On Sunday, WorldCom filed for Chapter 11 bankruptcy protection, groaning under $41 billion in debt and down to its last $200 million in cash. Essentially, the long-distance giant admitted it could no longer generate sufficient cash to pay all its bills.
Yet at the same time, WorldCom announced it was lining up a new credit line of $2 billion from Citibank, J.P. Morgan Chase, and GE Capital.
Now, one would think that WorldCom, having just defaulted on a debt greater than Colombia's GNP, might get the same sort of reception from blue-chip lenders that Ann Coulter would on one of those Nation cruises. But while no self-respecting banker will loan a buck to a company on the verge of bankruptcy, America's largest financial institutions will open the till as soon as the filing is made.
The reason for this is a 1978 reform of the bankruptcy code that allows banks to provide incredibly low-risk loans to so-called "debtor-in-possession" bankrupt companies. Even banks burned by a company before its bankruptcy eagerly extend credit to the company once it's in Chapter 11. J.P. Morgan and Citibank, which are leading WorldCom's DIP financing, are the company's largest and third-largest unsecured creditors, respectively. While many areas of Wall Street are down—from underwriting initial public offerings to mergers and acquisitions—DIP is hot. The amount of such credit extended through large syndicated loans doubled between 2000 and 2001 to about $8.3 billion and could double again this year.
Once a Chapter 11 filing is made, the failed company stops making debt payments, and its creditors divide into groups, creating a caste system of forlorn financial institutions and tradespeople. The Brahmins here are the secured borrowers—those whose obligations are secured by a claim on some of the company's assets. Unsecured creditors, whose debts are secured only by the borrower's promise to pay, are far less likely to collect. Trade creditors—caterers, construction crews, interior decorators, telephone companies (WorldCom owes Verizon $125 million)—are at the bottom of the pecking order. So are employees and former employees who are owed wages and benefits. It's a tiny measure of justice that former WorldCom CEO Bernard Ebbers will have to join the queue if he wants to collect his $1.5 million annual lifetime pension.
The theory of Chapter 11, in which companies continue to operate instead of liquidating, is that by regrouping and restructuring debt, they might return to health and repay creditors over time. During Chapter 11, creditors also frequently convert their debt stakes into equity, which they can sell down the road. But in the 1970s, it became apparent that companies in bankruptcy needed access to cash to run their businesses. The problem: Nobody would lend to such companies at reasonable terms. The solution was the 1978 bill authorizing debtor-in-possession financing.
Under the law, DIP lenders essentially show up at the party after it has already started and jump to the front of the line. The last to lend, they are the first to collect. And DIP lenders enjoy enormous protections. Once they lend, a federal court order provides they receive absolute first priority of payment. What's more, DIP loans are typically secured by the very best assets a company has. In WorldCom's instance, the loans are backed by real estate and accounts receivable—bills it has yet to collect—not by its network of rapidly depreciating fiber-optic cable. Because the loans are secured to the max, DIP borrowers don't have to pay usurious rates.
It's a nice little countercyclical business for Wall Street. DIP saw its first big surge in the early 1990s, as the detritus of the leveraged buyout boom floated ashore. After laying dormant for much of the 1990s, DIP has risen drastically in the past few years. In 1998, there were 16 such syndicated loans for $2.19 billion, according to Thomson Financial. (Syndicated loans are large loans made by big banks that parcel out portions of the loan to smaller banks.) Last year, there were 56 syndicated DIP loans for $8.26 billion. As larger companies fail, the size of the loans has increased, from an average of $104 million in 1999 to $206.8 million this year. Last December, Enron lined up $1.5 billion in DIP financing, arranged by Citigroup and J.P. Morgan Chase. In March, Kmart got a $2 billion credit line, led by J.P.Morgan Chase, GE Capital, and two other banks. J.P. Morgan Chase and Citigroup have extended $1.5 billion in financing to bankrupt cable basket case Adelphia.
For the lending banks, these loans are a low-risk chance to offset some of their prior losses and part of the overall suite of services they provide to longtime clients.
DIP financing is not entirely risk-free. One of the remarkable aspects of the telecommunications meltdown is the way that the value of the hard assets like fiber-optic networks has deteriorated so rapidly. Winstar, which filed for Chapter 11 in 2001, last July took out $225 million in DIP financing. But the sale of Winstar last December only brought in $42.5 million, suggesting that its hard assets were worth far less than the bankers expected.
The good news for big DIP lenders? Thanks to the huge amount of debt they helped companies amass in the late '90s, they can expect a steady flow of business for the next few years.