Analysts were appalled when Goldman Sachs (GS) paid a 10% coupon on a $5 billion investment made by Warren Buffett of Berkshire Hathaway (BRK-A)(BRK-B) in September of last year. He also was given an option to buy more shares at below market prices. Buffett drove a similarly hard bargain to make a $3 billion investment in GE (GE).The panic about the financial system was so pervasive that these kinds of investments were available to intrepid souls like Buffett. Any major financial firm seeking to raise capital now would do much better.
There is a pervasive impression that the credit markets have “thawed” somewhat and that capital is readily available on terms that are well shy of usurious. That is not entirely true. Companies with even modestly risky prospects are still paying interest rates that are high enough to hurt their balance sheets and put them at risk for default if their business prospects diminish even modestly. A case in point is United Airlines (UAUA), which raised $175 million in three-year of 12.75% debt at just over 90 cents giving the paper an effective yield of over 17%. The notes are secured by all of the company’s spare aircraft parts.
The United transaction is a perfect example of why the largest American companies that do not have perfect balance sheets will have such tremendous difficultly emerging from the recession. The higher interest rate that United has to pay will put pressure on the airline’s cash flow which is already being severely reduced by the drop in airline traffic and the increase in fuel prices. United is faced with the dual challenges of debt and operating trouble. The capital markets are not inclined at all to give the United a break even though that break might help the company weather a difficult period and rebuild as the economy improves.
The federal government has elected to supply money to businesses like the automotive industry which carry a risk comparable to that of junk bonds. Detroit is under-capitalized, even with US financial support if domestic sales of vehicles do not move quickly above the ten million units a year level, which is likely to be the final tally for this year. The government is not making money available at reasonable rates to other industries that employ huge numbers of people. United has a staff of 45,000 and the five largest airlines in American support the jobs of about 300,000 people. Low -cost loans could be the difference between a healthy industry and one that falters and produces several bankruptcies.
The need for affordable debt is not restricted to the airlines. Large telecommunication companies which are in the process of building the nation’s broadband systems, a process that the Administration thinks is “strategic”, need money for capital expenses. Sprint (S) and Clearwire (CLWR) fit in this category. A government loan to these two companies at a level of $10 billion with a 5% interest rate could save both hundreds of millions of dollars in interest over the next five years while they complete their WiMax construction. The interest they would have to pay in normal capital markets transactions could be above 15%. The money that makes up the difference between a 5% and 15% coupon could go to employment and accelerated capital spending at Sprint, Clearwire, and other companies in the wireless broadband and related industries.
Biotechnology is another industry where America has a chance to dominate the world’s supply of new drugs and medical treatments. Many of the most promising companies in this sector still lose money and have tremendous hurdles when they need investment capital. The drop in their stock prices has damaged their chances of bringing in new money. A number of the biotech companies that have the most promising prospects for launching new products also have substantial debt burdens. Many will not make it to the point where they can release commercially viable drugs even if early trials are promising.
The arguments against the government making loans to businesses in important but struggling industries are compelling. It is a risk of taxpayer money. But, that is also true in Detroit and some companies in the financial industry such as AIG (AIG). Equally important to tax payers capital risk is the fact that the government does not have to expertise to evaluate the prospects of the future of firms in these sectors on a company-by-company basis. There are large money management firms that do. They maintain research on industries like biotech as part of their services as they invest the money entrusted to them by their clients.
The problem of access to credit by companies that are either strategically important to the US or represent important opportunities to maintain or increase the national employment base could prolong the recession by forcing firms to lay-off workers or cut back on critical business activities including capital expenditures and R&D. Proving low-interest rate capital does have considerable financial risks to that government. Some of the investments will fail. The same can be said of GM and Chrysler, but keeping industries like biotech and wireless growing is likely to make a long term contribution to GDP improvement and export numbers. The car industry is not.
Douglas A. McIntyre