When bankrupt Lyondell Chemical Co. announced it had received debt financing of $8.5 billion to continue operating in Chapter 11, the news seemed to signal the revival of the market for so-called debtor-in-possession financing. And why not? An inability to secure DIP financing, which provides funds for companies reorganizing under Chapter 11, had only weeks before forced several companies, including clothing retailer Goodys LLC and zinc miner Strategic Resource Acquisition Corp., to liquidate. But as bankruptcy professionals looked a little closer at the Lyondell deal, skepticism emerged. Was that hefty DIP for Lyondell an affirmation of a resurrected DIP financing market or an indication of something less favorable to bankrupt companies?

"The deal [Lyondell] was a self-help transaction," says one restructuring banker. The financing, he argues, was structured to protect some of the company's creditors. From his perspective, Lyondell is a less-desirable harbinger of bankruptcy in a straitened age, spawning fears of increasing conflicts not just between creditors and borrowers, but among different creditor classes.

In many ways, the clashing themes of the Lyondell deal -- part a sign that bankruptcy finance can get done, part evidence of creditor ascendancy -- encapsulates the uncertainty in a market that has moved front and center. After all, as the recession grinds on, the most active deal sector around is the one for bankruptcy and restructuring. And the financing key to bankruptcy is DIP lending. Ratings agencies estimate that default rates for high-yield borrowers could top 15%, from 7% at the end of the first quarter, according to Moody's Investors Service, many of which will end up seeking bankruptcy protection and needing DIP financing to operate.

Numbers like that threaten to take the previously obscure DIP market from a matter of bankruptcy professionals to a public policy question. The U.S. bankruptcy regime is built upon Chapter 11, meaning rehabilitation rather than liquidation. But without financing the possibility of rehabilitation, for General Motors Corp., Lyondell or any number of smaller companies, goes out the window, leaving unemployed workers and shuttered businesses in their wake.

The size of the DIP market has been increasing steadily throughout the decade despite a long period where bankruptcies fell to very low levels, according to statistics compiled by The Deal's Bankruptcy Insider. In 2001, there were 85 DIP loans, totaling $7.7 billion, with the largest, at $775 million, provided to retailer Ames Department Stores Inc. Although dollar volume has fluctuated since then, it did not drop below $7.6 billion in subsequent years, while the total number of loans rose steadily, hitting 338 in 2008. This year looks to be even busier, with 107 DIP loans doled out between January and April 11.

But some very large borrowers skew the numbers. In 2007, one DIP loan, the record-setting $10 billion extended to energy company Calpine Corp., made up the bulk of the year's total of $13.6 billion.

As Mark Cohen, head of Deutsche Bank AG's restructuring practice, explains, lax credit conditions prevalent during the credit boom bolstered DIP lending. Borrowers such as Mirant Corp., Calpine and still-struggling auto parts manufacturer Delphi Corp. of Troy, Mich., were all able during that era of easy credit to obtain multibillion-dollar DIP loans at rates that were actually lower than what they had paid for their pre-bankruptcy debt. Calpine, for example, paid only LIBOR plus 200 basis points on its DIP financing.

"It was a frothy period of time around DIPs," Cohen says, adding that lenders could easily syndicate DIP loans to yield-hungry hedge funds and collateralized loan obligation funds and were thus able to charge relatively low rates.

All that changed with the credit crunch, as the same malady that slammed other markets felled the DIP market. The nadir, in Cohen's view, came in the second half of 2007. "There was no longer enough confidence in the system for lenders to take on the risk [of making DIP loans]," he says.

Recently, however, there have been tentative signs of revival. DIP lending volume surged in the first quarter as bankrupt companies secured $13.6 billion in total DIP financing commitments, the most since early 2007. The first-quarter figure compares with $3 billion for the same period in 2008 and the paltry $2.6 billion that was loaned out in total for the last three quarters of 2007.

Superficially, it looks as though old lenders are returning to the market and new players are emerging, suggesting that risk aversion is abating as high yields again entice investors. Steve Smith, head of UBS' restructuring group, says that pricing on DIP loans is now in the range of LIBOR plus 1,000 basis points, with a 3% LIBOR floor. Add to that the numerous arranging and exit fees, and yields on the loans can approach a very attractive 20%. "This market will attract capital," he says.

But don't celebrate yet. On closer examination, signs of recovery remain mixed. The surge in DIP lending is still coming from relatively few borrowers. As the recession has forced larger companies to seek bankruptcy protection, the size of DIP packages has increased. For example, Lyondell, the U.S. subsidiary of the world's No. 3 chemical company, LyondellBasell Industries AF SCA of Rotterdam, and Aleris International Inc., a Beachwood, Ohio, aluminum manufacturer that received a $1.08 billion DIP, accounted for more than $9 billion in total DIP commitments between them.

Besides, much of the so-called funding in both the Lyondell and Aleris bankruptcies wasn't new money. Rather, it consisted of pre-existing debt that was bumped up in the capital structure through a so-called dollar-for-dollar rollup. Many professionals predict rollups will become increasingly common in future large DIP packages.

Nominally, Lyondell's DIP loan is the largest since Calpine's $10 billion in January 2007. It consists of a $6.5 billion, multiple-draw term loan and a $1.5 billion revolver that can reach $2 billion if outside lenders agree to take part in the financing. But, in reality, lenders participating in the term loan portion, including Citigroup Global Markets Inc., Goldman Sachs Lending Partners LLC, Merrill Lynch Capital Corp. and UBS Securities LLC, are putting only $3.25 billion of fresh money into the company as part of the term loan. The remaining $3.25 billion consists of existing debt that lenders are rolling up into the facility, meaning they are giving that debt the same seniority atop the capital structure as the new money.

Likewise, Aleris' $1.08 billion facility features only $440 million in new money, with the rest accounted for by existing debt loaned by Apollo ALS Holdings LP and Oaktree Capital Management LP, among others, that's being bumped up in seniority.

Existing lenders find the rollup feature attractive. The reason: Because DIP claims enjoy a higher priority than even existing senior secured bank claims, they must be paid in full in cash under a Chapter 11 plan.

Proponents of rollups argue that the structure provides struggling companies with new money that would otherwise not be available. One banker says raising $3.25 billion is a struggle these days for even healthy companies, and Lyondell had to do something to make itself attractive to lenders. Although restructuring lawyers and bankers say judges tend not to like the idea of rollups because they put nonparticipating creditors at a disadvantage, few choices are available these days.

"This was the company's only shot at getting a DIP," says one banker who was involved in the deal. "Its only other choice was liquidation."

Tempering criticism of the structure is that Lyondell's rollup, which did cram down other lenders in terms of seniority, doesn't enjoy the same protections as the new money in the deal. In fact, Simpson Thacher & Bartlett LLP attorney Stephan Feder, who advised UBS on the Lyondell financing, says that instead of being guaranteed cash payments upon exit, the rollup portion of the DIP can, at the company's discretion, be rolled over into a new exit facility, removing a potentially intimidating obstacle to exit.

Still, most of the benefit of such a structure lies with senior lenders. And, in Lyondell, that benefit came at the expense of subordinated creditors who were not invited to join.

According to one banker involved in the talks, lenders waited until the last minute over the Christmas holidays to propose the rollup, mainly because they wanted to limit the number of participants, reducing opportunities for dissent and protecting more of the prepetition debt for themselves.

Not surprisingly, this led to conflict within the creditor group, and junior lenders sued to stop the deal from going forward.

They argued that the new facility was negotiated in bad faith and its one-year term didn't provide the company with enough time to reorganize.

According to Standard & Poor's Leveraged Commentary & Data, Judge Robert Gerber overruled those objections, although he agreed to grant more time for the company to submit a rough reorganization plan and extended the Dec. 15 maturity for the DIP by one week.

"This does set up the potential for valuation fights," says a banker involved in the deal, noting that crammed-down creditors will now have to fight harder to protect any value left in the company, which will make things complicated on the other side of Chapter 11. "Lyondell could have a harder time emerging from bankruptcy," he says.

Another fear: that the type of "defensive DIP" the Lyondell rollup characterized could come at the expense of the reorganizing company. As Harvey Miller, a senior partner at Weil, Gotshal & Manges LLP's restructuring practice, described it during a March 11 congressional hearing, "The term [defensive DIP] is a misnomer. Financings by pre-Chapter 11 secured creditors have become offensive."

Take Circuit City Stores Inc. The company announced on Nov. 10 with a dash of optimism it was filing for Chapter 11. "The decision to restructure the business through a Chapter 11 filing should provide us with the opportunity to strengthen our balance sheet, create a more efficient expense structure and ultimately position the company to compete more effectively," said Circuit City's acting CEO James Marcum.

At least that was the theory. In hindsight, Marcum's Nov. 10 statement appears delusional. Only two months after that announcement, the electronics retailer went out of business, tossing 30,000 people onto unemployment rolls. "The company was a dog. It wasn't going to survive," says one restructuring banker, noting that Circuit City had announced it was shuttering 20% of its stores only a week before filing for bankruptcy.

Why the initial optimism? And why didn't Circuit City go straight into liquidation, instead of filing for Chapter 11 with the aim of exiting as a healthier company? The answer: The company's senior creditors wanted to protect their interests, which drove the process, even over the company's own prerogatives. "That's what creditors are supposed to do," says Eric Goodison, an attorney in Paul, Weiss, Rifkind, Wharton & Garrison LLP's financing practice. "Creditors don't owe a company anything other than their contractual duties."

At the time of its filing, Circuit City announced it was receiving $1.1 billion in DIP financing. However, the structure of the DIP virtually assured liquidation within months but did so in a manner that allowed creditors to wait out the holiday season, then pull the plug after securing their debt's seniority. The telltale sign: Despite its size, the DIP loan, led by Banc of America Securities LLC, General Electric Capital Markets Inc. and Wells Fargo Retail Finance LLC, contained only $350 million of new money and rolled up about $898 million on Circuit City's $1.3 billion prepetition credit line.

Miller argued in his testimony that the DIP terms didn't give Circuit City a chance to survive. The loan, he said, made it extremely difficult for Circuit City to function by restricting the extent to which the electronics retailer could draw on the facility, limiting its freedom to restructure and charging the company heavily for its use. "The potential new money was likely inadequate to support the reorganization effort of Circuit City," he said.

Of course, it's not as though Circuit City -- like Lyondell -- had much choice. As Miller himself says, "The problem with DIP financing in the current environment is that there isn't any available [from traditional DIP lenders]." Loans that are available, he says, are "extraordinarily onerous."

This absence of alternatives makes it easier for existing lenders to demand their pound of flesh.

In fact, it's unlikely that any large-scale borrower in today's market will be able to get money by cobbling together syndicates of new money, given that traditional DIP lenders such as Cerberus Capital Management LP subsidiary Abelco Finance LLC, Silver Point Capital LP and Angelo, Gordon & Co. have relatively limited capacity to meet multibillion-dollar needs of a growing pool of borrowers. The lending pool has also been shrinking, through the disappearance of firms such as Lehman Brothers Inc., and the hobbling of formerly reliable lenders including CIT Group Inc. and GE Capital Corp. Several sources have confirmed that GE, in particular, has seemed hesitant to put money forward, most recently pulling back from committing $600 million of new money to a DIP loan to Canadian pulp and paper company AbitibiBowater Inc. Abitibi filed for bankruptcy protection on April 16, receiving a $200 million DIP from Fairfax Financial Holdings Ltd. and Avenue Management LLC.

This dearth of new money gives active lenders more power in negotiations with borrowers. Tim Coleman, co-head of Blackstone Group LP's restructuring unit, says new money is available, but it's limited to the smaller end of the market. "There are really two DIP markets," he says. "One is the third-party market of under $1 billion, and the other is the market for existing lenders. Those deals can be much bigger."

With negotiating leverage in hand, senior lenders can curb their risk by including short maturities, restrictive cash flow covenants and fast-paced sale deadlines.

One banker argues that the situation is not a matter of lenders' greed or the banks' desire to pursue self-interest at all costs. Regulatory considerations constrain banks. Under international banking regulations, DIP loans are rated at the low end of banks' internal ratings models, as if they were defaulted securities. This occurs despite the absolute priority they get and effectively makes DIP loans expensive for banks. "It's a disaster from a regulatory capital standpoint," he says. "The returns are great, but I still have to justify to my creditors' committee it's worth the capital hit."

Making things even more difficult for borrowers is that exit financings, which are meant to replace DIP loans once a company leaves Chapter 11, are even more scarce than DIPs themselves. Bankruptcy Insider's statistics show only about $10 billion in exit financings done in 2008 (excluding a $13.6 billion financing for a Canadian asset-backed commercial paper vehicle). That compared with $34 billion in 2007 and $27 billion in 2006. For the first quarter, exits have totaled $4.1 billion, a 36% drop from the fourth quarter's $6.5 billion.

Given all this, it's not as if the banks are irrational. DIP loans are not risk-free, and if anyone needs a reminder, they just have to look at the continuing struggles of Delphi, the bankrupt auto parts supplier. "Delphi is the poster boy for no exits," says Simpson Thacher's Feder. A restructuring adviser adds, "Delphi is absolutely weighing on people's minds."

It's been a long haul for Delphi, which declared bankruptcy in 2005 after losing $700 million. Since then, it has obtained $4.586 billion in DIP financing from a consortium of lenders including J.P. Morgan Chase & Co. and Citigroup Inc. But it hasn't been able to exit as it struggles to craft a reorganization plan dealing with myriad issues, from union renegotiations to unraveling its complex relationships with former parent GM.

Delphi actually flirted with an exit late in 2006, when a consortium led by David Tepper's hedge fund, Appaloosa Management LP, and including Cerberus Capital, Harbinger Capital Partners Master Fund I Ltd., Merrill Lynch & Co. and UBS Securities LLC, agreed to provide $3.4 billion to the company. But that deal fell apart in April 2008 after investors pulled out, citing material adverse changes and leaving DIP lenders to support the operation.

Deutsche Bank's Cohen calls the Delphi situation "unique" in that it is inextricably tied to the fate of a cratering auto industry and to GM. In fact, GM has provided roughly $950 million in liquidity to Delphi following a settlement between the companies in 2007, a key component of the reorganization plan that Delphi had been putting together until the Appaloosa consortium withdrew. "It's difficult to have a sense of Delphi's future cash flow and earnings without understanding the problems with GM," Cohen says.

Delphi most recently asked for, and received, an extension on its DIP to June. The company, however, faced an April 17 deadline to file a term sheet with the Treasury Department and GM that outlines its plan to resolve outstanding problems related to its 1999 spinoff from GM.

According to filings with the Securities and Exchange Commission, if Treasury, GM or Delphi's senior lenders don't approve the term sheet, the company will have to pay back its loans on April 20, which would mean the end of the company. Although few expect that to happen, sources close to the talks say senior lenders to Delphi have indicated they've had enough and aren't willing to extend further lifelines.

"The question [for lenders] is: How much money are you going to keep throwing at them?" says one banker representing some Delphi creditors.

Although the government's role in Delphi is unique, given its ties to GM, and the administration's avowed interest in keeping GM afloat, it is becoming clear that government intervention, both in specific deals and in the broader market, looks increasingly possible. The government thus looms over the DIP market, not just because of its involvement with Detroit -- if GM went into bankruptcy, the federal government would probably have to be the DIP lender of last resort -- but in the event that bankruptcies occurred in such numbers that private lenders were overwhelmed.

"There's much more demand for DIP loans than there is anywhere close to enough supply," says Paul Weiss' Goodison. Even with new lenders, it may not be enough. "The government's next bailout fund is going to be a DIP fund," declares one restructuring banker.

Weil Gotshal's Miller puts it this way: "The federal government believes that reorganization [of certain businesses] is necessary for the economy, so there ought to be some facility backstopped by the federal government to provide DIP financing at a reasonable rate of interest that would enable these companies to reorganize."

That, after all, is the point of all of this.