganization process that has been mortally wounded.  Consequently, debtors contemplating reorganization must take into account:

  • the increased fungibility of assets and the ease of disposition of most assets, as the bankruptcy marketplace has achieved respectability, and, in effect, often preserves going concern value;
  • the sophistication of secured creditors and distressed debt traders;
  • a less sympathetic court;
  • contracts that contemplate default and provide remedies;
  • the entry of financially focused investors who may have bought claims or interests at sharp discount and who have short term objectives; and
  • the changed environment and objectives of chapter 11.

The effects of globalization have enabled companies to spread risk, thereby avoiding major loss in any one transaction that would cause an institutional crisis.  In addition, credit default swaps allow speculation in risk without owning the underlying debt.  One consequence is that the failure of one hedge fund, for example, does not cause a ripple in the market.

Emboldened by the so-called reforms that have stripped power from and neutered the debtor in possession and concerns of their relative lack of power compared to the all-mighty DIP lenders and even second lien lenders, creditors’ committees in many cases have begun to view themselves as the directors of the process.  They consider themselves to be the owners of the debtors, a super board-of-directors of sorts, and they view the debtors’ management to be merely a nuisance in their path to ultimate control.

In addition, the emergence of hedge funds as active participants in the passion play, and the advent of pernicious litigation largely tolerated by bankruptcy courts, may lead to the debtor’s conclusion that chapter 11 reorganization is too inhospitable.  An adversarial situation that may be enhanced by the new 800 lb. gorilla – the hedge fund.

Distressed debt traders may have morphed into hedge funds, or hedge funds may be distressed debt traders.  Recently, I asked several knowledgeable persons, “What is the definition of a hedge fund?”  No one would answer me.  They had difficulty distinguishing a private equity fund from a hedge fund.  Later, a hedge fund manager gave me his definition of a hedge fund.  He said, “It’s a machine to make the fund’s managers enormously wealthy in a very short period of time.”  The top 25 hedge fund managers earned an aggregate of $15 billion in 2006.

Whatever the definition, hedge funds have taken on an activist role in restructuring and bankruptcy reorganization cases.  Many hedge funds yielded dramatically high returns for the period 2003 through 2005.  As a result, money flowed into the hedge funds from pension and retirement funds, endowments, major corporations, state and local governments, all seeking better returns on their investments.  This flow of money has resulted in record numbers of assets being managed by hedge funds.

Although it is difficult to estimate with accuracy the amount of money in the unregulated hedge funds, some reports have estimated the numbers to be, through the end of the first quarter of 2007, of over 8-9,000 individual funds administering approximately $2 trillion in assets. This is an increase of more than 30% of the assets under management just a year ago.  The top twenty hedge funds now control nearly one-third of hedge fund assets, according to a recent survey reported by MarketWatch. The New York Times (5/27/07) noted that the 100 largest hedge fund firms in the world managed 69% of hedge fund assets.

The hedge fund and private equity boom can also be seen in Europe.  Seven years ago, traditional banks held 95% of the share of the leveraged lending in Europe.  As of the end of March 2007, that share was just 49.8%.  Over 50.2% of the share of the European leverage lending market now belongs to hedge funds and other non-bankers.  In fact, Europe was the fastest-growing region in terms of hedge fund assets last year, growing 40% to $260 billion.

Interestingly, the quick expansion of hedge funds over the last ten years has sparked concerns that more new entrants in the business would struggle and eventually shut down, or suffer big losses.  There is no doubt that hedge funds are operating in a market of severe competition.  Paradoxically, as pointed out by The New York Times (5/23/07), the hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments.  The competition has caused at least 83 U.S. hedge funds, collectively managing approximately $35 billion, to shut down in 2006.  But many more new ones have quickly filled their space.

Despite all the hoopla, hedge funds are not even performing that well overall.  Last year, hedge funds returned an average of just under 13%.  The S&P 500 stock index, in contrast, went up almost 15%.

Some large hedge funds and hedge fund investors have begun seeing losses.  About a year ago, the hedge fund run by John Henry, the owner of the Boston Red Sox, had $2.5 billion under management.  After Merrill Lynch recently announced that it is pulling out $600 million that had been invested in Mr. Henry’s fund, the fund is down to only $500 million.  Many of Mr. Henry’s investments are down more than 20% over the last year.

Despite the bumps in the hedge fund arena, the market so far has been resilient.  Even the demise of Amaranth Advisors last fall ($6 billion) did not create much of a ripple in the market, and it appears that the managers of Amaranth did not suffer any real loss or were required to give back past takings from the infamous 2+20 or higher, unless the management had substantial monies in the fund.  The demise of fraud-ridden hedge funds such as Bayou, MIF, and others likewise did not cause any concern among investors or the market.

Hedge funds exalt short term performance and encourage companies to take on questionable amounts of debt, significantly increasing leverage.  Martin Lipton, the noted corporate attorney, said of private and hedge fund activists, “I think it is a terrible thing for corporate America.  I think what we are seeing is a replay of the attempt to drive American business to short term results instead of long term values.  And, ultimately, it is a tremendous threat to the vitality of our economy.  I think that it is even more dangerous than the kind of junk bond bust-up, the greenmail activity of the ‘70s and early ‘80s.”  The European Central Bank has warned that hedge funds represent a major risk to global financial stability. They have been described as “locusts” by Germany’s Deputy Chancellor.

Recently, an economist at the New York Federal Reserve (Tobias Adrian) released a report that stated that hedge funds may now pose the biggest risk of a crisis since 1998 when the implosion of Long-Term Capital Management threatened the global financial system.  Nevertheless, the head of the New York Federal Reserve, along with other top officials, remain wedded to the position that hedge funds should not be regulated, but should regulate themselves.

In May, 2006, Alan Greenspan characterized hedge funds as “a plus for the financial system” that increased “the efficiency of the markets by taking advantage of mispriced securities and other market inefficiencies.”

Where the truth lies remains to be seen!

In any case, hedge funds are potent; they have edged aside traditional lenders, such as banks and insurance companies, to become the primary lenders and major participants in providing the apparently endless flow of financing to troubled companies; financings that have allowed these companies to avoid defaults in exchange for assuming higher leverage.  This is often accomplished with very complex debt structures sometimes involving different tranches of debts, inclusive of first and second liens.  It makes one think that when a company fails, we may very well find tranche warfare breaking out.

Hedge funds are buying the debts created by leveraged private equity deals and trading that debt.  At the moment private equity and hedge funds appear to be in harmony.  If an economic slowdown occurs, will the harmony dissipate?  If a portfolio company of a private equity fund needs a waiver of a potential covenant default, will the hedge funds be as compliant as banks have been to private equity funds?  The owners will not know who the lenders are, as the debt trades each day.

In the restructuring world of today, hedge funds have assumed pivotal roles in the formulation of reorganization frameworks.  Because of their objective for fast returns and their desire to coerce concessions, they have been described as often destructive and instigators of litigation.  The result is that some private equity funds are attempting to restrict banks from selling loans to certain hedge funds.

Hedge funds have found restructuring in bankruptcy reorganization a fertile field.  The reverse is true too.  The Turnaround Association recently revealed the results of a survey showing that last year 35% of turnaround firms named hedge funds and private equity funds as sources of businesses, up from a mere 13% in 2005.  NYU Professor Altman counts 170 institutions that invest primarily in distress, more than ever before, with an estimated $300 billion at their disposal.  He calls today’s market “almost insane” and says the “glut” will surely end dramatically.

The generally narrow focus of hedge funds exacerbates the already fragile chapter 11 environment.  Because they are largely unregulated, it is difficult to ascertain the positions held by a particular hedge fund.  This may change somewhat in the context of a bankruptcy case as a result of Bankruptcy Judge Gropper’s decision in the Northwest Airlines case that ad hoc committees of hedge fund members must reveal specified information about their holdings.

Hedge funds tend to play in all levels of the debtor’s debt and often in the equity.  This creates potential conflicts that may impair the ability to effectively reorganize.  Even buying junior seemingly out-of-the money claims may be attractive to hedge funds because juniors often retain some option value in a reorganization notwithstanding the absolute priority rule.  Some have speculated that this is because seniors are willing to give a part of their share to juniors due to the uncertainly of valuation.  Some commentators have posited that the BAPCPA provisions that limit the debtor’s exclusive period to file a plan of reorganization will give the hedge fund, and its fraternal twin the private equity fund, even more power in a chapter 11 case.

The funds influence the outcome of the chapter 11 case, often determining whether they want to be cashed out (by selling the company in bankruptcy and taking the proceeds) or owning the company (by taking equity in the chapter 11 plan).  Either way, chapter 11 may be seen as an M&A transaction.

Studies demonstrate that over half of large chapter 11 cases today result in the sale of the debtor’s business—perhaps demonstrating hedge funds’ penchants for quick returns.   A “free market” of reorganization has emerged.  This is exactly what existed 100 years ago before the Supreme Court and then Congress intervened to change the system because it was rife with corruption.

In the meantime, the cost of chapter 11 and bankruptcy have continued to skyrocket:

  • Refco – $143 million in one year, with a projected $180 million cost to completion
  • Delta Air Lines – $185 million, through the end of January, 2007, or approximately $12 million/month
  • United Airlines – $335 million over a three year period
  • Collins & Aikman – over $100 million for a failed case
  • Delphi Corporation – over $200 million over 15 months
  • Adelphia Communications – approaching $450 million
  • Of course, you have the always referred to Enron in which total cost may approach $1 billion.

The Process

Perhaps with the exception of particular old-line unionized industries, such as rust belt,  automotive, mass tort and environmental cases, there may be no need for chapter 11.  Maybe it would be better, or at least cheaper, to appoint a chapter 7 trustee with authority to operate the business and be the fulcrum for the sales of assets without all of the paraphernalia attendant to current chapter 11 cases and the huge fees and expenses now incurred.  One conclusion is clear, the chapter 11 originally conceived in 1978 is not the chapter 11 of today.

While this may not be fatal, there are basic infirmities in the process that will probably get worse until there is a scandal.  That should not stop us from finding solutions for distressed situations with imagination and innovation within the context of the prevailing legal system.

Conclusion

Is the Market Headed for Disaster?

Will the benign credit environment, fueled by significant liquidity from traditional and non-traditional institutions, continue to materially affect the default and recovery rates in the high-yield, leveraged loan and distressed debt markets?  Will the hot money from non-traditional lenders recede and move to other uses resulting in a more normal default and recovery pattern based upon firm fundamentals?

As hedge fund returns decline, some funds may find it difficult to cover their own loan requirements, as well as the probability of fund withdrawals.  The signals are less than clear, but cycles do change.  Unfortunately, the past is not necessarily a perfect guide to future performance.  The ultimate question is, when will there be a manifestation of the past and which past will it be?

What are the prospects for the future of the global economy and the role of chapter 11 in the context of distressed debt?  As stated, the number of chapter 11 cases has decreased precipitously since the early part of this decade, particularly for public companies.   It has caused the same learned comments that preceded the crash of 2000, e.g.,  “This time it is different.”

In a sense that may be true.  The stock market is not as overheated as it was in 1999 and early 2000.  Nevertheless, from a historical perspective, financial collapses are persistent and as old as markets.  Clearly, the collapse of 2000 ranks among the broadest and most systemic in financial history.

As one commentator stated:

The speculation was epic, the abuse of investors was pervasive, and the fraud was more widespread than at any time under the present system of federal regulation.  It was not merely that many companies, or many Wall Street operators, misbehaved; it was that the very culture encouraged the misbehavior and was, in large measure, its accomplice.  It was not merely a matter of rogue executives and bankers, but a failure of America’s markets – its institutions, its financial community.  The crash was one of Wall Street’s worst.

Is the situation really very different than the late 1990s?  Leveraged loans and second lien financing have become the favorites of Wall Street.  Is the current situation reminiscent of the LBO hysteria of 1988-1989 or the pervasive euphoria that existed prior to the crash of 2000?  Certainly, speculation is epic and the race for accretion of wealth is unbounded.

The question before the House is whether the much praised resilience and flexibility of the market will prevent an economic recession and eliminate the need for chapter 11 professionals, and cause most of us to search for alternative careers.

There are at least two responses:

On the “Yes” side:

A number of economists have submitted data that support potential time bomb that is ticking:

  1. A deeply indebted consumer, the person at the bottom of the feeding chain
  2. Potentially increasing interest rates
  3. News reports that many restructuring firms and increasing their numbers of restructuring bankers and attorneys as they anticipate an increase in defaults:
    • On May 30, 2007, Bloomberg reported that “[t]he biggest winners from the global buyout boom are hiring distressed-debt bankers in Europe at the fastest pace in five years.” For example, Goldman Sachs, Morgan Stanley, and Blackstone are either starting or beefing up existing restructuring practices.
    • Bloomberg reported that restructuring groups are growing faster in Europe that in the U.S., as companies in the U.K., France, and Germany pile on record amounts of debt.
  4. Over the last five years, American households have spent more than they’ve earned, for almost 30 years, beginning in 1970, the opposite was true, e., households saved more than they spent. Today the guiding principle appears to be:

Shop until you drop!!!

  1. S. economic growth for the year has been downgraded. Real gross domestic product has expanded a little more than 2% over the past year, compared with an average annual growth rate of 3-3/4% over the preceding three years.  The estimated growth for 2007 would be the lowest in 5 years.
  2. A cooling housing market:
    • After rising at an annual rate of nearly 9% from 2000 through 2005, house prices have decelerated, even falling in some markets. At the same time, interest rates have moved upwards, reaching multi-year heights in mid-2006.
    • The decline in the housing market has contributed to significant problems in the market for subprime lending. Adjustable Rate Mortgages are coming home to roost.  Over the next five years, $1 trillion ARMS will reset.  Over the next few months, resets will cause an increase in the interest rate to 11%, a rate totally unanticipated by mortgagors.
  3. Consumers view their homes as cash machines. Consumers have extracted billions from their   The consequence is there is much less equity in those properties.
  4. Signs that the hedge fund boom is cracking are beginning to appear. Last month, Swiss Bank UBS AG announced that it has shut down a key in-house hedge fund after a $124 million loss.  The hedge fund, which managed $1.5 billion in an outside fixed-income fund and more than $3 billion of the bank’s own money, invested in risky subprime loans.
  5. Continuing Federal deficits and the drain of the war in Iraq will adversely affect the economy.
  6. Negative effects and implications of bankruptcy amendments and the conduct of chapter 11 cases. A return to the 1960s.
  7. Small businesses are now failing at a higher rate than in the past few years, particularly in the construction industry. For example, 8,000 more businesses closed than opened in the third quarter of 2006, the worst quarter in five years.
  8. Even those who have created the bubble are now predicting its prospective demise. Recent Bloomberg articles quoted several prominent private equity and hedge fund managers predicting doom:
  • Dan Fuss of the $10.7 billion Loomis Sayles Bond Fund said, “I haven’t felt this nervous about a market ever.” Thomas Lee (who stepped down last year from the takeover firm he founded
  • Thomas H. Lee Partners LP) said recently, “Defaults are almost non-existent today and, well, we know that doesn’t hold forever.” “When the economy goes bad, defaults will spike up from 1 percent into the 9 percent level.”
  • Michael Weinstock, who helps manage $3 billion of distressed debt at Quadrangle Group, a private equity firm, recently said, “It’s like a hangover, people will wake up and say ‘what have I done’. . . .  Record-high levels of financing now mean record levels of defaults in the future.  There’s every reason to believe we near a market top.”

We have a fractured economy:  The specific sectors generally tied into old line industrial or similar organizations with legacy exposure constitute the bulk of our chapter 11 population today.  The complications of hedge funds, private equity funds, the second lien market and globalization need to be recognized and accounted for, as well as the possibility of contraction of liquidity at some point in time.

On the “No” Side:

On October 12, 2005 Alan Greenspan delivered remarks on “economic flexibility” at a meeting of the “National Italian-American Foundation” at Georgetown University.  In his remarks, Mr. Greenspan noted that in the 18 years that he has been with the Federal Reserve, he has been most surprised by the remarkable ability of the U.S. economy to absorb and recover from the shocks of stock market crashes, credit crunches, terrorism and hurricanes – blows that he would have thought would certainly precipitate deep recessions in decades past.  He attributed the resilience to these events as representing a remarkable increase in economic flexibility resulting from deliberate economic policy and, particularly, the consequence of innovations in information technology.

Mr. Greenspan believes we are returning to the philosophy of Adam Smith, as expressed in his “Wealth of Nations.  Smith postulated an “invisible hand” in which competitive behavior drove an economy’s resources toward their fullest and most efficient use.  Economic growth and prosperity, Smith argued, would emerge if governments stood aside and allowed markets work.  In effect, a free market paradigm.  Thus, Mr. Greenspan noted that the United States weathered the crash of October 19, 1987 when 1/5 of the market value disappeared with little evidence of subsequent macro-economic stress – an episode that hinted in a change in adjustment dynamics [post 1987 LBOs].

In effect, Mr. Greenspan has argued in favor of, or recognizes, a return to a laissez faire economy and a removal of governmental regulation as a preventive for recession.  Some may question this thesis.  It reminds me of a report in a Connecticut newspaper – two inmates of the state prison were in the dining half for their Thanksgiving dinner.  One inmate looked at the other inmate and said, “The food was a lot better here when you were governor!”

Current Chairman Bernanke appears to adopt a similar view, advocating a laissez faire or self-regulating approach to the riskiest segments of the economy.  He applauded these risky segments, noting (on April 11, 2007) for example that “[i]f hedge funds did not take risks, their social benefits — the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others — would largely disappear.”

We do have a vibrant economy – fueled by the enormous liquidity referred to before.  The global economy appears to be very resilient.  2006 marked the fourth successive year of a broad, strong, and stable global expansion, supported by a number of forces:

  • rapid technological innovation and greater economic integration;
  • financial innovation and greater integration of national financial systems; and
  • improved macroeconomic policy.

Notwithstanding slight cracks in the U.S. economy, most economists have stated that the global economy appears to continue strong growth in 2007, thanks in part to the resilience of important economies such as Europe and Japan.  Thus, while Merrill Lynch economists in December 2006 predicted that the U.S. economy will grow at only 1.7% in 2007 (compared to 3.2% in 2006), they predicted global growth outside the U.S. to be 5.3% in 2007 (albeit down from 5.8% in 2006.).  These economists point to the world’s increased independence from the U.S. and expect long investment booms in Japan, Europe, and many emerging markets (such as India).

Similarly, in an April 2007 IMF report, the IMF said that we are in the midst of an unusually prolonged and widespread global expansion, the strongest in more than three decades.  As for the future, it predicted that Europe, Japan, and China will help carry the global economy as a housing slump cuts growth in the United States (which accounts for a fifth of the world output).  It noted that “so far, the cooling of U.S. activity seems to have had a limited impact beyond its immediate neighbors, Canada and Mexico. . . .  However, a further cooling of the U.S. economy that increasingly spreads to weakness in consumption and business investment in 2007 would be challenging.”  Other risks to the global economy noted by the report include a rebound in oil prices, a resurgence of inflation and rising calls by politicians to increase barriers to commerce to protect domestic industries from overseas competition.  The report also noted that the global economy could be hurt by a sudden withdrawal of the overseas investment needed to sustain the U.S. current-account deficit.

Economists and industry officials that gathered in Davos last January repeatedly emphasized the relative decline in the importance of U.S. economic power.

Also, we have an emboldened investor community.  Investors are turning to activism because it is getting tougher to show top-notch returns, as the more than 8-9,000 hedge funds pursue similar investment ideas in the face of overall market volatility drops.  Activism is expected to increase over the course of the coming year, particularly in Europe where hedge funds see even more companies that they consider to be underperformers.

Activists today are having more impact because they are more willing to engage in proxy fights to replace executives or take other steps, something pension funds generally shied away from.  Recent activism from hedge funds has created some positive wealth effect.  However, Professor Gillan of the Business School at Arizona State University and others have noted that hedge funds already have knocked down some of the low hanging fruit and it may become harder to pressure companies in the months ahead.  If the economy slows, the effort to push companies to drain their cash could turn out to be misguided.

Timothy Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York summed up the global economy — and its great resilience and the great risks it provides to investors.  He said on January 11, 2007:

The global financial system is in the process of very dramatic change.  The changes of even just the last five years are extraordinary, in terms of the size, and strength, and scope of the major global firms, the role of private leveraged funds, the extent of risk transfer and the increase in the size of the derivative market, the change and structure of the credit market, the increase in and changes in the pattern of cross border financial flows.

These changes, and others, seem likely to have made the financial system both more effective in moving capital to its most productive use and more stable and resilient over time.  But they do not, of course, mean the end of systemic risk in financial markets.  They could, in some circumstances work to magnify rather than mitigate stress.”

There is no obvious reason why the current euphoria should end now.  In the words of one commentator, “There may be kindling on the forest floor, but where is the spark that is going to ignite it?”  However, as time passes, more brush wood accumulates.  What will be the spark that sets it off is not yet discernable, but if and when the conflagration comes, it could be very dramatic.

Perhaps “stock prices have reached what looks like a permanently high plateau” as Yale economist Irving Fisher famously stated shortly before the 1929 crash?  Is this the “end of the business cycle?”  I suggest the answer is not yet clear.  The game is to follow the sensitive areas of 1) interest rates, 2) interest spreads, 3) hedge fund withdrawals to the extend ascertainable, and 4) liquidity contractions.  Of course, we can never discount the potential consequences of a major terrorist attack in the United States.

As the noted physicist Neils Bohr said, “Prediction is a difficult task, particularly if it involves the future.”

So if you expected me to predict the future, I apologize for declining that opportunity.