The Disaster Is Far Broader Than Just Too Many Bad Subprime Mortgages

With the economy sputtering and banks pulling back on lending, the noose is starting to tighten around a host of struggling companies.

For years, companies had access to easy money for everything from expansions to acquisitions to leveraged buyouts. For many, this global credit boom forestalled painful plant closings, job cuts and asset sales.

Now, the day of reckoning is arriving for some of them, as skittish corporate lenders push them to the brink of bankruptcy and beyond. Yesterday, the credit crisis hit two national retailers: San Francisco-based Sharper Image, which sells high-tech gadgets such as air purifiers and massage chairs, and Lillian Vernon Corp., which sells low-cost gifts such as Easter baskets and welcome mats. Both filed for federal Chapter 11 bankruptcy protection. (See related article.1)


The mounting woes of the banks that supply corporate capital are contributing to the crisis. "The banks really don't know what kind of room they have to add new loans for companies until [the banks] fill the hole on their nonperforming loans," including mortgages, credit-card debt and auto loans that are souring, says Henry Miller, chairman of Miller Buckfire, a financial restructuring firm. "The dominoes have started to fall."

Corporate defaults and bankruptcies have risen sharply this year. The total value of corporate-bond defaults is already approaching the total for all of 2007. Moody's Investors Service now lists 41 companies it considers to be at risk of violating terms of their loan agreements, compared with 25 at the end of last June. Many companies that depend on consumers are on the list, including movie-rental company Blockbuster Inc. and the Landry's Restaurants Inc. chain.

Even some companies already operating under federal bankruptcy protection are feeling the squeeze. Auto-parts maker Delphi Corp. and chemicals concern Solutia Corp. have been unable to line up financing to emerge from court protection.

"The last couple years had been all about delaying the pain," says Scott Brubaker, managing director for the corporate turnaround firm Alvarez & Marsal. "Troubled companies refinanced in 2005 and 2006 that maybe shouldn't have. Now credit markets have snapped the other way, and some companies that should be able to refinance can't or will struggle to."

The companies at risk range across already-weakened sectors such as home builders and mortgage providers. A squeeze in the broader economy is expected to bring tougher times for trucking firms, restaurant chains and retailers.

Edward Altman, an expert on bankruptcy and corporate defaults who teaches at New York University's business school, says that if his forecasts prove correct, companies could default on more than $220 billion of high-yield corporate bonds, leveraged loans and other nonbank debt this year and next. The spike in defaults and bankruptcies, he argues, is a leading indicator of economic trouble.

'Contagion Effect'

"There is a contagion effect the credit markets have on the real economy," he says. "The traditional view had been: The economy impacts defaults, so peak defaults come at the end of a recession. But in the last two recessions, the default rate went up even before the recession."

UBS AG and Credit Suisse Group are among the banks that have recently written down the value of corporate loans on their books. They announced last week a combined $400 million decline in the value of their leveraged loans. Bank losses on corporate loans, which are expected to grow, will come on top of more than $100 billion in write-downs financial firms have taken on subprime-mortgage holdings.


One concern is that banks grappling with such losses will grow more reluctant to lend to fundamentally creditworthy companies.

"There will be big, sound, reasonable companies out there that will be left on the outside looking in," says John G. Chigounis, chairman of Global Investment Advisors, a $1.8 billion investment fund and division of Reich & Tang Asset Management LLC. "They didn't get their refinancing when they should have, and now the window is shut and the credit markets have closed."

Both Sharper Image and Lillian Vernon suffered through abysmal Christmas seasons. Lillian Vernon, a catalog and Internet retailer based in Virginia Beach, Va., has already laid off about 200 people, about half of its work force. The company said in a news release it is weighing a sale or liquidation.

At Sharper Image, sales declined 25% in 2007. Like a growing number of distressed companies, the retailer found itself unable to borrow more money in recent months, as it had done between 2004 and mid-2007, people familiar with the matter say.

Its lender, Wells Fargo & Co., was unwilling to refinance Sharper Image's debt, in part because it found no interest when it looked to sell pieces of the loan to outside investors, these people say. As a result, the retailer "never got the last $10 million" of the financing it expected, one of these people says. Keeping Sharper Image out of bankruptcy court, he says, "was going to take tremendous financing," which wasn't available in the tight credit markets. A spokeswoman for Wells Fargo declined to comment.

Sharper Image, which employs about 2,500, said yesterday it expects to close nearly half its 190 stores and reorganize the remaining operations. The company "could well be sold" during the bankruptcy process, says the person familiar with the situation, but company officials have yet to begin looking for a buyer. Calls for comment to Sharper Image weren't returned.

Sharper Image "was a classic bankruptcy, because it was a company that wasn't able to address its problems for lack of time, lack of cash, and then, lack of credit," says Ted Stenger, managing director at the turnaround and consulting firm AlixPartners LLP. "A year ago, lenders could have found time to refinance. Not anymore."

Closing Stores

Mr. Stenger says Sharper Image may eventually choose to close even more stores and adopt "premier market" strategy: Keep just a few stores in major cities like New York, and rely on its Internet, licensing and mail-order businesses.

Pressure also is building on other retailers. Kohl's Corp., Gottschalks Inc. and Bon-Ton Stores Inc., for example, all posted double-digit sales declines in December.

Bon-Ton, based in York, Pa., is trying to manage a substantial debt load as the retail outlook worsens. It employs about 33,000 at 280 stores across the Northeast and Midwest. In 2006, when money was cheap, it took on more than $1.7 billion in debt to buy 142 former Saks stores from Northern Department Store Group.

The move allowed it to expand from its core markets in New York, Pennsylvania and Ohio into Illinois, Wisconsin, Minnesota and the Dakotas. It has proved costly to integrate the two companies and to market in the new regions, among other things. The 110-year-old retailer had just $24 million in cash and cash equivalents on hand on Nov. 3, a public filing indicates.

Like many regional department stores, Bon-Ton has faced stiff competition from giants like Target. December was an especially difficult month. Bon-Ton's holiday sales were down 11.3%. It has lowered earnings projections twice since November, and its shares were trading yesterday afternoon at $7.12 on the Nasdaq Stock Market, down from $36 a year ago. A spokeswoman for the company declined to comment on its situation.

Bon-Ton has seen customer traffic drop in recent months, despite spending heavily to upgrade its stores. On the second floor of a Bon-Ton store in Lancaster, Pa., on a recent Monday afternoon, construction workers and clerks outnumbered shoppers seven to two.

The dismal Christmas season has led to numerous markdowns. For much of February, Bon-Ton's store in Reading, Pa., has been holding what it calls a Yellow Dot Clearance sale, with aisles of purses, women's apparel, men's jackets and baby clothing marked down, first by 25% to 30%, and then 70% to 75% off the marked-down price.

Last week, Moody's lowered the company's credit rating by one notch, saying that poor consumer traffic over the holidays could force the company to resort to "heavy markdowns." The ratings agency said that it believes that over the next 12 to 18 months, Bon-Ton's cash flow "will not be sufficient to cover all of the cash requirements, including the working-capital needs....Bon-Ton has limited alternative sources of liquidity since all of its assets are pledged to the bank facility and mortgage loans."

Beyond Retailers

Such adverse conditions are hitting more than just retailers. Restaurant chain Buffets Holdings Inc., which owns Ryan's Steakhouse and Old Country Buffet, recently sought bankruptcy protection. It has shut about 50 locations.

Plastech Engineered Products Inc., which makes plastic parts for car makers, also filed for bankruptcy protection recently. Like other auto suppliers, it has been hurt by declining auto sales at customers such as Ford Motor Co. and General Motors Corp. It has also moved to shed employees.

Tight credit markets are also proving a problem for companies operating under bankruptcy protection. In order for a reorganized company to emerge from court supervision, it must line up new capital, called exit financing.

Chemicals giant Solutia and auto-parts supplier Delphi have been unable to secure the billions of dollars each one needs to get out of bankruptcy proceedings. St. Louis-based Solutia, the former Monsanto chemicals division, claimed in a lawsuit that three banks backed out of a commitment to provide about $2 billion in exit financing. The banks said they terminated the deal because they couldn't find other lenders to participate in the loan.

Delphi is seeking $6.1 billion in such financing. It may need to turn to its former parent company, General Motors, for more funding if banks and lenders remain unwilling to step up.

Advisers who specialize in guiding troubled companies through such ordeals are bulking up for a restructuring boom. Miller Buckfire, for example, now numbers about 60 professionals, double where it was three years ago.

"The warning signs were there when you saw companies that had seven-times leverage decide the answer to their problems was to add more debt," says Mr. Miller. "They were doing that when the economy was getting soft. You do the math."

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