The president was under pressure to say who would handle the issue before tomorrow, when General Motors Corp. (GM) and Chrysler LLC must give progress reports on plans to restructure as a condition of $17.4 billion in U.S. Treasury loans. The so-called car czar – an approach that had some support in the American auto industry – was viewed as a key move in the federal government’s push to revamp the U.S. auto industry. The task force puts an end to reports Obama would recruit a well-known figure from outside to serve in that role, an approach that had some support in the industry itself.

Ron Bloom, a United Steelworkers union adviser and former Lazard Ltd. (LAZ) vice president, will join the Obama administration team, Bloomberg said of the alleged appointment, which has yet to be made publicly.

“There needs to be a trail boss here,” said Andrew Gross, chairman and chief executive officer of Automotive Consulting Services LLC in Clackamas, Oregon, told Bloomberg in a telephone interview yesterday. “Typically when you have a committee set up it provides cover. Everyone’s responsible, but no one’s accountable.”

Geithner has “got his hands full” trying to rescue the banking industry, Gross said.

After Congress failed to approve a bailout for the automakers, former President George W. Bush on Dec. 19 authorized the loans, a move that effectively made the Treasury secretary the car czar, imbued with the responsibility for making sure the companies meet deadlines and authority to revoke the loans.

Under the new plan, Geithner will remain Obama’s official “designee” to oversee the restructuring, meaning he’ll have the authority to pull back the aid if the automakers fail to submit a return-to-profitability plan by the established March 31 deadline.

“It’s going to be something that’s going to require sacrifice not just from the auto workers, but also from creditors, from shareholders and the executives who run the company,” senior White House adviser David Axelrod told NBC TV’s “Meet the Press” on Sunday.

Representatives from Cabinet departments and White House offices will serve on the task force, too.

Market Matters

So what will $790 billion buy these days?  Hopefully, a few roads and bridges, about 3.5 million new jobs – and perhaps an economic recovery for the country, too. President Obama is expected to sign the legislation today (Tuesday), The Washington Post reported.

But as the stimulus package moves closer to Obama’s signature, the jury is still out on its future success. Perhaps the sign of a successful compromise exists when neither party is completely satisfied (or not at all satisfied) and points out flaws in the final package.

In this case, budget hawks and other conservatives claim that the bill is a giant spending package that will do little to revive the economy, or create any real jobs. Many bleeding hearts and other liberals were counting on a larger stimulus and believe the tax cuts and rebates will not help and, if anything, similar actions over the past few years have contributed to the current mess.

President Obama seemed pleased with the progress and praised the plan as an “endeavor of enormous scope and scale.”  Then again, his views on effective stimulus may have cost him another cabinet nominee as his willingness to cross partisan lines to find a Commerce Secretary failed over insurmountable economic and ideological differences with Sen. Judd Gregg.

News from the bailout front grew more pessimistic during the week as Treasury Secretary Geithner’s initial attempt to win over Congress, investors, economists, and the media proved no more successful than Hank Paulson’s before him.  The stock market had run up significantly in the days leading to his speech, as folks hoped to hear some specifics about how the next round of the Troubled Assets Relief Program (TARP) (and other initialed programs like TALF) would work far better than the initial plan.  Instead, disappointed investors ran for cover when his remarks left many questions about the valuations of toxic assets and private/public partnerships unanswered.

As plenty of finger-pointing continued over the failed bailout initiative and its lack of direction, some signs of success from the U.S. Federal Reserve and Treasury Department’s moves have slowly emerged.  The once-frozen credit markets have started to thaw as corporations have borrowed almost $80 billion so far in 2009, issuing high quality bonds to take advantage of low interest rates: Cisco Systems Inc. (CSCO) alone sold $4 billion in debt securities to raise cash for potential merger-and-acquisition activities.

In other (optimistic) news, Intel Corp. (INTC) will be investing $7 billion in technology enhancements at its factories during these dire times.  McDonalds Corp. (MCD) showed that Big Macs are near necessities as same-store sales jumped by more than 7% last month.  Still, earnings season wound down with profits at Standard & Poor’s 500 Index companies projected to plunge over 30% in the fourth quarter, the worst showing in about two decades.  In fact, it was the first-ever quarter of negative earnings, MarketWatch.com reported.

Oil plummeted below the $34-a-barrel level (at one point) as inventories climbed to an 82-week high amid lower demand for energy during the downturn.  Investors unloaded stocks following the Geithner remarks (remember the old market adage: “Buy on the rumor, sell on the News”), despite some better-than-expected economic releases.

Bonds experienced a “flight to quality,” and also rose on news that a comprehensive foreclosure-assistance plan is in the works.

Economically Speaking

First the bad news. In the latest Wall Street Journal poll of top economists, the vast majority revised (downward) their outlooks for the second half of 2009, and said that the prospects for a full-fledged recovery seem much less promising.

While most predict that we’ll see some economic growth during the last six months, the rate of such expansion is lower than earlier projections. In fact, several economists expect that economic contraction will continue to be a reality through the end of the year.

But that brings us to the good news: These economic surveys are rarely on target.

Federal Reserve Chairman Ben Bernanke did his best Tony Robbins impersonation (the power of positive thinking), and highlighted the recent successes of certain policies.  Bernanke suggested that the commercial paper markets have benefited from the central bank’s decision to buy these short-term securities and more companies are meeting their liquidity needs.  He promoted the newfound stability among money-market funds as investors ceased the mass withdrawals that were occurring last year. Finally, he expressed relief that mortgage rates have declined dramatically and that borrowers have taken advantage of purchase and refinance opportunities (at least those borrowers with high-paying jobs and stellar credit).

While the trade deficit declined to its lowest level in almost six years, the pessimists claim that the improvement is more reflective of the recessionary times which have restricted domestic demand for the imports of oil and other foreign-made products and services.

Meanwhile, the imbalance with China climbed to an all-time high.  In retail news, sales in January surprisingly jumped by 1%, the first increase in seven months and the best showing in more than a year. While Wal-Mart Stores Inc. (WMT) took advantage of the consumers’ hearty appetites for groceries and other (discounted) necessities of life, buyers also hit the auto lots again to check out the “too-good-to-be-true” deals.  While the initial jobless claims actually fell slightly in the most recent week, the number of unemployed continuing to search for a job moved higher, an indication that the labor markets remain tight.

The foreclosure initiative will be of particular interest to many who believe the housing sector remains the key to any recovery. Investors also get the latest look at the inflation picture as both the producer price index (PPI) and consumer price index (CPI) for January will be released.  While oil has continued to plunge, gas prices seemed to have stabilized as of late (unfortunately for consumers) and talks of deflation may have been put on the backburner, at least for now

Weekly Economic Calendar

Source: Obama Administration Kicks the “Car Czar” to the Curb; Treasury’s Geithner to Take the Wheel

Private equity is an asset class consisting of equity securities in operating companies that are not publicly traded.  The name “private equity”is the rechristened, kinder and more gentile label for what used to be known as leveraged buyouts, or LBOs. But make no mistake about it, while leverage may not be part of the name any more, it remains a big part of every private equity deal.

LBO firms, or “franchises”, as Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co. (KKR), likes to call his shop, acquire publicly traded operating companies. Then they streamline management and operations to increase profitability and hope to cash out through a merger, an outright sale of the company, or by taking the company public again through an initial public offering, or IPO.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

Generally, once a target is identified, an offer is made to buy a majority, or all of the stock of the company. The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. Except for the private equity firm’s initial equity investment, the target company is essentially buying itself.

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

The leveraged buyout business has been around for a long time and it has worked very well for investors and the private investment bankers who make an extravagant living with other people’s money. In fact, the business was so successful it eventually led to its now very problematic fork in the road. The problem facing private equity is that their leveraged deals were at one time in such great demand that it became too easy to borrow too much money.

The result was that they chased too many deals, paid too much for targets, paid themselves too many dividends and fees, and now their portfolio companies are straining and collapsing under the weight of too much debt.

Act I: The Two Big Mistakes that Made Leveraging Possible

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called  collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Since banks were able to sell off their leverage loans to investors they had plenty of recycled money to lend out again and again. Competition to lend out all that money put borrowers in an advantageous position, which they exploited.

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.

But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders.

Among other things, some borrowers demanded and got rights to:

• Increase debt-to-EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) levels to 10:1.
• Freely substitute collateral.
• Have collateral “released” outright.
• Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
• Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
• Employ PIK toggles, sometimes called “extendibles.”

PIK toggles (think of a toggle switch which is used to turn something on or off) let the borrower can roll interest payments into principal and extend the maturity, instead of making twice yearly cash payments. If that sounds like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal, it’s because it is the exact same borrower covenant.

It’s like déjà vu all over again.

Act II: With No Leverage Private Equity Deals Fall Apart

Junk, junk and more junk. When the music stopped and the credit crisis began last August, money and credit evaporated. Only then did it bother leveraged loan investors that the private equity guys were leveraging their private companies to pay themselves huge dividends – enough in many cases to repay the entire initial cash equity investment used to underpin the leveraged buyout of their targets. And only then did they realize that all the debt heaped onto these companies was going to drag many of them into bankruptcy.

At that point, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans which were securitized and subject to mark-to-market accounting. And they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Also in the clutches of the three-headed-dog from Hades, Cerberus, is Chrysler LLC; Chrysler Financial, GMAC LLC (General Motors Acceptance Corporation) (GMA) – 51% owned by Cerberus – and Residential Capital LLC, a GMAC company. By most accounting standards, all of these companies are, if not already, close to insolvent.

GateHouse Media Inc. (OTC: GHS), 40% owned by Fortress Investment Group LLC (FIG), is at risk of debt default and may likely be headed for bankruptcy. Former Lazard Ltd. (LAZ) deputy chairman and  media honcho Steve Rattner’s Quadrangle Capital Partners may lose control of American Media Inc., publisher of The National Enquirer and Star magazine, as he battles with bondholders and may also lose portfolio company Alpha Media Group Inc., publisher of Maxim magazine. These few examples of failures are just the tip of the iceberg.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months.

It’s understandable that bankrupt target companies are suing. Mervyn’s, for example, filed a 57 page suit against its lead dog master Cerberus, alleging fraud among other charges. But what is not as easily understandable is that some other lawsuits have the potential to turn the game viciously against the private equity firms and all the major bank lenders. I’m not talking about the deals that got done; I’m talking about the deals that didn’t get done because private equity firms walked away or otherwise tried to dissolve pending deals.

Apollo Management asked a Delaware Court of Chancery to kill a transaction it had entered into to have one of its portfolio companies, Hexion Specialty Chemicals Inc., buy NYSE listed Huntsman Corp.(HUN) for $6.5 billion. Huntsman sued and won. The judge issued a ruling that Hexion “knowingly and intentionally” breached parts of the merger agreement and ordered the company to complete the deal. Not only is Apollo being forced to go through with the deal, the ruling allows Huntsman to seek damages from Apollo. Apollo is now suing the banks it had lined up to provide debt financing for the deal.

There are hundreds of billions of dollars of abandoned deals that may now be re-visited in courts around the country. The implication for private equity firms and banks is potentially staggering.

Here are a few of the larger failed deals that resulted from a lack of debt investor interest:

• Cerberus’ failed  deal for United Rentals Inc. (URI).
• The Blackstone Group LP’s (BX) failed deal for Alliance Data Systems Corp. (ADS).
• J.C. Flowers’ failed deal for SLM Corp. (SLM), also known as Sallie Mae.
• And Appaloosa Management in conjunction with Harbinger Capital Partners, Merrill Lynch & Co. Inc. (MER), Goldman Sachs Group Inc. (GS), and UBS Securities LLC’s failed financing of Delphi Corp. (OTC: DPHIQ) to take it out of bankruptcy, for which they are being sued for fraud and conspiracy to “derail” the bankruptcy plan; a serious situation because interfering with a bankruptcy is a federal crime.

The amount of leverage involved in private equity deals is a problem if banks aren’t eager, or able, to supply needed loans. But that alone isn’t scary. What is scary is the effort private equity firms are making to actually get into the banking business themselves.

Act III: Private Equity Seeks to Corrupt Banking System

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

The prospect is frightening.

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. In addition, the holding company is forced to serve as a “source of strength”, meaning its capital will be called upon to support its bank.

Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. The private equity firms are sitting on hundreds of billions of dollars of fresh money raised recently. While it may seem reasonable and expedient to allow private equity capital to be infused into ailing banks, any compromise of existing regulations would result in the creation of the mother of all moral hazard enablers.

There’s no doubt that if the recession is as deep and as long as feared,, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

Source: Overly Leveraged Private Equity Deals Add to Unemployment and Deepen Recession