A Multi-Disciplinary Task Force Meets The Financial Markets Crisis

Saturday, November 1, 2008 - 01:00
Carolyn Zander Alford

Editor: Ms. Alford, would you tell our readers something about your professional experience?

Alford: I joined King & Spalding on graduation from law school in 1992. The firm's transactional practice was nationally recognized, the people were high energy and collegial and I liked the Atlanta location. It has been a terrific platform for my practice.

I have been a partner in the firm's finance group since 2000, and most of my career has been focused on representing lenders, investors and corporate borrowers in a variety of debt transactions.

Editor: How has your practice evolved over the course of your career?

Alford: I represent banks, insurance companies and other lenders in a range of financings, including investment-grade and leveraged syndicated lending, private placements, subordinated note issuances, project finance in the energy sector, acquisition finance for private equity sponsors, and letter of credit "wrap" solutions for the auction-rate securities market.

My practice has evolved with changes in the credit markets and our economy. For example, at the beginning of my career, banks provided syndicated credit facilities with the expectation of holding their commitments for the life of the facilities. Today there is an active market for secondary trading in syndicated credit facilities, and the lender group often includes hedge funds and non-bank finance companies. As private equity drove the M&A activity over the last five to seven years, my practice increasingly focused on financing these transactions. Since the auction-rate securities market failed earlier this year, I have used my syndicated lending background to help develop letter of credit "wrap" solutions on a multi-bank basis to provide liquidity for these securities. When I entered practice in 1992, I frequently advised on financings for the textile industry; today I represent lenders financing wireless, fiber and data center companies, pharmaceutical and medical device enterprises, and ethanol facilities.

Editor: As you know, most of our readers are general counsel and the members of corporate legal departments. Few things have riveted their attention recently as have the financial markets crisis. For starters, would you give us your thoughts as to how the American economy managed to get itself into such a state of affairs?

Alford: The current disruption in the financial markets stems from a number of causes. The bubble in the U.S. housing market - fueled by aggressive mortgage lending - was a primary cause. The boom in securitization contributed to the decline in underwriting quality for mortgage origination. When you separate the ultimate providers of credit from the borrowers by several layers of securitized structures, you lose the accountability for strict underwriting standards, and credit quality deteriorates. In addition, Congress leaned on Fannie Mae and Freddie Mac to be more aggressive in making home ownership in America available to people who historically had not qualified for mortgages. Loosening the capital requirements for investment banks permitted them to leverage their balance sheets to very high levels. But the single most important factor, in my view, is that there was simply too much leverage in the system. When a mountain of debt rests on a very narrow sliver of equity, there is little cushion for a bump in the road. The amount of leverage in the system - whether it is at investment banks or hedge funds - exacerbated what might have otherwise been only a cooling down of an overheated housing market.

Editor: I understand that King & Spalding has put together a group from across the firm to address the needs of the firm's clients in connection with the crisis.

Alford: The credit crisis is the biggest economic story of our generation. It has brought about an enormous disruption to the financial system that, in turn, has resulted in both enhanced risk and opportunity for our clients. The firm has positioned itself to help these clients minimize their exposure to risk and, at the same time, benefit from the opportunities that this situation presents.

Our Financial Markets Task Force is a multi-disciplinary group consisting of lawyers with expertise in bankruptcy and restructuring, finance, mergers and acquisitions, governmental advocacy and litigation. One team is engaged in transactional matters, including advising on derivatives and the buying and selling of distressed assets. A second team is advising on litigation and governmental investigations from the sub-prime mortgage fallout. A third team is focused on legislative and regulatory changes emanating from Washington now, a landscape that will no doubt be affected by the presidential election. We think the congressional focus for the next year will largely be on the financial markets, investigating how we got to this point, implementing the bailout and developing new rules to make this less likely to happen again.

Editor: Just recently the House of Representatives enacted legislation, earlier passed by the Senate, that, depending on where you sit, constitutes a "bailout" of Wall Street or a "rescue" of the financial services industry.

Alford: The Treasury and the Fed concluded, with good reason, that a more systemic approach was necessary to address this crisis. The ad hoc emergency financing for Fannie Mae, Freddie Mac and AIG created almost as much uncertainty as relief and was unsuccessful in contributing any new confidence in the financial system. The first initiative under the Emergency Economic Stabilization plan is intended to remove from the balance sheet of the financial institutions the "toxic assets" that have eroded trust in these institutions among their trading counterparties and in some cases their depositors. More recently Treasury announced that it will use a portion of the bailout proceeds to make direct equity investments into U.S. banks. $125 billion will go to the largest U.S. financial institutions, and another $125 billion will be invested in regional and community banks in the United States.

The Emergency Economic Stabilization legislation has a number of goals, some conflicting. Obviously the legislation sought to stabilize the financial institutions, recapitalizing the banks with more liquid assets and reassuring investors that our banks are solvent. Buying at a price sufficient to recapitalize the banks, however, conflicts with another goal in the legislation - maximizing return to the taxpayer - which would have Treasury buy assets at as low a price as possible. A third goal is to maximize home ownership and minimize foreclosure in the United States, which really requires restructuring mortgages and writing off some of the loans. Treasury will have to make some difficult judgment calls about how to balance these goals.

Editor: Any thoughts as to how this is going to roll out?

Alford: The legislation gives the Treasury a great deal of latitude, and at this point the details are just starting to emerge. The big questions include what portion of the $700 billion will ultimately be used for direct equity investments and what portion will be used to purchase mortgages and mortgage-backed securities; who will the Treasury invest in and who will they buy assets from; at what price will assets be purchased; and will the exit strategies work - how will Treasury ultimately liquidate the positions it is taking and will they make or lose money for the U.S. taxpayer.

The recent change in direction from just buying assets from financial institutions to direct equity investment is a perfect example of the flexibility that Treasury has been granted. The initial concept was simple: remove those assets from the equation, and the solvency of the institution becomes more apparent and normal lending and trading can resume. However, rolling out the auctions for these assets was going to take time - at least a month - and with further deterioration in the markets we could not wait that long. The new initiative to invest directly in equity of U.S. banks can be executed much more quickly and directly addresses the goal of recapitalizing banks. It may also allow Treasury to focus on buying the "toxic assets" at the lowest price.

The lingering question is whether the plan will actually resolve the liquidity crisis and get financial institutions to start lending again. At the moment we seem to be caught in a liquidity trap where the additional liquidity provided by the government dissipates in a cycle of de-leveraging and debt liquidation. This is very deflationary and problematic for a leveraged economy like ours. We need asset prices to stop falling and lenders to be willing to take on some risk before we can return to normalized credit flows. Right now, however, many lenders are focused on their own liquidity.

Editor: Would you share with us your thoughts as to what the financial services industry might look like when the dust settles?

Alford: Clearly the financial markets will be more regulated going forward, and not just the banks. Mortgage brokers - who arrange for loan transactions without any liability as to whether the borrower meets the criteria for being able to repay - may be targeted for more regulation. Hedge funds, certainly those which are literally too big to fail, will be prime targets for regulation going forward. Credit default swaps, currently traded over the counter, will probably migrate to an exchange and be regulated.

As Wall Street firms become bank holding companies, we will see a return to a less-leveraged financial institution. We will not see large, highly leveraged unregulated lending institutions, at least not operating in the United States.

The current liquidity crisis is a vivid example of how global the capital markets really are. There has been no way to contain the problem to a single country or currency. We will see greater international coordination of regulation and oversight going forward. How the new regulatory regime that emerges in the U.S. compares to the regulation of UK, European and other banks will have a significant impact on how dollar-based lenders and investors operate in the future. If the regulatory burden becomes too great in the U.S., capital may move to London or other overseas markets that have a more flexible regulatory structure.

Editor: In your opinion, is governmental intervention of this magnitude a good thing?

Alford: That is, of course, in part a philosophical question. We reached a tipping point where the consequences of not intervening were severe; we hope that the cost of intervention will be less burdensome. Looking forward to the legislative and regulatory changes that will undoubtedly come, we don't want to stifle innovation, and we don't want to force the financial markets to move overseas. This is why it will be so important to have better international coordination of oversight and accountability going forward, since capital is so mobile.

Our experience is that financial markets regulation has been successful when it focuses on (i) capital adequacy and leverage limitations and (ii) disclosure and transparency; regulation has failed when it has attempted to dictate pricing, establish lending terms or set limits on interest rates paid for deposits. The U.S. can continue to have the leading financial markets if we establish the most liquid, most well-capitalized and most transparent markets in the world; we risk that position if we over-regulate.

Please email the interviewee at czalford@kslaw.com with questions about this interview.