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4 PATHOLOGY OF
DEBT PART 4: Lessons
unlearned By Henry C K
Liu
investments to
"eligible" securities. An eligible security must
carry one of the two highest ratings (1 or 2) for
short-term obligations from at least two of the
nationally recognized statistical ratings
agencies. A tier-1 security is an eligible
security rated ''1'' by at least two of the rating
agencies; a tier-2 security is an eligible
security that is not a tier-1 security. The sum of
tier-1 and tier-2 securities will not add up to
the total due to ineligible
securities.
Money
funds may hold no more than 5% of their assets in
the tier-1 securities of any individual issuer and
no more than 1% of their assets in the tier-2
securities of any individual issuer; moreover, a
money fund's holdings of tier-2 securities may
constitute no more than five% of the fund's
assets.
The one-day rate for AA financial
commercial paper peaked at 6.62% on January 2,
2001. It bottomed at 1.64 on January 18, 2002. As
of the week of August 22, 2007, there were $2.042
trillion of outstanding CP in the US credit
markets of which about half were asset backed, or
$1.057 trillion, falling from $1.083 of the week
of August 1. The non-financial CP volume peaked
around $350 billion in January 2001 and was $204
billion in the week of August 22, 2007. The
non-financials had difficulties accessing the CP
market in 2001. Reports to that effect concerning
Ford, DB/Chrysler and GM were in the news.
The CP crisis of 2001 The deep
crisis that the European communication sector fell
into in 2001 began rather innocently. Nokia signed
a $500 million US-Commercial Paper Program on
March 12, 1997. The dealers of the program were
Credit Suisse First Boston (CSFB) and Merrill
Lynch, and the issuing and paying agent was
Citibank NA. The issuer in the program was Nokia
Capital, Inc, guaranteed by Nokia Corporation.
Nokia’s program had a A-1 rating by S&P and a
P-1 rating by Moody's. Nokia said it was
re-entering the US commercial paper market to
further diversify its funding sources. The success
of the Nokia CP program started a wave of
communication issues that led to the communication
debt bubble in Europe.
When CP rates are
at historical lows, the net effect is to keep the
walking-dead companies alive, a situation well
recognized in Japan in recent decades, or to
launch new white elephants. British Telecom,
privatized in 1984 and having spent extravagantly
on 3G technology, crumbled under a debt of 28
billion pounds in 2001, losing 1.8 billion pounds
in the first quarter. When companies cannot roll
over their CP because of a drop of credit rating,
they generally have to resort to drawing down
their revolving bank credit line at much higher
cost, which in turn puts further stress on their
already falling credit ratings. In a high leverage
situation, the downward spiral can undo a major
corporation is days. For financial companies, the
impact can be catastrophic.
Growing
concern about access to short-term capital sent
tremors through Wall Street in February 2002 amid
signs that more companies were about to be frozen
out of the commercial paper market, the main
source of day-to-day corporate funding. Investors
dumped stocks of telecommunications companies when
Qwest Communications was forced to turn to its
banks for $4 billion after it was squeezed out of
the CP market. It had failed to find buyers for an
issue of new short-term funding.
Concern
that other companies would suffer the same fate
rose after JP Morgan Chase said Sprint, another US
carrier, was overextended in the CP market and
would have to look elsewhere for financing, such
as the bond markets or bank loans at higher cost.
Sprint had $3 billion of CP outstanding at the end
of the year. It needed to raise an extra $1.7
billion to meet its funding needs for the next
year as current paper matured. It sought to cut
$60 million in costs by laying off 3,000 staff to
meet the cash short fall.
On February 15,
2002, New Hampshire conglomerate Tyco
International Ltd got clipped by up to $3 billion
in its sale of CIT Group, the commercial financing
firm it bought in June the previous year for $10
billion. The company, which was grappling with a
heavy debt load and trying to soothe skittish
investors, was negotiating from a position of
weakness as it sought a quick sale of CIT, one of
the nation's leading specialty and commercial
finance companies.
CIT, which operated
across North and South America, in Europe and the
Pacific Rim, was an expert in some of the more
arcane aspects of corporate borrowing, using
intimate knowledge of its small- to mid-sized
client companies to arrange equipment leasing,
factoring, lending for acquisitions and expansion,
and credit management. The clients included more
than 700,000 companies, with specializations in
transportation, the apparel industry and
construction equipment.
CIT was a
subsidiary of RCA and then Manufacturers Hanover
Bank in the 1980s, after being a freestanding
public company for many years. It went public
again in 1997 before being briefly owned by Tyco
in 2001. It was spun off to the public again in
2002. Its business suffered when it lost access to
the short-term commercial paper market, the
cheapest source of financing for big companies,
because of questions raised about Tyco's
accounting practices. Lenders like CIT depend
heavily on inexpensive financing for the loans
they make. Being shut out of the commercial-paper
market left CIT at a big competitive disadvantage.
An industrial company known for its ADT
brand security systems and for its electronics
component business, Tyco had begun growing quickly
through acquisitions with easy credit, making four
major purchases in the four months before it
announced the CIT deal. Tyco apparently thought it
was getting CIT for a bargain price, given its low
recent performance.
CIT Group was under
Tyco's umbrella only for about a year. By early
2002, Tyco's stock price was in a steep slide as
rumors hit Wall Street about accounting
regularities and suspicious payments to its
director, Dennis Koslowski. Tyco's declining
reputation had damaged CIT's ability to borrow,
and in February 2002 Tyco announced that it would
sell the financial company within the next few
weeks. When it failed to find an immediate buyer,
Tyco spun CIT off to the public in July 2002. Tyco
had hoped to sell CIT for $10 billion; it was spun
off as a stand-alone public company for about $4.6
billion. At almost the same time, the Securities
and Exchange Commission announced that it was
investigating Tyco. Kozlowski was eventually
sentenced to jail in September 2005 and ordered to
pay fines of $167 million for his part in
financial wrongdoing at his company.
Tyco
and CIT were dealt serious blows when they were
shut out of the CP market and rating agencies
downgraded their debt. Commercial paper represents
a critical source of borrowing for firms like CIT,
which was forced to turn to $8.5 billion in more
expensive bank loans when it lost access to
commercial paper. CIT cannot effectively compete
in the market place if it cannot play in the CP
markets. The inability to sell CP, and its having
to take down short-term debt to cover obligations,
forced CIT into the position of having to sell
right away. Tyco was forced to draw down $14.5
billion of bank funding to repay all its CP debt
outstanding.
The problem was global. A new
procedure implemented on November 13, 2001 by
Euroclear group enabling GE Capital, the largest
issuer of Billets de Trésorerie, to deliver on a
same-day basis an EONIA Index linked BT not only
to Euroclear France clients but also to Euroclear
Bank participants. This new procedure explains the
operating process between the issuer, its issuing
and paying agent (ie domiciliataire) Euroclear
France and Euroclear Bank. The development was
driven by GE Capital, the largest issuer of CP in
Europe. GE Capital actively sought to offer its
floating rate CP to institutional investors across
Europe. Euroclear extended the deadlines for index
communications between Euroclear France and
Euroclear Bank to provide to BT issuers a same-day
issuance for one-day securities. The new procedure
confirmed that the Billets de Trésorerie were not
domestic instruments any more and could circulate
all across Europe. This also confirmed that any
financial product under French law could be
provided to all international investors.
In October 1999, GE Capital Aviation
Services (GECAS), a wholly owned subsidiary of GE
Capital, completed the financing of four A330-200
aircraft for Flightlease, a wholly owned
subsidiary of SAir Group of Switzerland. The
aircraft were sub-leased to Swiss Air under a
long-term operating lease. They were part of a 10
aircraft order by Flightlease and were purchased
in September and October 1999 by GECAS. This
cross-border financing
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