Happenings in the Credit Markets - January 2012

So, things change fast apparently.  A little over a week ago I wrote that: "On the credit side, things feel pretty customary on the new issue front. High yield and bank debt deals are not 3-5x oversubscribed like they are in "go-go" markets.  There has been a pretty good amount of supply but these deals are not flying off the shelves"  


Well, I take that back: Deals (some of them quite suspect) are flying off the shelves.  Many of deals priced this week in high yield land were 5x+ oversubscribed.  Some marginal issuers, brought by marginal dealers / agents, were also getting done but more akin to 1-2x oversubscribed.  One of the hottest deals in the market, which I particularly liked at both original and (less so, but still interesting) final pricing was the Eastman Kodak DIP.  The final pricing was L+750, 1% floor, issued at 98.   Originally it was talked in the 96-97 range at L+850 with a 1.5% floor.  The deal was nearly 10x oversubscribed and probably right so at that initial pricing.  The deal is now trading at 100.5-101 with good 2-way markets


What concerns me though, is the feeling of rumbling of risk taking percolating in the market.  We're no where near "All hands on deck: sell everything" in terms of where I feel risk is priced.  But initial deal pricing is tightening in dramatically, bankers are increasing the size of deals (always to the detriment of creditors), and cuspier and cuspier borrowers are coming to the market. It feels like many marginal issuers have been waiting on the sidelines for their window to issue into a hot market:  This is feeling like that sort of market.

In early December, I wrote 

"But with everyone painting a doomsday scenario, I'm not quite sure that will happen.  The market is NOT ready for a sustained bullish rally - too many investors are flat or are running with a low gross exposure.  The only thing that I've known to be true in macro prognosticating: The market will move in a way that hurts the most people at anyone time.  If everyone is long, it will go lower.  The pain trade today, surprisingly, is up. "

Since then everything is up except: Credit, distressed, equities, Italian bonds, etc.  As I am oft to do, I point to Howard Marks' view of the risk spectrum as a pendulum.  I visualize this as 5 points on a pendulum:

1. When the world is extremely bearish and you can buy most things indiscriminately for a sizable gain.  At these times, your friends call you a lunatic / maniac and are one of the few buyers out there (November 2008 is the prime example)
2. When the world is bearish, there are more buyers, and risk assets will still produce a better than commiserate return for the risk underwritten
3. When markets are fairly valued and the bulls and bears are equally on the side of the fence.  At this point, investors are taking return for the exact amount of risk  
4. When markets and the world are bullish, assets are becoming fully valued, and really the best strategy to employ here are event driven ones like merger arbitrage or liquidations (LBHI) that remove market risk from the equation.  Here you start to see short squeezes
5. When markets are fully valued, everyone is a buyers (except for you hopefully), and you are playing with fire by buying any risk asset

We moved very quickly from point 2 which I felt represented a lot of the 3rd /4th quarter of 2010 to point 4 (or maybe a 3.75 if I was exact) which I would characterize now.  We're no where close to 5 - there are still too many bearish people out there but we are at a point where I am definitely a better seller of risk assets and am instead focusing 100% of my time on special situations (I would characterize the EK DIP as such, as well as a few other distressed situations).


The high yield market, as measured by the CS HY Index, is up 2.62% YTD.  CCC/Split CCC is up 5.75% year to date(!).  Yesterday was one of the stronger days I can remember in high yield with buyers of everything and very few cash sellers.  It felt like a panic really to be long risk, especially down the credit spectrum.  High yield recorded $1.9b of inflows last week which I am sure will push prices up higher.   As inflows push bids up, the HY market shows higher returns, which makes retail investors (read: dumb money) chase returns further propagating the cycle.  With the Fed on hold until 2014, the appetite for yield seems insatiable right now.  


I am generally early (like most value investors) so do not take this post to mean I am sitting on my hands waiting for the market to turn.  I continue to do work on special situations (in and out of bankruptcy), and see value in certain structures (I am still working through Petroplus).  In fact, one of my largest positions (at least in my personal account) is a bankrupt equity that I plan to post on the DDIC sometime in the next few weeks with a possible 5-10x return with minimal downside.


The one word to describe my sentiment: Cautious.  

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Bankruptcy Concept: Credit Bidding and the Supreme Court

A few months ago, I asked volunteers for writers for the blog as we expand our coverage of all things distressed.  We have three writers that have volunteered - one that will focus on structured finance concepts and two that will focus on legal concepts. In addition, I am looking for two other writers - one to cover European situations and one to cover domestic distressed situations.

With that out of the way, I want to introduce George Mesires, partner in the Finance and Restructuring Practice at Ungaretti & Harris LLP, who will be contributing an article once a month for the blog. I asked George a few weeks ago to delve further into the Supreme Court's decision to look at the ability of secured creditors to bid their claims in a bankruptcy auction as it has been topical on a number of case in the past 18 months.  Enjoy!


U.S. Supreme Court to Provide Guidance on Credit Bidding Rights

On December 12, 2011, about six months after the Seventh Circuit issued its decision in the River Road Hotel bankruptcy case and split from its brethren in the influential Third Circuit (home to the Delaware bankruptcy court) and the Fifth Circuit, the U.S. Supreme Court agreed to hear whether a secured creditor has an absolute right to credit bid its debt under a plan of reorganization whereby a debtor proposes to sell the lender’s collateral free and clear of the lender’s liens.  The Supreme Court’s decision, expected near the end of the Supreme Court’s term in June 2012, should provide needed guidance to lenders.  Although the Seventh Circuit’s River Road decision provided some comfort to secured lenders (at least to those in Illinois, Indiana, and Wisconsin!) that they may exercise their right to credit bid under an auction sale proposed under a plan of reorganization–– the unsettled state of the law has added uncertainty and risk in these credit bid situations, resulting in a higher cost of capital.

What is credit bidding?

Credit bidding is the ability of a secured lender to bid at the sale of the lender’s collateral using the lender’s outstanding loan balance as credit against the purchase price of the collateral.  By using the amount of the outstanding claim as currency, the secured lender does not have to come out of pocket with cash, which eliminates the costs – administrative and financing – associated with making a cash bid.  Credit bidding protects the secured lender against an attempt by a debtor to sell the collateral too cheaply.  If the secured creditor thinks the collateral is worth more than the sale price, the lender may credit bid its debt, and if the lender’s bid prevails, it will have preserved its ability to participate in any appreciation of the value of its collateral in the future.

Credit bidding in bankruptcy.

Generally, a debtor in bankruptcy may sell its assets in two ways: (i) under section 363 of the United States Bankruptcy Code the (“Bankruptcy Code”); or (ii) pursuant to a plan of reorganization under section 1123 of the Bankruptcy Code.

Under Section 363, it is not disputed that a secured creditor may credit bid its debt (unless the court in very limited circumstances finds that “cause” exists to deny the secured lender the right to do so).
 
Alternatively, a debtor can sell its assets pursuant to a plan of reorganization. In certain circumstances, a debtor can “cramdown” a plan of reorganization over the objection of creditors, including a secured creditor. To cramdown a secured creditor, among other things, the reorganization plan must be “fair and equitable” to the secured creditor. The “fair and equitable” standard may be satisfied by showing that the plan provides: (1) that the holders of such claims retain the liens securing such claims and receive deferred cash payments having a present value equal to the value of their collateral; (2) for the sale of the collateral free and clear of liens (with such lien attaching to the sale proceeds of the sale) but subject to the secured creditor’s right to credit bid; or (3) for the realization of the secured creditor’s claim by some means which provides the secured creditor with the “indubitable equivalent” of its claim.

Thus, the plain language of section (2) above states that a secured creditor shall have the right to credit bid in a sale of its collateral pursuant to a plan of reorganization.  Indeed, historically, there has been little dispute that a secured lender had the right to credit bid its debt in such cases.  Recently, however, several creative debtors (see e.g., debtors in the Pacific Lumber and Philadelphia Newspapers cases) have sold a secured creditor’s collateral pursuant to a plan of reorganization without allowing the creditor to credit bid.  And such arrangements have been upheld by two federal circuit courts.  

In the River Road bankruptcy case, the debtors proposed selling substantially all of their assets, consisting mainly of the InterContinental Hotel Chicago O’Hare, pursuant to a plan of reorganization. As part of its plan, the debtors sought to deny the lenders the ability to credit bid their debt.

But rejecting the rationale of the Third and Fifth Circuits, the Bankruptcy Court for the Northern District of Illinois denied the debtors’ attempt to bar the secured lenders from credit bidding, which was immediately appealed by the debtors.  In June 2011, the Seventh Circuit upheld the bankruptcy court’s decision. Not only did the Seventh Circuit find support for its decision in the plan language of the cramdown provision of the Bankruptcy Code, but the court also was influenced by the way auctions are recognized and the way secured creditors are treated elsewhere in the Bankruptcy Code. The Seventh Circuit recognized that under both section 363 and the plan cramdown provision, a secured creditor is permitted to credit bid, which “promises lenders that their liens will not be extinguished for less than face value without their consent … Because the Debtors’ proposed auction would deny secured lenders the ability to credit bid, they lack a crucial check against undervaluation. Consequently, there is an increased risk that the winning bids in these auctions would not provide the Lenders with the current market value of the encumbered assets.”

With its decision, the Seventh Circuit split from the Third Circuit’s decision in 2010 in Philadelphia Newspapers and the Fifth Circuit’s decision in 2009 in Pacific Lumber, setting up a clear dispute among the circuit and bankruptcy courts, which made this issue ripe for consideration by the Supreme Court.

Why it Matters.

The Supreme Court’s ruling will be important for at least two reasons.  First, in recent years, most chapter 11 bankruptcy cases have resulted in asset sales – not reorganizations.  Thus, resolution of this issue is critically important to the administration of bankruptcy cases and to providing secured lenders clarity as to whether they can credit bid their bid in both 363 and plan sales under the Bankruptcy Code.  Continued uncertainty and disagreement among the circuits will lead to disparate results, higher risk, and increased costs of capital.

Second, without clarification by the Supreme Court that a secured creditor has an absolute right to credit bid, over 100 years of bankruptcy jurisprudence stands to be undermined.  Generally, bankruptcy law has not permitted a secured creditor to lose its lien in bankruptcy without the lender’s consent, payment in full, or surrender of the collateral to the lender.  The continued ability by debtors to block secured creditors from credit bidding will shake the lending community’s faith in the bankruptcy system, and be reflected in higher costs of capital at a time when the economy is still on fragile footing.

Bankruptcy practitioners are following this case closely.  Briefing on the case should be completed by early March 2012, with oral arguments to follow.  A decision will likely be issued near the end of the Court’s term in June 2012.  We will report on this case as soon as a decision is issued.  

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Advanced Distressed Debt Lesson: Election Forms and DIMEQ

A few weeks ago, contributing author Rodney McFadden introduced readers to the DIMEQ security (Dime Litigation Tracking Warrants).  He ended his post with this:

"The max upside in this case for DIMEQ that would result from being classified as a Class 12 GUC claimant or an equitable lienholder is about $3.00 per LTW (versus today ~ 65 cents) before post-petition interest if the full $337 million reserve goes to the LTW Holders. If the federal judgment rate is applied to that award for 3.5 years it moves the recovery up to about $3.20. On the downside, if DIMEQ is deemed to be Equity and if the Debtor prevails in applying the improper conversion rate then the worst scenario based on Plan value would put the DIMEQ security between $0.07 and $0.10."

As those following the case now know, Judge Walrath opined that the litigation tracking warrants were more equity like and the stock collapsed.  The risk factors posed by judges ruling against you (in one shape or the other) is ever present in bankruptcy and investors need to use caution when approaching situations with such binary outcomes.  For full disclosure, I purchased DIMEQ AFTER the decision was released.  I have since sold my position on the settlement which we will get to shortly.

Rodney McFadden is back tonight with another post: This one digging into the DIMEQ election form.  Buying and selling a security is only part of the equation as it relates distressed debt investing.  Many forms and agreements are needed to be filed to insure that a creditor (or in some cases, equity holders) receive what is owed to them.  Warning: This is a highly technical post.  With that said, I think you'll definitely learn a lot from it.  Enjoy!

Parsing the DIME Litigation Tracking Warrant (DIMEQ) Class 21 Election Form

Anyone who has followed the DIMEQ situation within the Washington Mutual Inc., (WMI) Bankruptcy for the last year and a half would probably be willing to concede that the Dime LTW’s are one of the most esoteric securities ever created. Indeed, many millions of dollars were spent by the LTW Plaintiffs and the WMI estate to determine what the Holders of these securities were entitled to. Ultimately the Court determined that these were equity securities that were entitled only to whatever treatment was afforded to other Common Equity Interest Holders. Following the Court’s ruling, there was a subsequent Settlement entered into, by and between the LTW Plaintiffs and WMI, which provided that the LTW Holders would be entitled to receive a $9 million General Unsecured Claim in Class 12 (less up to $3.2 million for the legal expenses of the LTW Plaintiffs); a $10 million “out of the money” Subordinated Claim in Class 18 and 8.77% of the 30% portion of Reorganized WMI going to all Common Equity Interest Holders.

The Settlement seems fairly straightforward, right? Well at first blush, perhaps, but a closer look reveals a much more complex situation which primarily results from the trifurcated treatment of the Class 21 LTWs under the Settlement. When looking at the treatment under the Plan, and the Capitalized terms and definitions therein, in combination with the respective Ballots for Class 12 Claims and the Class 22 Interests, a Class 21 Election Form cannot, (and perhaps more precisely) will not be drafted to provide for the fairest or simplest of treatment for the LTW Holders. Before we go forward, and in the interest of clarity, the Class 21 LTW Holders are not entitled to vote under the plan because, despite the settlement, they remain “disputed” thus they receive “Election Forms” not Ballots. A link to a non-executable version of the LTW Election Form is provided below. The version that is currently available, for viewing only, urges Holders to “PLEASE CONTACT YOUR NOMINEE TO RECEIVE A VALID ELECTION FORM” which has me wondering if they ever intend to distribute executable versions, absent an overt request. The LTWs have always been the red headed stepchild of this Bankruptcy Estate, so I guess there’s no point in stopping that now.

It is only fitting that a security as esoteric as DIMEQ would be difficult to parse, all the way to the bitter end, and the Election Form for Class 21 does not disappoint. In fact, it presents some interesting decisions for an LTW Holder. Understand that in order to even find out what the options are, it requires a bit of reading and cross referencing. In order to receive anything under the Plan, you apparently have to take action because as I read the Class 21 Election Form, it appears that if you do nothing, you get nothing. So, in order to find out what you get as an LTW Holder, you need to avail yourself of a copy of the Reorganization Plan and Disclosure Statement, paying close attention to the deadlines and Capitalized Terms therein, and read them in combination with the Class 21 Election Form. In light of a reading and cross referencing of these, I understand the following to be correct for LTW Holders:

• Provide the releases by February 29, 2012 and receive: 
• Pro Rata share of 8.77% of whatever percentage (if any) that Common Equity Interests get under the Plan. Common Equity Interests are currently slated to share 30% of Newco but this is subject to Court approval;
• Pro Rata share of ($9.0 million less approximately $3.2 million) on account of the allowed Class 12 Claim; and
• Pro Rata share of a Class 18 Subordinated Claim, up to $10 million, which is currently viewed to be out of the money.

• Provide the releases after February 29, 2012 and receive:
• None of the Newco Stock going to Common Equity Interest Holders (if any). My understanding is that there either cannot or will not be any Newco Stock escrowed for the Common Equity Interest Holders. 
• The recovery on account of the Class 12 Claim and Class 18 Claim if you turn in your paperwork within 12 months following the Effective Date.

So, given the above, exactly what are the risks, going forward, for an LTW Holder and what is the potential value of these LTWs?

According to the liquidation analysis within the Disclosure Statement accompanying the 7th Amended Plan of Reorganization for WMI, the value attributable to “Equity Interests” is approximately $145 million. This amount is comprised of the $70 million value of Reorganized Common Stock as valued under the Plan plus the $75 million cash “Release Consideration” paid over from the Senior Noteholders. At a $145 million Plan value for all Equity Interests collectively, the theoretical value in the hands of LTW Holders, assuming nothing changes, would be calculated as (0.0877*.30*145,000,000/113,000,000) which yields a value of $0.034 per LTW on account of the Newco portion of the LTW Settlement. The $9 million Class 12 GUC claim, less up to $3.2 million in fees paid to LTW counsel, would yield a value of $0.051 per LTW on account of the allowed General Unsecured Claim portion of the LTW Settlement. The total theoretical value for DIMEQ would seem to be $0.085 per each LTW based on Plan value. And realize that this is discounting entirely the Class 18 claim of $10 million for now because it is “out of the money”. It also assumes that an LTW Holder tenders the releases so as to be received by February 29, 2012 and that the Common Equity Interests actually receive a recovery under the Plan.

However, the discussion doesn’t end there because there apparently is some risk that the Court will apply the Absolute Priority Rule (APR) and rule that Common Equity Interest Holders (Class 22 – WAMUQ & PFG Claimants and Class 21 - DIMEQ) can’t be paid until the Preferred Holders in Class 19 are paid in full and that would present a $7.5 Billion hurdle based on Par value. The TPS Group, representing the Cayman REIT Preferred Holders, has been lobbying for the application of the APR, and they are not alone. Near the end of the hearing on Wednesday, January 11, 2012, the Judge even opined that the Debtors’ assumption that it could violate the APR was “Optimistic”, which signals that she is giving some consideration to instituting the APR. Absent that, the Court has the discretion, and the blessing of the Debtors and the Equity Committee, to adjust the proposed distribution of 30% of Newco to Common Equity Interest Holders. The institution of the APR or any downward adjustment of the Newco allocation by the Court would necessarily mean that the currently proposed recovery for all Common Equity Interests would be decreased if not entirely eviscerated. Accordingly, there is risk that the Newco portion of the recent LTW Settlement may have no value in the hands of the LTW Holders.

So it begs the question, if the APR is instituted, why would the Preferred classes receive all of the Newco when senior classes of subordinated claims in Class 18 are projected to receive no recovery under the plan? The answer there would seem to be that, since the Court bestowed upon the Equity Committee the opportunity to pursue “Colorable Claims” for the purported insider trading of certain Settlement Noteholders, the EC would obviously not agree to give up the opportunity to pursue those claims (via the current settlement embodied within the Plan) if none of their constituency would receive any benefit. So my guess is that if the Absolute Priority Rule is applied, and that is still a big if, it would only be imposed amongst the equity classes. It remains to be seen what will happen there but it bears noting that, according to the Ballot Instructions, votes for the Common Equity Interest Holders (except for DIMEQ) and the Preferred Holders in Class 19 would have to be submitted and received no later than February 9th for the votes to count and the Releases would have to be tendered by February 29th in order for the equity classes to be eligible to receive a recovery under the Plan. The big downside is that by the time that the Releases are provided, Equity Interest Holders won’t know what the final treatment will be.

The resultant problem here for LTW Holders is that they also have until February 29th to tender their securities and give the Releases. In reality, to be safe, one would need to turn in the paperwork a few days in advance of the deadline to be certain it is timely received. Once again, based on a reading of the Class 21 Election Form, it would appear that if the Releases and the LTW securities are not tendered by the deadline, one would not be eligible to receive any Newco but could apparently still get the recovery on account of the allowed Class 12 Claim and the recovery from the Class 18 Claim (if any) if the Releases are provided within 12 months after confirmation. However, it appears that you have to request a special form from the Liquidation Trustee in order to affirmatively provide the releases on a post-confirmation basis if you miss the Feb. 29th deadline. Since the Confirmation hearing is on February 29th you have to tender the LTWs and releases before you know whether the APR will be applied so you are just flying blind at that point and can do nothing about it. Accordingly, heading into the February 29th Confirmation Hearing, the only guaranteed recovery for LTW Holders would be the Allowed Class 12 Claim of $9 million, less up to $3.2 million in legal fees for LTW Plaintiff Counsel, shared amongst approximately 113 million LTWs.

One final item that LTW Holders should be aware of is that once the Election Forms are turned in, if the Holder makes the choice to provide the requisite Releases in order to accept the treatment under the Plan, the securities themselves will also be tendered. As such, the LTWs would no longer be tradeable and likely a contra cusip would be issued within the Holder’s account to freeze the securities.

Link to non-executable LTW Election Form:

http://www.kccllc.net/documents/0812229/0812229120116000000000001.pdf

The main case In re Washington Mutual, Inc., Case No. 08-12229 (MFW)

The Adversary case is: Nantahala Capital Partners, LP, et al. v. Washington Mutual Inc., et al., Adv. Proc. No. 10-50911 (MFW)

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Sahm Adrangi's Kerrisdale Capital 4Q 2011 Letter

A few years ago, I introduced readers to Sahm Adrangi who, in 2009, launched Kerrisdale Capital. Sahm found an incredibly lucrative niche: being one of the first fund investors to aggressively short Chinese frauds, a strategy that has produced a whopping 588% net return to investors since inception, at a time when the S&P is only up 44%. In 2011, he generated ~200% return for investors - definitely the highest number I've seen printed in 2011 among funds.  He has grown his asset base to $60M, and rightly so given his ability to identify alpha opportunities that are market agnostic.  If the Eurozone breaks down, China has a hard landing, or the U.S. finds itself in a double-dip recession, I believe Sahm will find a way to generate positive returns for his investor.

I've provided his letter below that he sends to interested parties. For more information, their website can be found at http://www.kerrisdalecap.com/.  Enjoy!

Kerrisdale Quarterly Letter 12-31-11

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