Should The Government Guarantee DIPs?

To assure banks begin to dole out more debtor-in-possession financings, some market participants say the government should step in and guarantee some or all DIP financings. However, others argue that allowing the government to decide which companies or sectors are guaranteed DIPs would be the start of a downward spiral into too much government involvement in the restructuring process. There are already mechanisms in place to help distressed companies avoid a DIP altogether, they say.

One of the biggest criticisms of the Troubled Asset Relief Program has been the fact that, despite all the effort and money to jumpstart lending, there continues to be a dearth of new financings. This reality hits especially hard those companies on the verge of bankruptcy that need a DIP financing to keep their operations running long enough to restructure. Lack of financing has been one of the unique factors distinguishing this downturn from others, especially given the fact that DIPs take priority over other debt in the capital structure.

One way banks might make more DIPs available is to have the government lend directly to a bank with the intent of having it then lend to a distressed company. Another is to have the government backstop DIPs by agreeing to buy underperforming DIPs just as it has with other troubled securities.

"The important question today is: What is a company's collateral worth? If it's not worth what we think its worth, and the company has to liquidate, where else can they look to? In certain cases, absent a guarantee from some third party or the government, the best a company can do is to liquidate," said Samuel Star, senior managing director in corporate finance for FTI Consulting.

For now, a government guarantee is just talk on the street. Sources say they've seen no indication the government plans to make such a guarantee, and they were unsure even which department could do so.

What they were certain of, though, is that if nothing is done, the only choice some distressed companies will have is to close their doors. They said this is especially true for smaller companies that were taken private. Larger, public companies like LyondellBasell and Smurfit-Stone will fare better because they are able to negotiate better terms. Contech, a Portage, Mich.-based auto supplier with roughly 65 employees, is one of the latest companies to have had trouble lining up a DIP as it entered Chapter 11. Contech was acquired by New York private equity firm Marathon Asset Management in 2007.

Exacerbating the situation is the fact that borrowing for bankrupt companies has gotten more expensive, according to Standard & Poor's. The cost of a DIP loan in 2008 was roughly 400 bps to 750 bps over Libor. That is up from a range of 225 bps to 600 bps over Libor in 2007.

Derailed reorganizations like Circuit City could further thin out the number of willing lenders, S&P analysts added. So it is no surprise that DIP loan volume has dropped while the need for it has shot up. In 2008, total DIP volume was $9 billion. In 2007, there was $21 billion worth of DIP financing. Though the 2007 totals were skewed by the Delphi and Calpine bankruptcies, and 2008 totals were skewed by Delphi's bankruptcy, the trend clearly shows a drop in the number lenders willing to stake money to bankrupt companies.

That may begin to change as the year goes on however. Lenders from different ends of the market are interested in lending more to DIP facilities in 2009, according to a survey by Bingham McCutchen, FTI Consulting, Macquarie Capital, and Debtwire. The survey, which polled 100 hedge fund mangers, proprietary trading desks and asset managers, found that of the one-third of respondents who participated in a DIP financing in 2008, 52% plan on being more active in 2009.

The counter argument for a government guarantee focuses on the moral dilemma the government faces by choosing which companies or sectors it will guarantee.

Furthermore, some sources pointed out that it would cost the government more than it would be willing to spend to study a distressed company's finances. "I mean, investment banks get paid a lot to do that," said a lawyer at an international law firm.

King Penniman, president of independent high yield research firm KDP Investment Advisors, added that if the government made such a guarantee it would most likely come with strings attached. "To dictate how a company is supposed to restructure runs counter to our entire system of confidence in giving anyone credit."