Tuesday I attended one of the regular lunch-time meetings of the ABA’s "Back
to Business Law" project which describes itself as "a pilot project
sponsored by the ABA Section of Business Law, [to] provide periodic continuing
legal education programs and informal networking opportunities for attorneys
who temporarily leave active practice in law firms or corporate settings
(including women who leave for a period of months or years in order to care
for children) but remain interested and engaged in business law issues."
This is surely a laudable initiative, as all too many participating in and
commenting upon the appalling rates of attrition among female lawyers content
themselves with merely "viewing with alarm" and doing nothing whatsoever
concrete to ameliorate the situation. (Indeed, faithful readers of
longstanding may recall that I reported on this initiative once
before. If you’d like information on how your firm could get involved—or,
perhaps as importantly, information on how to launch a parallel initiative
outside New York City—please take a look at my earlier column.)
Tuesday’s meeting was at Skadden Arps, where the presentation on the current
ongoing credit crunch was by Peter
Neckles, a Skadden partner whose practice
focuses on corporate borrowers and institutional lenders, with a particular
emphasis on restructurings, refinancings, workouts, and debtor-in-possession
loans. After rehearsing the sine-wave
behavior of financial defaults,
with recent local maximums in 1991 and 2001/2002, Peter explained the pain
associated, across the economy, with "The Great Deleveraging" that
we may now be about to experience. As The Wall Street Journal reported serendipitously
on the day of the meeting, sucking credit out of the economy is both deeply
painful and constricting and can be a phenomenon—like the pumping up
of credit during the prior "leveraging" period—that feeds
on itself. Here’s how both those "snowballs" work:
• When Debt Was Good: People bid more for a house
because banks were willing to lend more. That helped house prices rise and
gave the bank more confidence about lending yet more. So people borrowed even
more and built an addition or bought a new car.
• When Debt Becomes Bad: Banks decide they
need to call in lines of credit. As some borrowers are forced to sell assets,
prices fall. Banks get spooked by the falling value of collateral and cut
back even more on lending.
• How Bad is Bad? In Japan, despite massive
government borrowing and five years of a near-zero interest rate on overnight
borrowing, the prices of shares and real estate declined by 40% to 70%. In
the U.K., house prices dropped by 40% in the early 1990s, after taking inflation
into account, but share prices rose.
And the devil of it is that there’s not much the Fed can do this time:
Witness Japan’s mid-1990’s experience with zero interest rates. If
the economy is in a deflationary period, anyone who borrows must expect to
pay back the loan with more valuable dollars/yen, and against an
asset (the collateral for the loan) that is diminishing in value. This
is obviously the obverse of borrowing during inflationary times: Inflation
is the debtor’s greatest champion, enabling borrowers not only to repay with
cheaper currency but, perhaps, to refinance the loan against the increased
value of the collateral.
Marty Feldstein, chairman of the Council of Economic Advisers under Reagan,
and now a professor at Harvard, pointed
out precisely the Fed’s predicament yesterday, also in the WSJ (emphasis
supplied):
"The collapse of the credit markets began last summer when the subprime
mortgage crisis demonstrated that financial risk of all types had been greatly
underpriced, that the market prices of complex financial assets overstated
their true values, and that the credit scores provided by rating agencies
are not to be trusted. Because market participants now lack confidence in
asset prices, they are unwilling to buy existing assets, thus preventing
current asset owners from providing credit to new borrowers."The lack of confidence in asset prices also translates into a lack of confidence
in the creditworthiness of other financial institutions, impeding the extension
of credit to those institutions. And because financial institutions do not
even have confidence in the value of their own capital and in the potential
availability of liquidity, they are reluctant to make new lending commitments."It is not clear what can bring back the confidence
in asset prices that is needed for credit to flow again."
Peter talked about how each downturn was the same as, and yet different
than, every other: "It’s not ‘Groundhog Day,’ but it’s close." But
even though there are clearly differences he sees on today’s landscape vs.
earlier episodes, including the existence of ~$45-trillion (notional value)
of derivatives outstanding, and Sarbanes-Oxley, with its increased penalties
for filing too "sunny" 10-K’s, Peter talked about the human ingredients that
never change.
The first reality of human nature is, according to Peter, that most senior
executives of companies now coming under financial pressure think
they’re very smart. "Imagine tossing an infinite number of coins a
thousand times; one of them will come up heads every single time, and you
know what that coin will think? ‘I’m really smart! None
of the other coins figured out how to do what I just did.’"
This can lead to a false sense of denial about the severity of the crisis
and an equally false sense of optimism about how well things will turn out
without the need for drastic intervention.
The second reality is that a financial "death" (of a corporation,
an investment fund, etc.) is highly analogous to a human being’s death, at
least insofar as how people react to it. As we’ve known since Elizabeth
Kubler Ross’
On
Death & Dying, people need to navigate through the five stages
of grief:
- denial
- anger
- bargaining
- depression, and
- acceptance.
Clients whose firms are facing financial distress or even death are no different. They
will deny the problem is severe, look for people to blame, attempt to create
short-term or unrealistic fixes, refuse to deal with it at all, and only
then will they accept the reality of downgraded debt, impaired collateral,
reduced cash-flow, and be ready to deal with their counter-party realistically.
Until then, Peter noted, you as an attorney and counselor can, effectively,
do nothing.
Is that a "back to business" lesson? I believe it doesn’t
get much more business-like than Peter’s lesson about human nature.
