The Financing Squeeze
To hear Federal Reserve Chairman Alan Greenspan tell it, the U.S. owes a lot of its economic success over the past decade to the flexibility of its financial system. When U.S. banks savagely cut back on credit in 1990 following a collapse in property prices, American companies were able to turn to the capital markets for the financing they needed. That helped keep the last recession short and mild. And when the financial markets seized up in late 1998 after Russia's debt default, companies turned around and tapped banks for money, letting the economic expansion continue uninterrupted.
But don't look now. The twin financing faucets that have kept the U.S. economy afloat are both drying up. Since hitting a record high in March, the Standard & Poor's 500-stock index has dropped 13.5%, while the Nasdaq stock index has plunged by nearly 60%, with no firm bottom in sight. The bond market, too, is tightening; indeed, the junk-bond market has collapsed, with yields at their highest level in a decade. The combined turmoil is making it harder and costlier for companies to raise money through new issues of stocks and bonds. At the same time, banks are getting stingier with credit. Faced with mounting bad debts, they're raising interest rates on their loans, demanding more collateral, and in some cases cutting off business borrowers completely.
It's a nightmare scenario for many an executive and investor: a corporate credit crunch that, together with soaring oil prices and higher interest rates, could slow growth to a crawl and rob companies of the capital needed to fuel America's productivity miracle. "We'll be lucky if we get a soft landing," says Jason R. Trennert, managing director of ISI Group economic consultants. "The risks of a recession are rising."
What's going on? Nothing less than a fundamental reassessment of risk throughout the economy. And the growing evidence of a potential liquidity crunch seems to be everywhere. On Oct. 16, Bank of America reported that its third-quarter net income fell 15%, to $1.83 billion, as nonperforming assets jumped nearly 50%. The next day, Bank One Corp. reported a 37% drop in earnings, also in part because of dud loans. On the same day, bond guru William H. Gross, who manages the world's largest bond investments at Pacific Investment Management Co. (PIMCO), declared that he would avoid corporate bonds "at any cost" because of a deterioration of credit quality leading to more "debt defaults" in the future.
The situation is just as bad for equities, where the rout in the market, especially in technology company shares, is wreaking its own havoc with corporate financing plans. The IPO pipeline has shrunk dramatically. On Oct. 16, Verizon Wireless Communications pulled its widely anticipated initial public offering, citing poor market conditions. Since the start of October, 15 companies have postponed IPOs--more than double the amount delayed in the same period last year. Plunging stock prices have also put an end to the heady stock-financed M&A deals common earlier in the year and have called into question several pending pacts. "M&A activity in September was the lowest since November, 1996, in terms of number of deals," says Richard Peterson, chief market strategist of Thomson Financial Securities Data in Newark, N.J. "Year over year, the numbers are off by 12%."
What's behind the shift? As growth slows sharply under the impact of Fed-engineered interest-rate hikes and OPEC-induced oil-price rises, investors and bankers alike are being forced to radically rethink their overly rosy scenarios. That's true even though GDP growth, which should slow to about 3% in the third quarter from 5.6% in the second, still is strong by historical standards.
Nevertheless, the slowdown is already weakening corporate profits--and the fear is that they will continue to erode. "American business capitalized itself for a state of continuing and bountiful prosperity," says James Grant, editor of Grant's Interest Rate Observer newsletter. Corporate debt as a percentage of net worth rose to nearly 83% in the second quarter, according to Moody's--the highest level in more than seven years. That means that making debt payments could quickly get tough if earnings dry up. There's "very little room for error," says Grant. "When error is introduced, investors run for their lives."
The same worries have also sent psychology in the stock market south. "We've gone from rampant complacency to where we're beginning to see signs of panic," says Bank of America Securities LLC market strategist Thomas M. McManus. That's why investors are suddenly filled with "fear that the underpinnings of the bull market will disappear," says Joseph Battipaglia, strategist at Gruntal & Co.
FUTURE SHOCK. The angst among equity investors is clearly spilling over to the bond market. One reason: More bond dealers and institutional investors are using equity-linked computer models to estimate credit risk. The models derive asset value, leverage, and likelihood of default from the market value and volatility of a company's share price. So if the price drops precipitously, dealers and investors quickly mark down the value of its bonds as well. That hurts liquidity, since few investors want to hold bonds whose prices are falling.
Add it all up and U.S. companies can kiss goodbye to free-flowing, cheap money. Telecom investors got a terrifying glimpse of the future back in May, when GST Telecommunications Inc. filed for bankruptcy and defaulted on its bonds. Now, other telecoms that have tapped the bond and equity markets for tens of billions of dollars to finance their expansion plans face shakeouts of their own. With brutal competition undermining earnings throughout the sector, fears of more defaults are on the rise.
The most recent bad news came on Oct. 17, when Covad Communications Co., the leading independent broadband provider of digital subscriber lines, announced that some customers had not paid their bills. The stock dropped nearly 60% on the news, to $3.56, while its bonds plummeted 20 points. Covad recently raised $500 million in a convertible debt offering, but a day before its earnings announcement, Goldman, Sachs & Co. telecom analyst Frank Governali warned that debt and equity markets for upstart telecom carriers like Covad will remain largely closed through the end of the year. "If the availability of capital remains limited," says Governali, expect "additional bankruptcies."
SIGNS OF ROT. Still, it's premature to call the current financing environment a nationwide liquidity crunch, Many small companies report little trouble raising bank loans. Yet, more troubled companies are feeling the pinch. Carmike Cinemas Inc., one of the largest U.S. movie theater chains, filed for bankruptcy back in August after its banks refused to relax loan terms. And troubled copier maker Xerox Corp. said on Oct. 13 that it had failed to raise cash in the commercial paper market and was forced for the first time to tap a $7 billion bank credit line it set up in 1997.
Indeed, for weaker or risky companies, the credit crunch is already here. The yield on junk bonds now averages 13%, their highest level since the end of 1991. And new issuance is drying up. Through the first nine months of the year, only $52 billion in junk bonds have been issued, down 40% from the comparable 1999 period. Investment-grade debt has held up better, but there are signs of the rot spreading there as well. To entice investors to buy their bonds, industrial companies are having to pay higher rates relative to risk-free Treasuries. "There's a real crisis in corporate credit," says Grant. Adds PIMCO's Gross: "It will take quarters as opposed to weeks or months to play out."
Behind the market meltdown has been a gradual deterioration in credit quality that investors are just noticing. Diane Vazza, head of global-fixed-income research Standard & Poor's, a unit of BUSINESS WEEK parent McGraw-Hill Companies, says corporate debt downgrades have outnumbered upgrades for nine straight quarters. So far this year, S&P has lowered credit ratings on 325 bond issues, with a face value of $218 billion. That compares with 78 issues, or $62.3 billion, that have been upgraded.
The turmoil in the bond market has been made worse by a drying up of liquidity. The ongoing consolidation in the banking industry means that there are fewer and fewer bond dealers for investors to trade with. Investors wanting to sell bonds--especially junk issues from smaller companies--are having trouble doing so. That's feeding the sense of panic in the market.
MORE HEADACHES? With access to the financial markets closing down, where will companies turn for money? "More companies will be dropping in to renew relations with their bankers," quips Grant. But they may not get a warm welcome. The banks are facing problems of their own. Losses from large syndicated loans held by U.S. banks more than tripled to $4.7 billion this year. That's higher than in the last recession. And banking regulators think there are more headaches to come. "We do expect them to go up for a while," says Deputy Comptroller of the Currency David D. Gibbons.
It's not as if the banks didn't know what was coming. Regulators began warning them about the need to tighten up on their lending a couple of years ago. If banks had listened, much of the current crunch might have been avoided. Instead, bankruptcies are sure to rise as cash-strapped companies seek protection from their creditors. And cutbacks in capital investments to conserve precious cash may wind up slowing the economy far more than anyone had ever intended.