Loans to Companies in Bankruptcy Dry Up

When KB Toys filed for bankruptcy on Dec. 11, the troubled chain didn't even bother to try to stay in business. Management already had realized it would be impossible to borrow money to pay suppliers, retool the merchandise mix, and fund day-to-day operations—all critical for the company's survival. A week later the retailer moved to shut down and close its 461 stores.

With the economy rapidly deteriorating, thousands of companies are rushing to bankruptcy court in a last-ditch attempt to reorganize and improve their fortunes. Trouble is, their main source of cash is quickly evaporating. Loans to companies in bankruptcy, known as debtor-in-possession financing, have dropped from $7.9 billion in the second quarter of 2008 to $2.9 billion in the fourth quarter, according to data provider Deal Pipeline.

Without that financial lifeline, more businesses will abandon revival plans in favor of liquidation. While some purging is necessary, the worry is that the corporate contraction will be more painful than in past downturns and will only exacerbate the economy's woes. "Numerous bankrupt companies are just going to go away," says Stephen J. Czech, chief investment officer at hedge fund SJC Capital Partners, which makes corporate loans.

For years, debtor-in-possession financing was considered a lucrative, generally safe activity. Under federal rules, these lenders sit atop the capital ladder, meaning they're among the first to get paid back whether or not a business emerges from bankruptcy. The loans, which have high interest rates, are often backed by collateral such as real estate or unsold merchandise, giving creditors an added layer of protection. "Usually a lot of companies compete" to make debtor-in-possession loans, says Jay L. Westbrook, a law professor at the University of Texas at Austin.

Lacking Scope

They aren't competing anymore. Major banks are shying away from these loans. Besides a general reluctance to lend, banks and other financial firms see better opportunities in the credit market. Goldman Sachs (GS), the largest lender to bankrupt companies in 2007, doesn't even land in the top 10 today. "Nobody has the scale and scope to make up for that lost capacity," says SJC's Czech.

Although nontraditional lenders, such as hedge funds, could fill some of the void, the potential returns don't look too enticing. Sure, interest rates on debtor-in-possession loans are running at 15% to 20%. But with so much corporate debt trading at distressed prices, hedge funds can make equally fat margins buying up the old loans of companies with relatively good financial profiles. "Why would you lend to an insolvent company when you can invest in other [debt] products with [similar] risk and higher returns?" says Chris Taggert, an analyst at research firm CreditSights.

Meanwhile, the few firms still providing cash to insolvent companies, including GE Capital (GE), Citigroup (C), and Bank of America (BAC), aren't loosening their purse strings that much. Most only are rolling over existing debt for current customers rather than providing fresh capital—another hurdle for companies to overcome. Consider Circuit City Stores (CCTYQ), which filed for bankruptcy in November. The electronics chain received $1.1 billion from Bank of America, marking one of the largest debtor-in-possession deals last year. But the package included only $200 million in new money. Says Taggert: "You have to scratch the surface and see how much liquidity has been provided."

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