INVESTING IN DISTRESSED SECURITIES

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<ul><li><p> Journal of Applied Corporate Finance S P R I N G 1 9 9 6 V O L U M E 9 . 1</p><p>Investing in Distressed Securities by Walter J. Bloomenthal, </p><p> BA Securities, Inc. </p></li><li><p>79JOURNAL OF APPLIED CORPORATE FINANCE</p><p>INVESTING INDISTRESSEDSECURITIES</p><p>by Walter J. Bloomenthal,BA Securities, Inc.</p><p>79BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE</p><p>ways. It can be done in the workout areathat is, on the private side of the</p><p>information wallin which case banks may take advantage (legally) of the</p><p>nonpublic information available to them through their direct relationships with</p><p>issuers. Trading in bank loans on nonpublic information is legal because bank</p><p>loans are not securities (although recent increases in the liquidity of the</p><p>secondary loan market are rapidly making this distinction less important for all</p><p>but lawyers) and because the transaction is an over-the-counter, private</p><p>transaction between sophisticated financial institutions with full disclosure of all</p><p>information.</p><p>Trading or investing in distressed assets can also be done on the public side</p><p>of the information wall, in which case investments can be made in all asset</p><p>classesnot only loans and trade claims, but notes, bonds, equities, warrants,</p><p>and options. To be permitted to engage in such public trading, however, traders</p><p>must have no access to nonpublic informationfor example, no communica-</p><p>tion with account officers or credit officers, and no access to credit files or</p><p>nonpublic offering circulars.</p><p>Banks, including Bank of America (BAC), engage in both types of distressed</p><p>debt investing through various holding company affiliates. In such cases, the</p><p>activities must be kept completely separate; for legal and regulatory purposes</p><p>they fall on different sides of the information wall. This article focuses on</p><p>distressed asset investing on the public side of the information wall. My aim in</p><p>the pages that follow is to comment on recent trends in distressed investing and,</p><p>in the process, to describe how we at BAC approach this business.</p><p>ommercial banks trade and invest in distressed assets primarily for</p><p>one reasonto earn high risk-adjusted returns. Distressed invest-</p><p>ing activity within banks is generally undertaken in one of two</p><p>C</p></li><li><p>80VOLUME 9 NUMBER 1 SPRING 1996</p><p>AN EXAMPLE</p><p>In March of 1995, BAC invested $19.4 millionin privately placed notes of a property securitycompany. We purchased slightly over 25% of theissue at a price just under 74% of the notes facevalue. Based on our previous experience in thisindustry, we saw what we took to be an under-valued situation as well as an opportunity toadd value through our own actions as a credi-tor (actions that I discuss later). Six monthsafter our initial investment, the company wasacquired, its debt was repaid in full, and wereceived full return of our investment as well asa $6.9 million profit (in the form of capitalappreciation and past due and accrued inter-est). The raw return on our investment was over35%, or about 70% on an annualized basis.</p><p>WHY THE HIGH EXPECTED RETURNS?</p><p>At BAC, our investments in distressed assets areconfined largely to debt claims. We define distressedassets as those claims trading at 95% of par or lowerprimarily because the issuer is experiencing somedegree of financial difficulty.</p><p>As mentioned above, the main attraction of thisbusiness for commercial banks is the potential toachieve superior risk-adjusted returns. Such returnsare likely to be available for two reasons: (1) thearbitrage opportunity created by the regulatory/accounting process, which in turn affects commer-cial banks decisions to hold or sell loans; and (2) thecomparative advantage of banks in analyzing andvaluing complicated debt claims.</p><p>Commercial banks are attracted to distressedassets in part because, unlike their standard businessof making new-issue loans, investing in distressed debthas upside potential. For example, bank loans tradingwell below face value have a reasonable chance toincrease in value, and thus the expected returns havea relatively normal, or two-tailed, distribution. Tradi-tional lending, by contrast, has a one-tailed distributionin the sense that the value of loans rarely increasesabove the issue price (par) and may decline signifi-cantly in response to negative information or a default.The only news that generally affects the value of atraditional loan is bad news; good news will not causethe price to increase much, if any, above par. In fact,because of the free option (the ability to prepay at anytime without penalty) built into almost all traditionalloans, good news is likely to cause the issuer tonegotiate a reduction in its interest spread or, at the veryleast, to prepay the loan.</p><p>Distressed asset investments are made at adiscount to par, and thus there is upside as well asdownside potential. In fact, because most of the badnews has probably already been disclosed (which iswhy the asset is distressed), there may well appearto be more potential upside than downside forinvestors in such deals. The size of the returnobviously depends on the price of the asset inrelation to its eventual value.</p><p>Of course, in a reasonably efficient market, theprice of a loan after the bad news is out should adjustso that new investors are promised only an adequate,or fair, rate of return on their investmentfair, thatis, for the level of the risk assumed. And in recentyears, the secondary market for distressed loans hasbecome somewhat more liquid and thus, presum-</p><p>ably, more efficient. But, at the same time, the levelof risk associated with distressed loans is likely to beconsiderably higher than the perceived risk ofhealthy loans, and the expected returns should becommensurately higher. (That is an important part ofthe definition of an efficient market.) And, as Idiscuss below, there are some reasons why commer-cial banks may have a comparative advantage bothin assessing and in managing such risks.</p><p>Regulatory/Accounting Arbitrage</p><p>There are regulatory/accounting pressures oncommercial banks (and, to a lesser degree, insur-ance companies) that create opportunities for in-vestors to acquire distressed bank loans (and pri-vate placements) at attractive prices. Commercialbanking is, of course, a heavily regulated industry.And, when faced with the regulatory costs ofhaving large amounts of nonperforming or criti-cized loans, many banks find it preferable to sellthe loanseven at prices that reflect less than theexpected recovery. In fact, a quirk of regulatoryaccounting ensures that the only way for a bank toend regulatory scrutiny of a nonperforming loan isto sell it. For, even if a charge is taken against aloan and the loans value is written down, theremaining value (cost minus writedown) continuesto be classified as nonperforming.</p><p>Another reason banks often sell distressed assetsis lender fatigue in combination with the economics</p></li><li><p>81JOURNAL OF APPLIED CORPORATE FINANCE</p><p>of the workout process. In many cases, banks oftendecide it is not worth the cost of continuing the attemptto restructure a troubled loan, especially if the amountis relatively smallsay, less than $5 million.</p><p>Thus, as banks periodically come under pres-sure to clean up their balance sheets by reducingtheir levels of nonperforming and criticized assets,they have incentives to sell such assetsagain, atprices potentially below the present value of ex-pected interest and principal payments. In additionto this regulatory motive, U.S. tax laws encouragesuch sales by allowing banks to deduct their losseson such loans from ordinary operating income. Atthe same time, the buyers of such assets, whethercommercial banks or otherwise, will buy those assetssolely for economic reasons. And such buyers,including other commercial banks, will place theassets in a trading account. In contrast to bankregulatory accounting, assets carried in a tradingaccount are valued at market pricesthat is, thereare no nonperforming or criticized assets and noreserves to be held against them (that kind ofinformation about expected losses has already beenincorporated into the market price of the loans).</p><p>In sum, distressed assets are often sold by banksfor regulatory or accounting reasons and purchasedby investors for their economic value. And, becausethe regulatory stigma associated with nonperformingor criticized assets makes them worth less to theoriginating bank than an outside investor, there issome opportunity for arbitrage.</p><p>The Real Effects of Regulatory Accounting</p><p>In attempting to understand selling banks be-havior, it is also important to keep in mind thatregulatory accounting can have real effects. Thearbitrage opportunity in buying distressed debtstems not only from regulators and regulation, butalso from the ways in which the stock marketsevaluation of banks is affected by regulations andregulatory accounting. When regulators criticizeloans or classify them as nonperforming, thoseactions have the effect of reducing banks reportedearnings (by requiring higher levels of reserves) aswell as various credit performance ratios. Studies ofthe correlation between banks stock prices andreserve levels have shown that the market dislikesreserve levels that are either too high or too low. Theclear message here is that the market does not liketo be surprised!</p><p>The following scenario was played out repeat-edly during the early 90s: Bank ABC has set itsreserves at a certain level based on losses expectedin its credit portfolio, and has shared those expecta-tions with bank stock analysts. Enter the regulators,who in the name of conservatism classify a larger-than-expected percentage of ABCs loans asnonperforming (even though many of them may becurrent on their payments). As a consequence, ABCsquarterly earnings and credit performance ratiosdisappoint the analysts, and the banks stock pricedrops sharply. In response, the banks managementattempts as soon as possible to sell enough criticizedor nonperforming loans to get the portfolio back inline with expectations.</p><p>One might be tempted to blame the stockmarket for this seemingly shortsighted behavior bybanks. But the markets problem with underfunding(and overfunding) of reserves can be traced toinvestors lack of good information about bankassets. Commercial banks wholesale loan portfoliosare basically blind pools, which means that theidentity and value of individual assets that make upthe pool are not disclosed. And, since investorsunderstandably tend to discount asset values tocompensate for their own uncertainty, any surprisebrings home to them their informational disadvan-tageand the market reacts strongly and negatively.</p><p>Making matters worse for bankersand enlarg-ing the arbitrage opportunitywhen a Federal ReserveBoard regulator classifies as nonperforming a nationalloan held by an agent bank, it is automatically classi-fied at all of the banks in the bank group. Conse-quently, one sale by a bank will often lead to sales byseveral other members of the bank group. Thus,nonbank buyers of classified assets may have a poten-tial advantage over banks in that the classified des-ignation is of no consequence to such buyers.</p><p>We have also seen similar responses to regula-tory action by insurance companies, thus sometimescreating buying opportunities for distressed inves-tors in private placements. For example, our 35%return on the private placement issue mentionedearlier derived in part from our perception (whichturned out to be correct) that excessive regulatoryconcern by the NAIC had artificially depressed thevalue of the notes. As a general rule, however, theselling behavior of insurance companies is less drivenby regulation than that of commercial banks, and soopportunities for regulatory arbitrage in private place-ments have been fewer than in distressed bank loans.</p><p>The level of risk associated with distressed loans is likely to be considerably higherthan the perceived risk of healthy loans, and the expected returns should be</p><p>commensurately higher. And there are some reasons why commercial banks mayhave a comparative advantage both in assessing and in managing such risks.</p></li><li><p>82VOLUME 9 NUMBER 1 SPRING 1996</p><p>Comparative Advantage</p><p>The regulatory arbitrage described above ap-plies only to bank loans and certain private place-ments. It does not apply to financial institutionsholdings of public bonds and equities, which areliquid, exchange-traded instruments that are gener-ally marked to market. If commercial banks have acomparative advantage in investing in distressedpublic bonds, that advantage can be expected tocome from bankers experience in assessing the risksof corporate debt claims and in analyzing the valueof a company in relation to its capital structure.</p><p>And, to the extent some banks do have anedge in valuing corporate debt of all kinds, thatcapability will come from three sources of humancapital that are consciously developed and culti-vated in large banks: (1) a large number of peopleand processes dedicated to determining whether ornot a company will be able to repay its debts (thecredit process); (2) a small, highly specializedgroup of people with a lot of experience withcomplicated out-of-court and Chapter 11 reorgani-zations (the workout or special asset area); and(3) a relatively small, moderately specialized groupof people with market knowledge and informationabout loans (the loan syndication/loan tradingarea). In some combination of people from thesethree disciplines lies the potential for a profitabledistressed trading/investing group. And if you addto the talents of these three groups the newlyacquired fixed-income research capabilities of manybanks Section 20 subs, you may have additionalsynergies for distressed investing.</p><p>Opportunities in Trading Distressed Debt,Public and Private</p><p>The relative advantage of banks over manynonbanks in analyzing and valuing distressed debtstems in large part from banks specialization in morecomplicated or smaller, typically unrated transac-tions. While rating agencies tend to concentrate onlarge companies whose long operating histories</p><p>have generated lots of publicly available informa-tion, banks are willing to lend to complicated andsmaller companies with little or no track record, inlarge part on the basis of expected future perfor-mance. Most bond rating agencies base as much as40% of their rating on a companys size, thusautomatically consigning even the most profitablesmaller firms (anything below about $200 million) tonon-investment-grade ratings. Banks have moretolerance for complexity and small size, and willaccordingly spend more time analyzing future cashflows, different capital structures, and various upsideand downside scenarios.</p><p>Banks take such pains because the relativescarcity of information about small companies gen-erally allows them to command higher yieldsor aliquidity premium, if you willwhen pricing theloans. Moreover, banks have ways of structuringtransactions to reduce their credit risk. For example,they routinely include various covenants in the loandocuments that increase their abil...</p></li></ul>