Financial Distress in Corporate Finance - Article Example

Financial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Financial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Financial distress at individual or household level, is simple insolvency, failure to repay the loans, to meet routine expenses and so on. In United States, the subprime mortgage financial crisis of 2007 consummated Financial distress at both organization and household. Let's see an example: ``A family, Husband-Wife both working, with their combined income around $65,000 a year, purchased a modest ranch house, say in Boston's Hyde Park neighborhood for $300,000, taken on loan. The family was paying it comfortably in installments. After two years, they got it refinanced (on different terms) and got a fresh loan from a lender. But that lender has since gone under. In fact the lender had written too many loans that customers didn't or couldn't pay back. The monthly payment on $300,000 loan started at about $2,100. Then, the payment was re-structured at an accelerating rate of more than $300 a month, and soon adjusted to about $2800 per month. In next six months, payments increased to even higher levels. Since nobody has any idea how much this monthly payments would go up and consequently the buyer found himself unable to afford his home.'' The subprime mortgage That was the case of the subprime mortgage financial crisis of 2007. As per definition the overall conventional mortgage market includes two broad categories of loans, prime and subprime. Prime mortgages is still the largest category, representing loans to those borrowers who are regarded as good credit ,``A'' quality, or investment grade. Everything else is called subprime – i.e. loans to borrowers who have a history of credit problems, insufficient credit history, or nontraditional credit sources. Subprime mortgages are rated by their perceived risk, from the least risky to the greatest risk. Amazingly the worst kind of borrowers account for 50 to 60 percent of the entire subprime market. Subprime lending is also described as high-cost lending. Borrower cost associated with subprime lending is driven predominantly by two factors: credit history and down payment requirements. This juxtaposes with the prime market, where borrower cost is primarily driven by the down payment alone, as the prearranged that minimum credit history requirements are satisfied. Subprime lending is at the same time viewed as having great promise and great peril. The promise of subprime lending is that it can provide the opportunity for home ownership to those who could not easily qualify for a mortgage in the past. A large number of such people who fulfilled their life time ambition to own a house, were the people who paid too much or borrowed too much against their homes. If their payments are rising and the houses are worth less than they owe, expectedly they'll just walk away from the re-payment commitments. However, in 2006-2007, at the first minor jolt to housing prices in many parts of the U.S., refinancing became more difficult. Re-adjustments can be available in the difficult times thus evolved, but interest rates, a direct function to the degree of `risk involved,' have been rising continuously, leaving the re-adjustment just impractical. And this not a single case. Economists are predicting that a historic number (several million) of people might lose their homes. At analysis table, it seems like a phenomenon as natural as eruption of a Volcano. In recent years, there was a nationwide real-estate boom, an overheated housing environment was created, and finally the boom busted. In early 2000s, the interest rates were low, economy was healthy and an all-round growth was perceptible to the consumers. This environment helped push real-estate values up across the country, in-fact countries. Refinancing was available, as long as the U.S. housing prices continued to increase (1996-2006). With values escalating, there was sufficient reason for the lenders about making mortgages to customers whose poor credit histories might have prevented them from buying homes in the past. With rising values, borrowers were less likely to default, as there was always the option for the buyers to take money out of their homes if they run into trouble. Thus the loans were freely sold by floating all the norms required for a sound loan, e.g. with little or no documentation, or no down payment, or without the income proof to qualify for a conventional loan of the size they wanted. Such a practice put more and more potential homebuyers in the market, resulting in rise of home-ownership rates to a record 69 percent in 2004 – and this pushed housing prices further up. Dramatically rising prices (double-digit growth year over year was common in some areas) enticed real-estate speculators, creating even more demand - and driving the cycle further into the hyperbolic phase. As the pool of borrowers was growing on, lenders mooted "creative financing" products, ignoring the creditworthiness of the borrowers, among the most popular were variations on the adjustable-rate mortgage, or ARM. In the ARMs loans interest rates are required to adjust up or down from time to time. The advantage is that for ARMs, the opening rates are lower than for traditional, fixed-rate mortgages. That makes the homeownership looking even more affordable as it allows borrowers to qualify for an even bigger loan. That is a fuel to the upward spiral. Some of the innovative ARM inventions that thrived included interest-only and payment-option loans. With the interest-only mode, a borrower only pays the interest on the loan – and not the principal balance - during the introductory stage. With the second, the payment-option ARMs, borrowers get to choose how much they pay each month: which is enough to cover the interest plus the principal, the interest only... or less than the interest. In that last situation, the outstanding interest is re-emerges with the principal. In such a case the borrowers owe more amount than the amount of the original loan. According to First American Loan Performance, in 2005, nearly 23 percent of all mortgages taken were interest-only ARMs. Similarly, more than 8 percent were payment-option ARMs. In some of the more `happening' markets, the numbers were much higher: For example, in California 34 percent of all new mortgages in 2005 were interest-only. The eager borrowers How these trapping products clicked to the borrowers, is the second part of the subprime mortgage financial crisis of 2007. A good number of borrowers thought that they might live in their homes for a few years, then sell at a profit or refinance. But by the time of the expected `ripening' the housing sales have stalled and prices started softening, eluding the borrowers from either of the options. On the other hand, the painful payment hikes were intact. According to a First American CoreLogic study, “one-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4 percent. Payments on these loans will double on average - if they haven't already done so,” says study author Dr. Christopher Cagan. From 9 percent a decade earlier, subprime loans expanded to 20 percent of the mortgage market in 2006. Higher interest rates were squeezed on these loans to compensate for the risk posed by the quality of borrowers. These harsh subprime loans were endemic with risky terms - interest-only payment options, penalties for paying off the loan early (which makes it costly to refinance into a better loan), and dismal documentation requirements. This in fact, meant that borrowers needed petite paperwork to verify their worthiness for the loans. According to First American LoanPerformance, “these loans accounted for about 58 percent of all loans in 2006. By October 2007, 16% of subprime loans were 90-days into default or in foreclosure proceedings, roughly triple the rate of 2005.” Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007. Creditworthiness- a farce either way The Subprime loans became the Mantra, unscrupulously. Creditworthiness or lack of it, and the rising (teasing and trapping, by design?) interest rates are normally deemed as the prime two reasons behind the subprime mortgage financial crisis of 2007. However, an analysis by The Wall Street Journal of “ more than $2.5 trillion in subprime loans made since 2000 shows that as the number of subprime loans mushroomed, an increasing proportion of them went to people with credit scores high enough to often qualify for conventional loans with far better terms.” The WSJ study says that in 2005, the peak year of the subprime boom, “ borrowers with such credit scores got more than half -- 55% -- of all subprime mortgages that were ultimately packaged into securities for sale to investors, as most subprime loans are”. The study by First American LoanPerformance, a San Francisco research firm, says “ the proportion rose even higher by the end of 2006, to 61%. The figure was just 41% in 2000.”According to the study “even a significant number of borrowers with top-notch credit signed up for expensive subprime loans”. The expectation of a higher interest payment of an ever ballooning product lured many major banks, mortgage companies and investment firms to jump into the shaky subprime market. Lenders and brokers aggressively marketed the subprime loans, offering easier and faster approvals -- and playing down and even hiding the maddening price paid over the long haul in higher interest rates or stricter repayment terms. Many borrowers were placed into ARMs that are to cost considerably more over the life of the loan than if they'd picked a fixed-rate option. Often, consumers could have locked in fixed-rate loans at low interest rates, but lenders made the advantages of these loans seem less important. However, hundreds of thousands of subprime loans have gone into default and many analysts expect hundreds of thousands more loans could go bad over next several years, the aggressive marketing came back home. Probably the credit-worthy borrowers were `taken in' to subprime loans to serve as a sort of shock absorber for the anticipable mortgage crisis. In most states, mortgage brokers and loan officers aren't under any legal obligation to put borrowers in those mortgage that best suits them, insulating the original sin of `aggressive marketing' further from shock absorption and higher profit. The entry of big money Financial institutions entered into these too-risky investments, primarily because of too lavish liquidity. In pre 2000 circumstances, they would not have touched a significant part of the current loans. But in the prevailing market, banks with a more prudent investment policy could lose customers and market share. Financial institutions were caught off-guard because competition had pushed them to disperse easy money they called investments, over several times beyond their normal norms and branches of activities. In their paradises, they comforted themselves by belief that globalization would stretch the risks and no individual institution would succumb if debtors defaulted, as lending was shared by a number of institutions. Issuing bonds was the second trick used by the financial institutions to quickly pass the burden - and the risks - to other investors. Rights to such mortgage payments were repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). With these two assumed tools, each and every bank and institute assumed a larger burden than sensible judgment would have prescribed. When the bubble burst, risk spread like “a prairie fire around the globe”. On 10th December,2007 Europe's largest bank by assets- UBS has revealed a shock write down from investments in the US subprime mortgage market of almost seven billion Euros. UBS announced that to cover this amount it is selling stakes to the Singapore government and an unnamed Middle East investor. This revelation came when only a month ago UBS's Chief Financial Officer, Marco Suter, advised analysts and investors in meetings that the bank did not expect to make any huge writedowns in the fourth quarter. So far UBS is the biggest victim of the sub-prime mortgage meltdown among major European banks, including losses announced earlier, its total is 9.6 billion Euros. US based Citigroup expects to write off at least 11.5 billion Euros for subprime debts. Other big european losers include Merrill Lynch, Morgan Stanley and Barclays. Similarly, on 10th December,2007 itself , after closer of the market and a few hours later than the UBS announcement, Washington Mutual announced that, it will conduct a $2.5 billion convertible preferred stock offering. It will also close 190 of its 336 loan centers and sales offices, lay off more than 3,000 employees and set aside up to $1.6 billion for loan losses in the fourth quarter. The company also said that during the first quarter of 2008 it expects loan losses to total $1.8 billion to $2 billion and that its losses will continue to remain high throughout the whole of next year. According to The Wall Street Journal, WaMu's portfolio has the most exposure to risky loans of any of the top five mortgage lenders. 29% of its 2006 loans are in the high-cost category, mostly subprime, and 15% are backed by homes other than the owner's primary residence. Mortgages on second homes and speculative properties are considered more vulnerable to default. Instantly, several investor services including Moody's and Fitch downgraded rates for WaMu. California-based Countrywide Financial Corp. was a bit less of surprise. On 26th April itself, the Countrywide Financial Corp. reported a net earnings loss of approximately $188 million between the final quarter of 2006 and the first quarter of 2007, according to the company's 2007 first quarter report. The decline was a direct result of the company's net earnings dropping from $622 million in the final quarter of 2006 to $434 million in the first quarter of this year. Countrywide Chairman and Chief Executive Officer Angelo R. Mozilo accepted ``Countrywide's earnings were impacted by charges relating to our subprime activities as well as increases to our loss reserves and related asset valuation adjustments stemming from higher delinquencies and softer housing markets.'' Even the US Federal Reserve was evidently caught by surprise. The Federal Reserve and four other federal regulators did not issue guidance for nontraditional mortgages until last year. But the US Federal Reserve acted quickly to prevent the market from collapsing. The Bush administration and major financial institutions are now working on a plan to restrict interest rates of certain subprime loans in hopes of avoiding an even bigger meltdown. The federal regulators recommended that lending institutions consider the borrowers' ability to make payments over the life of the loan before underwriting, and that they improve disclosure to consumers. But all that's left is to wait for is the fallout. According to First American CoreLogic, “this year and next, about $260 billion in prime ARMs and $376 billion in subprime ARMs will begin to reset.” The impact Several major corporations and hedge funds to shut down or file for bankruptcy due to the force of default and liquidity risk. Stock market declines among both depository and non-depository financial corporations were remarkable. Many hedge funds and other institutional investors holding MBS have incurred momentous losses. MBS, CDO, and structured investment vehicles (SIV) – the culprits of primary boom, have compelled the banks to reduce their loans to each other or make them at higher interest rates only. In a like manner, the corporations are no more obtaining funds through the issuance of commercial paper with the same ease, effecting even the Mergers & acquisitions (M&A) explosion. Similarly, several lenders are taking steps to curtail the foreclosures. Washington Mutual plans to refinance up to $2 billion in subprime loans at below-market rates. Citigroup and Bank of America are working with an advocacy group to similarly target $1 billion in subprime mortgages, focusing on cities with higher foreclosure rates. Freddie Mac has made a commitment to buy up to $20 billion in subprime loans, and Ohio is floating a $100 million bond issue to help the troubled homeowners. A home-foreclosure process may cost the lenders tens of thousands of dollars and thus the renegotiating loans, i.e. lowering the interest rate or extending the payment period – may be more attractive than foreclosing. There lies the future. References: A Ripple, Not a Tidal Wave: Foreclosure Prevalence and Foreclosure Discount,'' the study by Christopher Cagan, Ph.D., director of research and analytics at First American Real Estate Solutions, www.firstamres.com/pdf/Foreclosure_Study_2006.pdf. First American CoreLogic, www.facorelogic.com. Mortgage Bankers Association , http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm Rick Brooks and Ruth Simon , Subprime Debacle Traps Even Very Credit-Worthy , http://online.wsj.com/article/SB119662974358911035.html?mod=sphere_ts As quoted by Rick Brooks and Ruth Simon , Subprime Debacle Traps Even Very Credit-Worthy. http://www.euronews.net/index.php?page=eco&article=458576&lng=1 http://www.mortgagenewsdaily.com/12112007_WaMu_Layoffs.asp Countrywide Reports 2007 First Quarter Results, http://about.countrywide.com/PressRelease/PressRelease.aspx?rid=991271&pr=yes Read More