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February IS, 1989

eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland

Bank Lending to LBOs:
Risks and Supervisory Response
by James B. Thomson

An
increased use of debt financing
has been a hallmark of the financial
restructuring of corporate America that
has taken place in the mid- and late
1980s. An organization that develops
from a corporate reorganization now
commonly has 80 to 90 percent of its
financing in the form of debt, in contrast to the 30-percent debt-to-assets
ratio that prevailed in the previous two
decades. Because of the high degree of
leverage employed in these deals, they
are often referred to as leveraged
buyouts (LBOs), a form of highly
leveraged financings.
The news media, Congress, and the regulatory community have all focused
considerable attention on LBOs in recent months, largely because of the use
of this financing arrangement to fund
corporate takeovers. Media interest has
been heightened by the size and volume
of recent deals, particularly the reported
$25.3 billion that the firm of Kohlberg,
Kravis & Roberts paid for RJR Nabisco. The total volume of LBO deals for
1988 exceeded $98 billion.
Congressional attention concerns the
use of LBOs in takeover deals that involve a major restructuring of the acquired company. The result in such
deals may be layoffs and plant closings

ISSN 0428·1276

in communities where the acquired
firm is the major, and sometimes only,
employer. Some members of Congress
are also wary of the LBO market's
potential effect on consumer and smallbusiness credit and on the stability of
the financial system itself. Furthermore, because the tax code makes debt
financing relatively less expensive than
equity financing, Congress is concerned that tax considerations alone
may be a major motivation behind
many of the LBO deals. The LBO situation is so important that only the $100
billion thrift-industry bailout and
deposit-insurance reform take precedence over it on the 101st Congress's
agenda for regulatory reform in the
financial sector.
Bank regulators are becoming increasingly interested in bank participation in
LBO lending because of the dramatic increase in LBO credits on bank portfolios. The Comptroller of the Currency
estimates that of the $150 billion to
$180 billion in LBO debt outstanding,
$80 billion is held by U.S. banks. 1
Most of this exposure has been accumulated in recent years. In fact, estimates
of total bank lending for LBOs in 1988
may exceed $48 billion (excluding $15
billion in bank loans to RJR Nabisco).

Leveraged

buyouts (LBOs), a

popular method of corporate restructuring in the past decade, have attracted significant attention among
the news media, Congress, and bank
regulators. The huge size of recent
takeover deals and the dramatic
increase in LBO credits on bank

portfolios have raised concerns
about the risks of LBO financing.
This article examines these risks and
discusses the current response of
bank supervisory authorities to the
increased use of funding by
leveraged buyouts.

In addition,
credits

analysts

estimate

on bank portfolios

that LBO

equal

18 per-

cent of the total dollar

volume

mercial

loans and 50 per-

and industrial

cent of bank capital?

of com-

Concentration

LBO exposure

is uneven;

lished estimate

of LBO exposure

the 10 most active
market

banks

of

•

A Brief Primer on LBOs

What degree

of leverage

have in order for its financial
ing to be defined

one pub-

the Federal

in the LBO

cites a range from 40 to 140 per-

cent of equity capitalr'

System

for banks.

firms

Banks

have lent to highly

leveraged

while

market

as a

LEVERAGED

SIZEa

BUYOUTS IN 1988 BY TRANSACTION

Transaction
Size

Number of
Buyouts

Percent
of Total

Dollar
VOlumeb

their own LBO risk exposure.I

Percent
of Total $

teed by the Small

Business

tion can be defined

Administra-

as highly

However,

leveraged

the syndication

of loans for leveraged

buyouts

tional and multinational

of na-

companies

is a

Under $50 million
$50 million

105

34.5%

$2,206.6

2.2%

58

19.1%

4,086.8

4.2%

105

34.5%

22,334.0

22.7%

- $99.9 million

$100 million

- $499.9

$500 million

million

- $999.9

million

19

13,961.0

14.2%

17

Over $1 billion

6.3%
5.6%

55,687.0

the impact

are concerned

of increased

on bank soundness
the regulatory
leverage

the current
surance

guarantees

because

risk and larger

customers.

remains

For example,

was considered

of federal

deposit

intact, federal

deposit

may cause banks to under-

price the risk of LBO credits

to be highly

it resulted

ratio of 80 percent

common

in a country

highly

100.0%

$98,275.4

100.0%

these incentives,

it is likely that LBO-

related

credits

posure

in the banking

are considered

will be a point of ex-

RJR Nabisco,
table

that have

of attention

are the multibillion-dollar

lately

deals like

the data presented

the risks associated

looks at

with LBO lending

and the current

response

of federal

bank regulators

to banks'

increasing

participation

in this market.

will provide

a brief overview

Then we will examine
sociated

with lending

leveraged
outline

companies.

the current

bank regulators
ticipation
companies

First, we
of LBOs.

the risks asto these highly
Finally,

response

we will

of federal

in

to the increased

par-

of banks and bank holding
in funding

LBOs.

The last tier of

which

up 10 to 20 percent

usually

Inc., roughly

had a transaction

88 percent

lion, 19 deals were between
lion and $1 billion,

and 17 deals ex-

$1 billion.

The average

LBO transactions
million.

the market

lending,

however,

nearly 57 percent

accounting

of the $98.3 billion

in total transactions

7

for

on reasonable

be focused

real-estate

Recent

lending

agricultural

is a natural

Loans to support

experience

the problems

with
il-

that can arise

is based on inflated

values and not on accurately

for

LBO transac-

commercial

because

ings losses.

asset

projected

unexpected

the lender conduct

a sufficient

transaction

that

analysis

and of the

and that it appropriately

the risks of these loans.

earn-

essential

recession)

highly leveraged

firms'

have on many
abilities

A large part of a bank's
could conceivably

to serincome?

the valuation

company's

nounced.

as the
or

deal is an-

bank examiners

look for an internal

definition

adequately

or if there is a

downturn.

hedge against

The con-

are there procedures

pro-

are often based on a radically

reorganized

firm and on overly

tic assumptions

optimis-

about cost-cutting

sures and asset sales. These
ties make it difficult

mea-

uncertain-

to use historical

cash flows to project

loan

price

during

of lending
stable macro-

environment

1980s. Although
perience

higher

how LBO credits

loans is not

loans, it is unclear
will perform

stable macroeconomy.
leveraged

loss ex-

than for more tradi-

tional commercial

interest

of the mid-

banks'

on LBO-related

materially

to

finns has occurred

the relatively

economic

in a less

How much can

rates rise before some highly
firms can no longer meet

their debt payments?
would an economic

Does management

ability

to evaluate

management

diversification

the LBO

defaults,

service

and operating

the bank's

problems

itor their risk exposure
addition,

of these problems

LBO portfolio

on

is minimized.

to deal with
to mon-

to both indiLBO credits.

In

the banks must have estabprocedures

to handle

and docu-

the special

legal

problems associated with LBO lendIO
ing.
Finally, the adequacy of internal
will be examined.
has management

prudent

and reasonable

total amount
of exposure

diversifica-

to have in

procedures

stance,

of an LBO firm to

its debt. Through

tion, the impact

controls?

procedures

including

controls

is important.

or industry-specific

can affect the ability

have the

the target company's

For inestablished

limits on the

of exposure

and the type

to LBO credits

bank and a consolidated

(on both a

holding

com-

pany basis)?

future cash flows.

The recent expansion
leveraged

risk may not

by diversifying

Even in a robust macroeconorny,

•
highly

macroeconomic

regional-

the risk of LBO

loans?

lished policies,

be mitigated

its

and LBO loan expo-

vidual and aggregate

macro-

risks in its LBO-related

Although

of an

can the bank identify

place specific

cern is that a bank may not be able to

portfolio,

cash-flow

composition

a bank or bank holding

Banks are also expected

of collateral

Furthermore.

jections

su-

manage-

LBO exposure.

mentation

stock may double

a

LBO portfolio

go under if interest

rates rise dramatically

economic

the risk

there is less equity

It is therefore

of the proposed

of leverage

accentuates

in the firm to absorb

posi-

these risks.

the larger degree

of default,

creditor,

loans. so

be in an excellent

in LBO financing

Inc., January II, 1989, page 2.

severe economic

cash flows.

triple when a takeover

market

in evaluating

LBO portfolio

vice their debt from operating

and with

loans in the Midwest

value of a firm's

tions carry many of the same risks of
banks should

of

on col-

in Texas

Federal

ment skills and portfolio

LBO credit:

Iy a prolonged

projections

and cash flows may be difficult,

banks.

inadequate.

would emphasize

In their evaluation,

portfolio.

• Risks Associated with LBO
Credits

However,

in terms of total

primarily

should

cash flows and secondarily

However,

tion to assess and assume

deals

analysis

of bank holding

companies.

more traditional

size of

in 1988 was $327

The multibillion-dollar

dominated

$500 mil-

Lending

when lending

in the

firm may be held by non-

LBO financing

price under $500 mil-

pervisors

sure? In addition,

lustrates

of total

Some of the equity

bank subsidiaries

as LBOs by Venture

Economics,

dollar

makes

a. Deals announced or consummated in 1988.
b. Millions of dollars.
SOURCE:
BIIW!/IfS. vol. 2, issue I. Venture Economics.

lateral values.

in-

of LBO deals last year were rela-

identified

ceeded

is equity.

reorganized

tively small. Of the 304 deals in 1988
This Economic Commentary

(junk bonds).

financing.

I show that the bulk of the $98.3

billion

system.

of the total. These debentures

financing
the transactions

30

speculative

were deemed

against

procedures

in place for evaluating

of unse-

up roughly

highly

304

of secured

which consists

cured debt and makes

to be

of the

tier is mezza-

vestments

drawn the majority

of

consists

nine financing,
percent

leveraged.

folios than they would

Because

up 50 to 60 percent

a U.S.

and to

in the absence

The first tier is senior debt,

bank loans. The second

is not un-

like Japan,

have three tiers of

total and mainly

a debt-

firm with this ratio is considered

Even though

guarantees."

leveraged

Although

financing.

which makes

in a debt-to-assets

book more LBO loans for their portof deposit

the J.P. Morgan

to-assets
in-

LBOs typically

U.S. Steel in 190 I

ratio of 35 perceru."

Assuming

Totals

that constitutes

firm is a relative

deal that created

than most loans to

system

concept.

to be associated

with both increased
less-leveraged

on

leveraged

net. High levels of

safety

returns

of leverage

a highly

LBO exposure

and, ultimately,

are thought

expected

The degree

about

using their supervisory
would take action

56.7%

more recent phenomenon.
Bank regulators

Regulators,
authority,

bank only if its internal

for years. Most loans guaran-

financings.

guideliner'

firms in

TABLE 1

(deals under $500

million)

is now

debt financing

examination

leveraged

the middle

Bankers

debt financing,

Reserve

using 75 percent
general

restructur-

a firm as highly leveraged

if it has 70 percent

for

loans to highly

is not a new activity

as an LBO? There

seems to be no consensus:
Trust defines

Making

must a firm

What effects
downturn

(especial-

Current

Currently,

Supervisory
federal

supervise

bank authorities

and regulate

the banking
portfolios

system

on the activities

8

overdrafts

no addi-

Moreover,

as the bank's

to

much like the
system,

banks are being asked to define,
manage,

and impose

internal

limits on

industry
overall

Specifically.

as well

exposure

to

on both a firm and

basis. In the context

may be treated

they

of the credits

diversification,

asset portfolio,

tion of credit.

of

will pay

to the composition

total capital

the LBO portfolio,

taken to reign in daylight
in the payments

attention

and the overall

only the existing
pertain

particular

with their evaluation
bank examiners

will look at the quality

of banks participating

for bank lending

LBO loans
approach

Because

management,

of the LBO portfolio.

have been imposed

in the LBO market,
regulations

both

risks posed to

from the LBO

of banks.

tional restrictions

In conjunction

Response

of the

total LBO loans

as a specific

concentra-

In addition,
credits

analysts

estimate

on bank portfolios

that LBO

equal

18 per-

cent of the total dollar

volume

mercial

loans and 50 per-

and industrial

cent of bank capital?

of com-

Concentration

LBO exposure

is uneven;

lished estimate

of LBO exposure

the 10 most active
market

banks

of

•

A Brief Primer on LBOs

What degree

of leverage

have in order for its financial
ing to be defined

one pub-

the Federal

in the LBO

cites a range from 40 to 140 per-

cent of equity capitalr'

System

for banks.

firms

Banks

have lent to highly

leveraged

while

market

as a

LEVERAGED

SIZEa

BUYOUTS IN 1988 BY TRANSACTION

Transaction
Size

Number of
Buyouts

Percent
of Total

Dollar
VOlumeb

their own LBO risk exposure.I

Percent
of Total $

teed by the Small

Business

tion can be defined

Administra-

as highly

However,

leveraged

the syndication

of loans for leveraged

buyouts

tional and multinational

of na-

companies

is a

Under $50 million
$50 million

105

34.5%

$2,206.6

2.2%

58

19.1%

4,086.8

4.2%

105

34.5%

22,334.0

22.7%

- $99.9 million

$100 million

- $499.9

$500 million

million

- $999.9

million

19

13,961.0

14.2%

17

Over $1 billion

6.3%
5.6%

55,687.0

the impact

are concerned

of increased

on bank soundness
the regulatory
leverage

the current
surance

guarantees

because

risk and larger

customers.

remains

For example,

was considered

of federal

deposit

intact, federal

deposit

may cause banks to under-

price the risk of LBO credits

to be highly

it resulted

ratio of 80 percent

common

in a country

highly

100.0%

$98,275.4

100.0%

these incentives,

it is likely that LBO-

related

credits

posure

in the banking

are considered

will be a point of ex-

RJR Nabisco,
table

that have

of attention

are the multibillion-dollar

lately

deals like

the data presented

the risks associated

looks at

with LBO lending

and the current

response

of federal

bank regulators

to banks'

increasing

participation

in this market.

will provide

a brief overview

Then we will examine
sociated

with lending

leveraged
outline

companies.

the current

bank regulators
ticipation
companies

First, we
of LBOs.

the risks asto these highly
Finally,

response

we will

of federal

in

to the increased

par-

of banks and bank holding
in funding

LBOs.

The last tier of

which

up 10 to 20 percent

usually

Inc., roughly

had a transaction

88 percent

lion, 19 deals were between
lion and $1 billion,

and 17 deals ex-

$1 billion.

The average

LBO transactions
million.

the market

lending,

however,

nearly 57 percent

accounting

of the $98.3 billion

in total transactions

7

for

on reasonable

be focused

real-estate

Recent

lending

agricultural

is a natural

Loans to support

experience

the problems

with
il-

that can arise

is based on inflated

values and not on accurately

for

LBO transac-

commercial

because

ings losses.

asset

projected

unexpected

the lender conduct

a sufficient

transaction

that

analysis

and of the

and that it appropriately

the risks of these loans.

earn-

essential

recession)

highly leveraged

firms'

have on many
abilities

A large part of a bank's
could conceivably

to serincome?

the valuation

company's

nounced.

as the
or

deal is an-

bank examiners

look for an internal

definition

adequately

or if there is a

downturn.

hedge against

The con-

are there procedures

pro-

are often based on a radically

reorganized

firm and on overly

tic assumptions

optimis-

about cost-cutting

sures and asset sales. These
ties make it difficult

mea-

uncertain-

to use historical

cash flows to project

loan

price

during

of lending
stable macro-

environment

1980s. Although
perience

higher

how LBO credits

loans is not

loans, it is unclear
will perform

stable macroeconomy.
leveraged

loss ex-

than for more tradi-

tional commercial

interest

of the mid-

banks'

on LBO-related

materially

to

finns has occurred

the relatively

economic

in a less

How much can

rates rise before some highly
firms can no longer meet

their debt payments?
would an economic

Does management

ability

to evaluate

management

diversification

the LBO

defaults,

service

and operating

the bank's

problems

itor their risk exposure
addition,

of these problems

LBO portfolio

on

is minimized.

to deal with
to mon-

to both indiLBO credits.

In

the banks must have estabprocedures

to handle

and docu-

the special

legal

problems associated with LBO lendIO
ing.
Finally, the adequacy of internal
will be examined.
has management

prudent

and reasonable

total amount
of exposure

diversifica-

to have in

procedures

stance,

of an LBO firm to

its debt. Through

tion, the impact

controls?

procedures

including

controls

is important.

or industry-specific

can affect the ability

have the

the target company's

For inestablished

limits on the

of exposure

and the type

to LBO credits

bank and a consolidated

(on both a

holding

com-

pany basis)?

future cash flows.

The recent expansion
leveraged

risk may not

by diversifying

Even in a robust macroeconorny,

•
highly

macroeconomic

regional-

the risk of LBO

loans?

lished policies,

be mitigated

its

and LBO loan expo-

vidual and aggregate

macro-

risks in its LBO-related

Although

of an

can the bank identify

place specific

cern is that a bank may not be able to

portfolio,

cash-flow

composition

a bank or bank holding

Banks are also expected

of collateral

Furthermore.

jections

su-

manage-

LBO exposure.

mentation

stock may double

a

LBO portfolio

go under if interest

rates rise dramatically

economic

the risk

there is less equity

It is therefore

of the proposed

of leverage

accentuates

in the firm to absorb

posi-

these risks.

the larger degree

of default,

creditor,

loans. so

be in an excellent

in LBO financing

Inc., January II, 1989, page 2.

severe economic

cash flows.

triple when a takeover

market

in evaluating

LBO portfolio

vice their debt from operating

and with

loans in the Midwest

value of a firm's

tions carry many of the same risks of
banks should

of

on col-

in Texas

Federal

ment skills and portfolio

LBO credit:

Iy a prolonged

projections

and cash flows may be difficult,

banks.

inadequate.

would emphasize

In their evaluation,

portfolio.

• Risks Associated with LBO
Credits

However,

in terms of total

primarily

should

cash flows and secondarily

However,

tion to assess and assume

deals

analysis

of bank holding

companies.

more traditional

size of

in 1988 was $327

The multibillion-dollar

dominated

$500 mil-

Lending

when lending

in the

firm may be held by non-

LBO financing

price under $500 mil-

pervisors

sure? In addition,

lustrates

of total

Some of the equity

bank subsidiaries

as LBOs by Venture

Economics,

dollar

makes

a. Deals announced or consummated in 1988.
b. Millions of dollars.
SOURCE:
BIIW!/IfS. vol. 2, issue I. Venture Economics.

lateral values.

in-

of LBO deals last year were rela-

identified

ceeded

is equity.

reorganized

tively small. Of the 304 deals in 1988
This Economic Commentary

(junk bonds).

financing.

I show that the bulk of the $98.3

billion

system.

of the total. These debentures

financing
the transactions

30

speculative

were deemed

against

procedures

in place for evaluating

of unse-

up roughly

highly

304

of secured

which consists

cured debt and makes

to be

of the

tier is mezza-

vestments

drawn the majority

of

consists

nine financing,
percent

leveraged.

folios than they would

Because

up 50 to 60 percent

a U.S.

and to

in the absence

The first tier is senior debt,

bank loans. The second

is not un-

like Japan,

have three tiers of

total and mainly

a debt-

firm with this ratio is considered

Even though

guarantees."

leveraged

Although

financing.

which makes

in a debt-to-assets

book more LBO loans for their portof deposit

the J.P. Morgan

to-assets
in-

LBOs typically

U.S. Steel in 190 I

ratio of 35 perceru."

Assuming

Totals

that constitutes

firm is a relative

deal that created

than most loans to

system

concept.

to be associated

with both increased
less-leveraged

on

leveraged

net. High levels of

safety

returns

of leverage

a highly

LBO exposure

and, ultimately,

are thought

expected

The degree

about

using their supervisory
would take action

56.7%

more recent phenomenon.
Bank regulators

Regulators,
authority,

bank only if its internal

for years. Most loans guaran-

financings.

guideliner'

firms in

TABLE 1

(deals under $500

million)

is now

debt financing

examination

leveraged

the middle

Bankers

debt financing,

Reserve

using 75 percent
general

restructur-

a firm as highly leveraged

if it has 70 percent

for

loans to highly

is not a new activity

as an LBO? There

seems to be no consensus:
Trust defines

Making

must a firm

What effects
downturn

(especial-

Current

Currently,

Supervisory
federal

supervise

bank authorities

and regulate

the banking
portfolios

system

on the activities

8

overdrafts

no addi-

Moreover,

as the bank's

to

much like the
system,

banks are being asked to define,
manage,

and impose

internal

limits on

industry
overall

Specifically.

as well

exposure

to

on both a firm and

basis. In the context

may be treated

they

of the credits

diversification,

asset portfolio,

tion of credit.

of

will pay

to the composition

total capital

the LBO portfolio,

taken to reign in daylight
in the payments

attention

and the overall

only the existing
pertain

particular

with their evaluation
bank examiners

will look at the quality

of banks participating

for bank lending

LBO loans
approach

Because

management,

of the LBO portfolio.

have been imposed

in the LBO market,
regulations

both

risks posed to

from the LBO

of banks.

tional restrictions

In conjunction

Response

of the

total LBO loans

as a specific

concentra-

Another concern of bank regulators is

this approach is that banks should be al-

the syndicated loans in a bank's LBO
portfolio. To the extent that the lead
banks in the LBO loan syndicate primarily perform an investment banking

lowed to choose the risk of their
portfolio without regulatory inter-

function and retain only a small percentage of the loans on their books, the
banks purchasing the loans must conduct their own independent evaluation
of the loan. Examiners will scrutinize
this part of the portfolio to determine
the adequacy of internal procedures for
evaluating and managing the risks of
the syndicated loans. In addition, examiners are concerned with banks'
potential higher risk of obtaining liens
on collateral and participating in any
debt renegotiation.
• LBO Loans and Risk-Based
Capital Standards
Bank regulators view capital as the last
line of defense between unexpected
earnings losses on a bank's portfolio
and both uninsured bank depositors
and the regulatory safety net. The traditional approach to capital regulation
has been to set a uniform capital-toassets ratio for all banks, regardless of
their risk, and to control portfolio risk
through supervision and regulation.
This approach has been criticized for
two reasons. First, regulators do not
know with much precision how much
capital an individual bank (let alone all
banks) needs to hold to protect against
insolvency. Second, the amount of capital required to protect the federal
deposit insurance funds and uninsured
depositors from loss varies from bank
to bank depending on risk. In response
to the second criticism, bank regulators
in the United States and in the other
major developed countries have recently announced new international capital
standards for banks. II These new standards require banks to hold a level of
capital that corresponds to the credit
risk in their portfolio.
The new capital standards partition a
bank's asset portfolio into four risk
categories according to perceived
default risk. The amount of capital a
bank must hold against a particular
asset (or activity) is then determined by
its risk category. The premise behind

ference, so long as increased risk to
depositors and to the federal deposit insurance funds is offset by increased
capital protection.
Critics of the new capital guidelines
claim that they do not explicitly recognize the increased risk associated with
LBO-related loans. Under the current
risk-based capital standards, loans to
highly leveraged companies are placed
into the same risk category as more
traditional commercial and industrial
loans. This means that a bank must
hold the same amount of capital to
back up an LBO-related credit as it
would a similar credit to a lessleveraged firm.
Admittedly, the standards are not
perfect because they do not take into
account all risks. However, risk distinctions beyond those contained in the
regulatory framework are difficult to
define with precision. Additionally,
regulating risk runs the danger of introducing unwanted effects on credit allocation. More important, the riskbased ratio is only a first step in
assessing capital adequacy. As is the
case with other loans, the quality of
LBO-related loans and investments
must also be taken into account.
Moreover, the final risk-based capital
guidelines are the result of negotiation
and compromise between bank
regulators in the nations adopting the
new capital standards. Given the differences in capital structure for nonfinancial firms across countries (as
noted earlier, Japanese firms tend to be
much more leveraged than U.S. firms),
it would be difficult to gain a consensus among nations to adopt capital
guidelines that differentiate among
loans according to the leverage of the
borrower. Consequently, it is unlikely
that LBO-related loans will be assigned
their own risk class under the international capital guidelines.

• Conclusion
LBO financing is a natural market for
banks to
excellent
this risk.
much as

engage in, and they are in an
position to assess and assume
With returns on LBO loans as
four percentage points higher

than those available on more traditional
commercial loans, it appears that the
higher risk may currently be offset by
higher expected returns. 12
The high debt-to-equity ratio in the
resulting firm leaves little or no margin
for error when evaluating and pricing
these loans, however. Lenders therefore need to adopt adequate controls
and procedures for evaluating, pricing,
and managing the risks of this type of
lending activity. As long as banks
adopt appropriate internal controls,
bank regulators should reasonably expect that supervision-not
regulationis the appropriate approach to LBOrelated lending.

1. See Barbara A. Rehm, "Regulators Mull

Steel: J.P. Morgan Paved the Way for LBOs:

Changes in Fees on LBO Loans: Bank Exposure to Firms in Debt Raises Concerns,"

Bidding for RJR Nabisco Has Precedents
Dating Back to the Turn of the Century," The

-

American Banker, January 31, 1989, page I.

Wall Street Journal, Midwest Edition,

Balik of Cleveland. The author would like to

2. See Nancy J. Needham, "Son ofLDCs:

November 15, 1989,pageAl.

thank Lawrence Cuy, William Osterberg, and

Banks Are Borrowing Trouble with Loans to

7. See Buyouts, vol. 2, issue I, Venture

LBOs," Barron's, December 26, 1988, page

Economics, Inc., January II, 1989.

• Footnotes

13.

6. See George Anders, "Shades of U.S.

8. Additional reporting requirements for

3. See Sarah Bartlett, "Bankers Defend

LBO loans may be required. The Y-9 report

Buyout Loans But Investors Fret," The New

for bank holding companies may include a

York Times, October 28, 1988, page D I.

line item for LBOs in the near future. Further-

4. As I discussed in an earlier article, the

more, the federal bank regulators may

current system of federal deposit guarantees
subsidizes risk-taking behavior by banks.

change the accounting treatment of fees on
LBO credits. See Barbara A. Rehm, op. cit.

The value of the subsidy increases with the

9. For a discussion of the payments system

risk of the bank. Therefore, banks will tend

and daylight overdrafts, see E.J. Stevens,

to hold riskier portfolios than they would if

"Reducing Risk in Wire Transfer Systems,"

there were no deposit insurance subsidy. See
James B. Thomson, "Equity, Efficiency, and

Economic Review. Federal Reserve Bank of
Cleveland, Quarter 21986, pages 17-22; and

Mispriced Deposit Guarantees," Economic

E.J. Stevens, "Pricing Daylight Overdrafts,"

Commentary, Federal Reserve Bank of
Cleveland, July 15, 1986.

of Cleveland, December 1988.

5. However, not all loans to companies with

10.

Working Paper 8816, Federal Reserve Bank
Unique legal problems can arise during

75 percent debt financing are classified as

the first year of an LBO loan. mostly con-

LBOs by the Federal Reserve. In addition to

cerning fraudulent conveyance, equitable sub-

the leverage criteria, the loans must be for

ordination. and state bulk transfer laws.

the purpose of acquiring or reorganizing the
firm to be considered as LBO credits by the
Federal Reserve System.

Economic Commentary is a biweekly
below are available

through

periodical

the Public

ton, "New Guidelines for Capital: An Attempt to Reflect Risk," Business Review
Federal Reserve Bank of Philadelphia.
July/August
12.

1987, pages 19-33.

See Stan Hinden, "Executive Urges

LBO Loan Curbs: Moody's Official Sees His-

published

by the Federal

and Bank Relations

Reserve

Department,

Bank of Cleveland.

Copies

of the titles listed

216/579-2157.

James B. Thomson is an assistant vice president and economist at the Federal Reserve

Mark Sniderman for helpful comments.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

Has Manufacturing's
Presence
in the Economy Diminished?
Randall W. Eberts and John R. Swinton
1/1/88

Stable Inflation Fosters Sound Economic
Decisions
James G. Hoehn
5/1/88

The Case for Zero Inflation
William T. Gavin
and Alan C. Stockman
9/15/88

Public Infrastructure
and Economic
Development
Douglas Dalenberg and Randall W. Eberts
1/15/88

What's Happening
Compensation?
Erica L. Groshen
5/15/88

How Are the Ex-ODGF
Thrifts Doing?
Paul R. Watro
10/1/88

Bank Runs, Deposit Insurance,
and Bank Regulation, Part I
Charles T. Carlstrom
2/1/88

Debt Repayment and
Economic Adjustment
Owen F. Humpage
6/1/88

Bank Runs, Deposit Insurance,
and Bank Regulation, Part II
Charles T. Carlstrom
2/15/88

Measuring the Unseen: A Primer
on Capacity Utilization Measures
Paul W. Bauer and Mary E. Deily
6/15/88

The Bank Credit-Card
Some Explanations
and Consequences
Paul R. Watro
3/1/88

A User's Guide to CapacityUtilization Measures
Paul W. Bauer and Mary E. Deily
7/1/88

Boom:

Federal Budget Deficits: Sources
and Forecasts
John J. Erceg and Theodore G. Bernard
3/15/88

11. For a more detailed discussion of the
new capital guidelines, see Janice M. Moul-

Affairs

International
Developments
and Monetary Policy
W. Lee Hoskins
.
4/1/88
Merchandise Trade and the
Outlook for 1988
Gerald H. Anderson
4/15/88

to Labor

Three Common Misperceptions
Foreign Direct Investment
Gerald H. Anderson
7/15/88

Assessing and Resisting Inflation
Gerald H. Anderson
10/15/88
What's Happened
ing Jobs?
Randall W. Eberts
11/1/88

Productivity, Costs, and
International
Competitiveness
John J. Erceg and Theodore G. Bernard
11/15/88

About

Humphrey-Hawkins:
The July 1988
Monetary Policy Report
William T. Gavin and John N. McElravey
8/1/88
Is the Thrift Performance Gap
Widening? Evidence from Ohio
Paul R. Watro
8/15/88
Intervention and the Dollar
Owen F. Humpage
9/1/88

tory as a Warning," The Washington Post,
February 2, 1989, page F2.

to Ohio's Manufactur-

Commercial Lending of Ohio's S&Ls
Gary Whalen
12/1/88
Service-Sector Wages: the
Importance of Education
John R. Swinton
12/15/88
International
Policy Coordination:
Can We Afford It?
W. Lee Hoskins
1/1/89
Money and Velocity in the 1980s
John B. Carlson and John N. McElravey
1/15/89
Monetary Policy, Information,
and Price Stability
W. Lee Hoskins
2/1/89

BULK RATE
U.S. Postage Paid
Cleveland,OH

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387

Permit No. 385

Cleveland, OH 44101

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44101

1. See Barbara A. Rehm, "Regulators Mull

Steel: J.P. Morgan Paved the Way for LBOs:

Changes in Fees on LBO Loans: Bank Exposure to Firms in Debt Raises Concerns,"

Bidding for RJR Nabisco Has Precedents
Dating Back to the Turn of the Century," The

-

American Banker, January 31, 1989, page I.

Wall Street Journal, Midwest Edition,

Balik of Cleveland. The author would like to

2. See Nancy J. Needham, "Son ofLDCs:

November 15, 1989,pageAl.

thank Lawrence Cuy, William Osterberg, and

Banks Are Borrowing Trouble with Loans to

7. See Buyouts, vol. 2, issue I, Venture

LBOs," Barron's, December 26, 1988, page

Economics, Inc., January II, 1989.

• Footnotes

13.

6. See George Anders, "Shades of U.S.

8. Additional reporting requirements for

3. See Sarah Bartlett, "Bankers Defend

LBO loans may be required. The Y-9 report

Buyout Loans But Investors Fret," The New

for bank holding companies may include a

York Times, October 28, 1988, page D I.

line item for LBOs in the near future. Further-

4. As I discussed in an earlier article, the

more, the federal bank regulators may

current system of federal deposit guarantees
subsidizes risk-taking behavior by banks.

change the accounting treatment of fees on
LBO credits. See Barbara A. Rehm, op. cit.

The value of the subsidy increases with the

9. For a discussion of the payments system

risk of the bank. Therefore, banks will tend

and daylight overdrafts, see E.J. Stevens,

to hold riskier portfolios than they would if

"Reducing Risk in Wire Transfer Systems,"

there were no deposit insurance subsidy. See
James B. Thomson, "Equity, Efficiency, and

Economic Review. Federal Reserve Bank of
Cleveland, Quarter 21986, pages 17-22; and

Mispriced Deposit Guarantees," Economic

E.J. Stevens, "Pricing Daylight Overdrafts,"

Commentary, Federal Reserve Bank of
Cleveland, July 15, 1986.

of Cleveland, December 1988.

5. However, not all loans to companies with

10.

Working Paper 8816, Federal Reserve Bank
Unique legal problems can arise during

75 percent debt financing are classified as

the first year of an LBO loan. mostly con-

LBOs by the Federal Reserve. In addition to

cerning fraudulent conveyance, equitable sub-

the leverage criteria, the loans must be for

ordination. and state bulk transfer laws.

the purpose of acquiring or reorganizing the
firm to be considered as LBO credits by the
Federal Reserve System.

Economic Commentary is a biweekly
below are available

through

periodical

the Public

ton, "New Guidelines for Capital: An Attempt to Reflect Risk," Business Review
Federal Reserve Bank of Philadelphia.
July/August
12.

1987, pages 19-33.

See Stan Hinden, "Executive Urges

LBO Loan Curbs: Moody's Official Sees His-

published

by the Federal

and Bank Relations

Reserve

Department,

Bank of Cleveland.

Copies

of the titles listed

216/579-2157.

James B. Thomson is an assistant vice president and economist at the Federal Reserve

Mark Sniderman for helpful comments.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

Has Manufacturing's
Presence
in the Economy Diminished?
Randall W. Eberts and John R. Swinton
1/1/88

Stable Inflation Fosters Sound Economic
Decisions
James G. Hoehn
5/1/88

The Case for Zero Inflation
William T. Gavin
and Alan C. Stockman
9/15/88

Public Infrastructure
and Economic
Development
Douglas Dalenberg and Randall W. Eberts
1/15/88

What's Happening
Compensation?
Erica L. Groshen
5/15/88

How Are the Ex-ODGF
Thrifts Doing?
Paul R. Watro
10/1/88

Bank Runs, Deposit Insurance,
and Bank Regulation, Part I
Charles T. Carlstrom
2/1/88

Debt Repayment and
Economic Adjustment
Owen F. Humpage
6/1/88

Bank Runs, Deposit Insurance,
and Bank Regulation, Part II
Charles T. Carlstrom
2/15/88

Measuring the Unseen: A Primer
on Capacity Utilization Measures
Paul W. Bauer and Mary E. Deily
6/15/88

The Bank Credit-Card
Some Explanations
and Consequences
Paul R. Watro
3/1/88

A User's Guide to CapacityUtilization Measures
Paul W. Bauer and Mary E. Deily
7/1/88

Boom:

Federal Budget Deficits: Sources
and Forecasts
John J. Erceg and Theodore G. Bernard
3/15/88

11. For a more detailed discussion of the
new capital guidelines, see Janice M. Moul-

Affairs

International
Developments
and Monetary Policy
W. Lee Hoskins
.
4/1/88
Merchandise Trade and the
Outlook for 1988
Gerald H. Anderson
4/15/88

to Labor

Three Common Misperceptions
Foreign Direct Investment
Gerald H. Anderson
7/15/88

Assessing and Resisting Inflation
Gerald H. Anderson
10/15/88
What's Happened
ing Jobs?
Randall W. Eberts
11/1/88

Productivity, Costs, and
International
Competitiveness
John J. Erceg and Theodore G. Bernard
11/15/88

About

Humphrey-Hawkins:
The July 1988
Monetary Policy Report
William T. Gavin and John N. McElravey
8/1/88
Is the Thrift Performance Gap
Widening? Evidence from Ohio
Paul R. Watro
8/15/88
Intervention and the Dollar
Owen F. Humpage
9/1/88

tory as a Warning," The Washington Post,
February 2, 1989, page F2.

to Ohio's Manufactur-

Commercial Lending of Ohio's S&Ls
Gary Whalen
12/1/88
Service-Sector Wages: the
Importance of Education
John R. Swinton
12/15/88
International
Policy Coordination:
Can We Afford It?
W. Lee Hoskins
1/1/89
Money and Velocity in the 1980s
John B. Carlson and John N. McElravey
1/15/89
Monetary Policy, Information,
and Price Stability
W. Lee Hoskins
2/1/89

BULK RATE
U.S. Postage Paid
Cleveland,OH

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387

Permit No. 385

Cleveland, OH 44101

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44101