A Hole in the Middle of the Recovery
Although the U.S. is far from out of the woods, we have avoid-
ed sinking into a depression, prevented a systemic meltdown
of the financial system, and taken positive steps to thaw the
credit markets and increase lending activity. People may dis-
agree on the size, scope, implementation, or ultimate success of
the recovery initiatives, but it is unlikely that many believe the
government programs – ranging from propping up automak-
ers to financing the purchase of mortgage-backed securities –
are anything but comprehensive. However, the government’s
efforts to revive the credit markets have largely excluded a
significant driver of the U.S. economy – middle market com-
panies. Mid-size companies, too large for SBA loans but too
small to issue bonds or benefit from other government pro-
grams, have been largely shut out of the government’s stimulus
efforts and the improving debt markets. According to a recent
study, nearly a third of middle market companies surveyed are
having difficulty accessing credit, and nearly 40% expect the
availability of credit to negatively impact their business going
forward . In fact, by some measures middle market loan vol-
1
ume has fallen by nearly 50% in 2009 . Given the importance
2
of the middle market to the overall economy, it is difficult
to envision a sustained recovery taking place without
mid-size companies.
No formal definition exists for what constitutes the middle
market. Some place cut-offs at revenue of between $20 and
$500 million. Still others draw the dividing lines at $5 to $50
million in EBITDA. No matter the exact criteria, these not so
small but not quite behemoth companies are a driving force in
the U.S. economy. According to U.S. Census data, firms with
revenues of $10 to $500 million account for nearly 32 million
1 Merrill Lynch & Co. High Yield index
Bill Millar, U.S. Middle Market Outlook 2009: Navigating the Credit
Crunch (Forbes Insights, 2009)
2 7
Thomson Reuters, LoanConnector
CastleGuard Partners, LLC - August 2009
jobs, or 28% of total U.S. employment3. As a point of refer-
ence, large firms with revenues of $1 billion or more account
for 29% of employment. The impact of mid-size businesses on
GDP is not small either. Companies with $10 - $500 million
in revenue generate a combined $6 trillion in annual sales. In
addition, companies with less than 500 employees accounted
for 70% of net new job creation over the past decade accord-
ing to the SBA. Admittedly, these figures capture the impact
of both small and mid-sized companies. Nonetheless, middle
market firms are clearly an important driver of both the current
base of employment and job growth.
The credit markets have improved substantially since the
collapse of Lehman Brothers. The spread on high yield bonds
recently dropped to 9.88% above Treasuries, below the 10%
‘distressed’ threshold4. Many large companies have taken
advantage of the loosening public debt markets by issuing
bonds to replace term loans with near-term maturities. In
the first half of 2009, $59.2 billion of high yield bonds were
issued in the U.S., a 59% increase from the first half of 20085.
However, mid-size firms are generally too small to issue public
debt, so these companies have not benefited from the recent
liquidity in the high yield market. Middle market loan activity
contrasts sharply with the large cap debt markets. Year-over-
year, middle market loan issuance fell 49% to $27.7 billion
in the first half of 20096. Given that $15.6 billion of middle
market loans were scheduled to mature during the first six
months of 2009, net new credit issuance was far less than $28
billion7. In the secondary market, the average middle market
senior loan continues to trade below 80 cents on the dollar 8.
3
Note: excludes self-employment
4
5
SIFMA, U.S. Corporate Bond Issuance (2009)
6
Thomson Reuters, LoanConnector
Ibid
8
Ibid
A Hole in the Middle of the Recovery, Page 1 of 5
Why has middle market lending been left behind? First, many
middle market lenders utilized collateralized loan obligations
(CLOs) to syndicate loan exposure. Although CLOs and other
structured products have been demonized in the aftermath of
the crisis, these vehicles serve an important role in the credit
markets. CLOs allow lenders to generate fresh capital from
a broad base of investors and assist in matching the duration
of assets and liabilities. In fact, as much as 25% - 50% of all
syndicated middle market loan volume may have been sold
into CLO vehicles . As the CLO market came to a standstill
9
in 2008, a major source of capital for middle market loan
origination was cut off. Second, during the up-cycle, GE
Capital and other large players consolidated an already
significant share of the market. Third, regional banks have been
acutely impacted by souring real estate loans10. This weakened
capital base has inhibited the capacity of many regional banks
to extend new loans. Finally, the middle market has been
shut out of the government stimulus that has bolstered other
segments of the credit market.
Government Programs
Despite the importance of the middle market to the economy
and the dearth of credit available to these companies, the gov-
ernment recovery initiatives have done little to stabilize lending
in this market. In fact, the Federal Reserve and the U.S. Trea-
sury have created programs that directly support nearly every
segment of the credit markets, ranging from credit card debt
to commercial mortgages, except for middle market corporate
loans. Admittedly, the government’s actions to stabilize the
broader financial system have buoyed every asset class, includ-
ing middle market loans. The purpose of this article is not to
suggest that the government erred in allocating recovery funds
to the asset classes it has thus far chosen to support. Rather, the
intent is to illustrate how the government recovery efforts have
covered a great deal of ground, but have left mid-size compa-
nies behind. A brief survey of the major government recovery
programs illustrates this point.
9
Standard & Poor’s LCD
10
Matthias Rieker, Regional Banks’ Loan-Loss Increases
Stir Fresh Concerns (Wall Street Journal, 2009)
CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 2 of 5
Public-Private Investment Program
The Public-Private Investment Program (PPIP) is a $30
billion U.S. Treasury initiative facilitating the removal of trou-
bled legacy residential mortgage-backed securities (RMBS)
and commercial mortgage-backed securities (CMBS) that have
been clogging banks’ balance sheets. The U.S. Treasury will
provide attractive debt financing and invest equity alongside
private sector investment managers under the Legacy Securi-
ties Program (LSP). Addressing the withering real estate assets
that have played such a large role in creating the problems that
banks now face is clearly a positive step for the credit mar-
kets. However, the companion plan, the Legacy Loan Program
(LLP), designed to finance the purchase of troubled loans, has
not yet gotten off the ground. Similar to the LSP, this program
would attempt to bridge the valuation gap between banks and
investors and allow banks to sell loans in order to access fresh
capital. The U.S. Treasury and FDIC have stated that this pro-
gram will be scaled back significantly from its original design.
The FDIC’s rationale? “Banks have been able to raise capi-
tal without having to sell bad assets through the LLP, which
reflects renewed investor confidence in our banking system,”
according to FDIC Chairman Sheila Bair.
While it is true that many of the largest banks have successfully
raised capital, the same cannot be said for small and mid-sized
institutions. Furthermore, the “toxic” securities that will be
addressed by the LSP are only an issue for a relatively small
fraction of U.S. banks11. This leads to a bifurcation in the
health of the credit markets in which the availability of credit
for large companies (primarily served by large financial insti-
tutions) has improved significantly, while small and mid-size
borrowers struggle to obtain debt financing.
There is no question that distressed mortgage-backed securities
languishing on banks’ balance sheets are a serious problem that
requires attention. If successful, the LSP will improve banks’
liquidity and boost the health of the broader financial system.
However, this program will likely have only a modest impact
on the extension of credit to middle market companies.
11
David Enrich, Liz Rappaport & Jenny Strasburg, Wary Banks Hobble
Toxic-Asset Plan (Wall Street Journal, 2009)
Term Asset-Backed Securities Loan Facility
The Term Asset-Backed Securities Loan Facility (TALF) is a
$1 trillion initiative intended to resuscitate the securitization
market for asset-backed securities (ABS) and CMBS. The N.Y.
Federal Reserve provides financing to qualified purchasers of
eligible securities. Eligible ABS include securities collateral-
ized by credit card loans, auto loans, student loans, and small
business loans guaranteed by the SBA. TALF is largely focused
on financing the purchase of newly issued securities (although
legacy CMBS were later added to the program). Lenders to
these markets securitize loans in order to generate fresh capital
for new loans. By facilitating the securitization of loans, the
government is hoping to boost the volume of capital flowing
into the ABS/CMBS new issuance markets and, in turn, spark
increased lending activity.
In recent months, spreads have narrowed considerably in both
the ABS and CMBS markets (although TALF’s CMBS fund-
ing has been fairly small to date)12. A renewed flow of capital
into ABS and CMBS is clearly a positive sign for the health of
the credit markets. However, the impact of these inflows on
asset classes beyond real estate and consumer loans appears to
be limited. During the twelve months ending June 1, 2009,
commercial and industrial loans outstanding at U.S. commer-
cial banks declined 3.3%, while consumer and real estate loan
balances each grew more than 5%13. In fact, the amount of
commercial and industrial loans fell each of the first six months
of 200914. Only time will tell if these figures reflect a mod-
est extension of credit masked by the natural deleveraging of
an overheated economy, or a continued breakdown in the
credit markets.
Small Business Administration Stimulus Programs
When accused of neglecting mid-sized companies, the govern-
ment has often cited programs related to the SBA15. Specifi-
cally, the U.S. Treasury and SBA have increased the percentage
12
JP Morgan
13
Federal Reserve, Assets and Liabilities of Commercial Banks
in the United States - H.8 (2009)
14
Ibid
15
Jonathan Weisman, Small Businesses Have a
New Beef With White House (Wall Street Journal, 2009)
CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 3 of 5
of SBA loans guaranteed by the government to 90% from 75%
or 85% (depending on the type of loan), deemed SBA guaran-
teed loans eligible for TALF financing, reduced loan fees, and
allocated $15 billion for the purchase of SBA loans in the sec-
ondary market (although this funding has yet to be deployed).
While these programs are well intentioned and crucial to the
development of small businesses, these efforts do not address
the needs of the middle market. In order to be eligible for
the SBA program, loans must not exceed $2 million. While
adequate for a truly “small” business, this falls far short of the
amount of funding required by most middle market compa-
nies. A $2 million loan is insufficient to provide basic work-
ing capital or capital expenditure financing for most mid-size
firms. It is almost as if the government believes companies are
either fledgling, single location operations or titans of the S&P
500, and no companies exist in the space between.
Troubled Asset Relief Program
The Troubled Asset Relief Program (TARP) is the umbrella eco-
nomic recovery program. In fact, TARP provides a significant
amount of the funding for PPIP, TALF, and the supplemental
SBA programs. TARP’s recovery efforts also include stabiliz-
ing the auto industry, providing assistance to homeowners, and
propping up a variety of financial institutions large and small.
Clearly, middle market lending institutions that received assis-
tance from TARP benefited from this program. Furthermore,
the impact of this support extends beyond the individual in-
stitution (counterparties, asset classes in which the institution
invests, and the broader economy). However, the trickledown
effect of the TARP stimulus on mid-market loans is not nearly
as powerful as programs designed to directly stimulate a spe-
cific asset class (e.g., the TALF program’s impact on ABS). It
is unclear why the Fed/Treasury would directly support asset
classes such as credit card debt, commercial mortgages, and
small business loans but shun credit for mid-sized companies.
Potential Solutions
One solution to the anemic lending activity in the middle
market is to move forward with the previously announced
LLP. The program would provide financing to private inves-
tors purchasing portfolios of loans from banks. If the FDIC
believes this program is unnecessary because (large) banks have
succeeded in raising private capital, then why not limit the
program to institutions with less than $5 billion in assets or
simply to those still experiencing difficulty raising capital. The
LLP has the potential to improve the liquidity of participating
institutions and attract capital into the secondary market for
corporate loans, just as TALF and the LSP have done for the
CMBS market (despite less than $700 million of actual gov-
ernment funding hitting the CMBS market as of July 2009)16.
TALF is another existing program that could be used to
provide support to mid-size companies. Expanding the scope
of TALF to provide financing for recently issued CLOs would
generate fresh capital for new corporate lending. As CLO
issuances have effectively ceased in 2009, lenders have seen
a critical source of “dry powder” cut off. $16.4 billion of
CLOs backed by investment grade and high yield loans and
bonds were issued in the four quarters ending June 30, 2009.
This compares to $51.8 billion of such CLOs issued in 2004 –
before the credit cycle took off . 17
The biggest hurdle to the inclusion of CLOs in the TALF
program may be the fear of a public relations backlash. The
government might step into a firestorm of criticism if detrac-
tors viewed the program as “supporting leveraged buyouts,”
as debt used to finance LBOs fueled a meaningful portion of
the CLO market. However, according to Thomson Reuters
74% of the upcoming middle market debt maturities are non-
sponsored (i.e., a private equity firm does not control the bor-
rower)18. Nonetheless, these criticisms could be easily avoided
by thoughtfully structuring the program. First, only CLOs
with recently originated loans could be eligible for the pro-
gram. This provision is in line with the original goal of the
TALF program and similar to the rules governing TALF fund-
ing for ABS. Given the meager level of LBO activity in the
16
N.Y. Federal Reserve
17
Securities Industry and Financial Markets Association, Global CDO Data
(2009)
18
Diana Diquez, 2Q09 Review and 3Q09 Preview: Better times ahead?
(Thomson Reuters, 2009)
CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 4 of 5
past 12 months, this provision alone would go a long way to-
wards preventing a populist public relations headache. Second,
the government could impose limitations on the leverage of
the underlying companies. This would allow the N.Y. Fed-
eral Reserve to facilitate access to fresh capital without placing
the administration in a compromising political position. If
the CLO issuance market returned, even at a modest volume,
the availability of loans to middle market companies would be
greatly improved.
It is important to note that the financing offered by TALF for
newly issued CMBS is very different from every other recovery
program. This is not a means of supporting Main Street by
encouraging consumer lending, increasing the availability of
home mortgages, or even restructuring banks’ balance sheets
(only commercial mortgages issued after July 1, 2008 are eli-
gible collateral). Offering financing for recently issued CMBS
encourages capital to flow to originators of commercial mort-
gages in order to allow these firms to fund new mortgages. At
the end of the day, this program benefits commercial real estate
lenders and investors (such as REITs and real estate private eq-
uity funds) – not the average U.S. citizen. Why is the Federal
Reserve comfortable supporting investors in shopping malls
and office buildings, but not other classes of investors?
The government is correct to be concerned about the impact
that the halted $700 billion CMBS market will have on the
broader economy, particularly as debt issued during the real
estate boom begins to mature19. However, the government
should also be alarmed about the $450 billion in middle mar-
ket loans maturing over the next four years20. Meaningful par-
allels exist between the CMBS and CLO markets. However,
the government has chosen to support real estate lending to a
much greater extent than corporate lending. Real estate loans
may have sparked many of the current problems in the credit
markets, but an economic recovery cannot occur without a
healthy corporate lending market. Perhaps the most important
19
Hui-yong Yu & Sarah Mulholland Property Bond Sales May Resume With
$3 Billion (Bloomberg, 2009)
20
Thomson Reuters, LoanConnector
distinction between the two asset classes is the far greater job Perhaps even more daunting is the prospect of large numbers
losses that would result if companies, as opposed to buildings, of mid-size companies unable to refinance maturing debt as
cannot refinance their debt. a result of diminished lending capacity. The Federal Reserve
and U.S. Treasury must take steps to encourage capital to
Another potential stimulus to the credit markets would be to return to middle market lending. Otherwise, the government
temporarily remove the unfavorable tax treatment for debt may see the recovery, which has been building steam, begin
trading below par. Holders of debt securities that are pur- to stumble.
chased at a discount must either amortize the discount into
interest income annually or pay taxes on the amount of the
discount at ordinary income rates as principal is received and
when the instrument matures or is sold. The bottom line is
that the discount is not taxed at long-term capital gains rates,
even when the security is held for more than a year. In con-
trast, shares of a dividend paying stock purchased at a discount
to fundamental value are eligible for long-term capital gains
treatment. Changing the taxation of debt bought at a market
discount would increase capital flows into this market. While
this would not directly drive new loan origination, it would
allow banks to receive fresh capital by selling loans and also
provide a boost to the legacy and new issuance CLO market.

An additional option to improve middle market lending would

be to increase the size limit on SBA loans. However, in order
to have a meaningful impact on middle market companies, the
maximum loan size would need to be increased at least tenfold
to $20 million. It is unclear whether the government is will-
ing to provide the SBA with the funding necessary to increase
the size and scope of its operations. Furthermore, this may be
a less efficient option than encouraging private capital to flow
into middle market lending through stimulus programs such
as TALF.

Summary
The government has been appropriately concerned about
the availability of debt capital in the economy and has tak-
en a number of positive steps to restore the credit markets.
However, limited support has been extended to middle mar-
ket companies. It is unlikely that meaningful job creation will
occur until middle market companies, which represent nearly
a third of U.S. employment, have sufficient access to credit.
CastleGuard Partners, LLC, based in the Chicago area, is a
provider of debt capital to middle market companies. CastleGuard
originates new loans, refinances maturating debt, participates
in special situations lending, and invests in loans trading in the
secondary market.
For more information, please visit www.castleguardllc.com
info@castleguardllc.com
phone 847-201-3600 fax 847-201-3603
2700 Patriot Blvd, Suite 420 Glenview, IL 60026

CastleGuard Partners, LLC - August 2009 A Hole in the Middle of the Recovery, Page 5 of 5