In the face of gloom-and-doom predictions, rapidly rising unemployment, and an imploding economy, the market’s strong rally clearly anticipates a recovery in late 2009.

Is this just a bunch of bull?

While everyone seems focused on the economy hemmoraging red ink from the gash in the real-estate market, the broken bones of consumer demand and the unconscious state of banking and credit markets, only the stock market, and yours truly, seems to realize that the patient is being effectively triaged.

No, I haven’t lost my senses; I’ve simply regained a sense of optimism. I never drank the poisoned Kool-Aid of markets past and am on record calling in February 2008 for investors to not only “sell everything,” but to “short everything, buy short-dated Treasuries and hold cash, not cash equivalents.” And just because I was right then doesn’t mean that I’m right now; however, like back then, the traffic lights are flashing.

This time, however, they’re green, and not bright red.

There’s no doubt in my mind that the economy has farther to fall. Unemployment will hit double digits. Yesterday, the Labor Department announced that 5.6 million Americans are out of work, and that doesn’t count those who’ve given up looking for work. On top of that it was reported that based on fourth-quarter numbers, gross domestic product (GDP) actually shrank at an annualized rate of 6.3%.

So, what are rallying markets telling us?

First of all, the U.S. Treasury Department may not actually have to spend the approximately $13 trillion in rescue programs teed-up to drive the economy. If investor perception that the U.S. Federal Reserve and Treasury plans might actually work, whatever the details end up being, then traders and risk takers will lead the investing crowd by getting in early before the herd follows suit.

That is exactly what we’re seeing now.

Second, by some estimates, there is more than $9 trillion of cash sitting on the sidelines. I haven’t heard a single market commentator – or so-called expert – illuminate the new market reality, which is that there are far fewer shares available to buyers than anyone realizes.

Since the Tech Wreck of 2000, we haven’t seen any significant issuance of corporate equity. Since late 2007, for instance, the initial public offering (IPO) pipeline flow has been virtually at a standstill.

What hasn’t been at a standstill since 2002 are leveraged buyouts. Low interest rates drove the leveraged buyout (LBO) business, which now goes by the more genteel name of private equity. Giant and once-thriving private equity shops such as KKR & Co. LLP, TPG Capital, Cerberus Capital Management LP, The Blackstone Group LP (BX), The Carlyle Group LP, Bain & Co. Inc., and a host of other multi-billion-dollar buying machines took hundreds of public companies private by purchasing their outstanding stock with leveraged debt.

What will happen to most of these debt-laden “private” companies is another story, but the word “bankruptcy” will be featured prominently in the epitaph-like final chapter of most of their stories. The point, however, is that there are fewer companies and fewer shares for equity buyers to purchase. Add into the equation a share-drop in share prices to levels not seen in decades, and “Presto:” When institutional money and eventually retail buying comes back into the market, those trillions of dollars will be chasing fewer shares at low, low prices. It doesn’t take a Wall Street rocket scientist to figure out that robust demand for cheap assets will fuel a rapid run-up in prices.

As the perception that this dead-cat bounce or bear-market rally has real legs takes hold, more committed buyers will come out of the woodwork, not wanting to miss the opportunity to average down or pick up top-notch household names at bargain-basement prices. [For additional insights on the recent run-up in U.S. stock prices, please click here to check out a news-analysis story that appears elsewhere in today’s issue of Money Morning.]

Increasingly positive market breadth and momentum technicals aside, what’s fueling my optimism is that we’re finally seeing a real effort to constitute meaningful regulatory reforms. Recent statements from President Barack Obama and Treasury Secretary Timothy F. Geithner echo my clarion calls for regulation of derivatives, market-moving hedge funds and run-amok private equity firms. This week, Geithner said he was pushing “not modest repairs at the margin, but new rules of the game.”

In addition to reigning in freewheeling leveraged wrecking machines, I see unequivocal echoes of my calls for a systemic regulator to monitor all players with the potential to single-handedly corrupt the markets, tightened and more universal accounting standards and a systemic watchdog to monitor threats to markets and the general economic health of the country.

Equally encouraging are statements that signal interest in adopting the “Spanish model” of requiring banks to set aside more capital in good times to cushion their equity and support regulatory reserve and capital ratios in bad times. Also, in a wink and a nod to stemming the moral-hazard implication of charging all banks the same Federal Deposit Insurance Corp. (FDIC) deposit insurance premiums, smaller and better run banks may not have to pony up premiums on an equal basis with insanely large and egregious and incompetently run money center universal banks.

The upcoming G20 meeting on April 2 will spotlight whether America will take charge in orchestrating a better international regulatory order by demonstrating its commitment to meaningful wholesale changes in it own feeble domestic regulatory apparatus. Clearly, President Obama had Treasury Secretary Geithner float several trial balloons this week, and clearly in the face of terrible economic data, the markets found a reason for increasing confidence.

It’s just not possible to say enough about what effects appropriate, protective, and dynamic regulations can do for investor confidence in banks, markets and the safety of committed investment capital.

Unfortunately, as far as the economy, unemployment, embattled homeowners, businesses and devastated investors are concerned, the pain may not be over. On the other hand, if the tide of investor perception flows towards the potential for a safer investing climate and roots itself in anticipation of a stampeding bull run, all boats may rise with the tide a lot sooner than the gloom-and-doomers would have us believe.

I’m looking to the future.

Are you?

Source: Stock Markets Move Past Gloom and Doom in Anticipation of the U.S. Economy’s Recovery

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