A New Credit Crunch
When the economy was last struggling to come out of a recession more than a decade ago, it was held back by what Federal Reserve Chairman Alan Greenspan described as financial headwinds. Banks, smarting from a string of loan losses from a commercial real estate boom gone bust, curtailed credit to all but the most worthy. Rather than roaring out of the recession, the economy was forced to fight its way through a credit crunch into a tepid recovery.
Sound familiar? The implosion of Enron Corp. (ENE ) in a mushroom cloud of scandal has profoundly rocked Americans' perceptions of financial markets, accounting practices, and corporate ethics. And it has led to a fundamental reassessment of risk throughout the economy as investors, banks, and rating agencies grapple with the realization that profit statements may not be what they seem. All that heightened doubt is leading in one direction: costlier credit that will put a crimp in corporate spending plans and act as drag on growth just as the recovery is getting under way.
For the Federal Reserve, that means holding off on raising interest rates as it struggles to rev up the economy. For banks, it means bracing for another hit to profits. Bank earnings are expected to fall 10% in 2002 as bad loans eat into profits. And for companies, it means treacherous waters in which any hint of trouble could threaten to capsize the ship. The latest: Shares of Computer Associates International (CA ) in Islandia, N.Y., tumbled 13.5% on Feb. 6, after Moody's Investors Service said it might downgrade the software maker's credit rating because of ebbing cash flow.
Worried that other Enrons are lurking in the shadows and stunned by the meltdown of such high-profile companies as Kmart Corp. (KM ) Investors are treading cautiously. They're selling shares of former highfliers that use accounting gimmicks they don't understand and even questioning such blue-chip stars as General Electric Co. (GE ). And they're demanding that many companies pay top dollar for access to debt markets, in some cases forcing companies to turn to banks for even more costly cash. A prime example: Tyco International Ltd. (TYC ) and its finance arm, CIT, which in early February had to tap up to $14.4 billion in credit lines from its banks after being shut out of the commercial-paper market.
But banks are getting stingier, too. Stung by the demise of Enron and other high-profile bankruptcies, they're tightening lending terms and cutting off companies that don't pass muster. "Banks are nervous, investors are nervous, everyone's nervous," says Howard E. Janzen, CEO of embattled telecom Williams Communications Group Inc. (WCG ) in Tulsa, which is in heated loan negotiations with its banks.
Throughout the boom of the 1990s, banks stretched lending to the limit, extending cash to companies and consumers at a rapid pace. Now, this aggressive lending is coming home to roost. Bad loans at big commercial banks have jumped nearly 30%, to more than $25 billion, according to the Federal Deposit Insurance Corp. Throughout the fourth quarter of 2001, lenders warned that they were slashing their earnings estimates to write off bad loans and take reserves against bad debt through 2002. At FleetBoston Financial Corp. (FBF ), the cost was $1.2 billion. J.P. Morgan Chase & Co. (JPM ) lopped off $807 million. PNC Financial Services Group Inc. (PNC ) knocked off $615 million--then subtracted $155 million more after the Securities & Exchange Commission advised it to change its accounting. In the first half of 2002, bad commercial loans are expected to jump 20%, says Salomon Smith Barney.
That may not be the worst of it. There's also the credit banks have extended that isn't on balance sheets--and for which they have no reserves. Banks have nearly tripled their off-balance-sheet credit lines since the last recession, to about $5 trillion outstanding, notes Prudential Securities Inc. analyst Michael Mayo. Banks tack these lines of credit onto a loan to sweeten the terms of the deal. Generally, they're unused until a company gets in trouble.
As if that weren't enough, banks have heartily embraced another off-balance-sheet risk in the past decade that analysts say is nearly impossible to quantify. "Credit derivatives" act as insurance for a company that invests in a corporate bond or loan. If the debt goes bad, the company that issued the derivative pays the debtholder. Banks, including J.P. Morgan Chase, Citigroup (C ), and Bank of America (BAC ) are the major issuers of derivatives in the $1 trillion market.
But don't expect to find their exposure on the balance sheet. Credit-derivative activity is generally listed in the footnotes, if at all. The downside can be brutal. J.P. Morgan Chase surprised markets when it said in mid-December that its unsecured exposure to Enron was triple original estimates, in part because of credit derivatives.
When you add it all up, the outlook could be grim for banks and their borrowers. Expect banks to play cleanup well into 2002. That means many will opt to lend less. Says the head of commercial lending at a top five bank: "You're going to see banks get tougher on terms, loans, and prices." Most affected will be corporate borrowers that rely on the same sort of aggressive accounting that Enron did--financial engineering, a steady stream of acquisitions, or off-balance-sheet entities to make their numbers. But even conservative companies could be hurt. "We're concerned that the general credit market will tighten up more," says Bruce W. Smith, CFO of Atlanta-based biotech Theragenics Corp. (TGX ) "Enron is just putting further pressure on large banks that already feel under the gun."
Enron's demise has sent shock waves throughout the financial markets as well. The multibillion-dollar commercial-paper market that companies use to raise short-term money had already shrunk by a third last year as investors simply refused to finance many firms deemed too risky. Now, in the wake of Enron's collapse and growing doubts about corporate accounting, many companies still in the market are finding they're having to pay more to issue commercial paper. In some cases, they're paying up to a quarter percentage point extra.
Enronitis has also sent borrowing costs higher in the corporate-bond market in recent weeks as nervous investors cut their exposure to risky companies with questionable accounting. The junk-bond market has been smacked hard, but many higher-rated companies have been hit, too. According to Morgan Stanley Dean Witter & Co. (MWD ), on average, borrowing costs for the 35 most active investment-grade corporate borrowers jumped by over a quarter percentage point in early February.
Credit-rating agencies are also doing their part to raise the cost of credit throughout the economy. Even before the collapse of Enron, they were aggressively slashing corporate credit ratings as the economy deteriorated. Downgrades soared to record levels in the fourth quarter of last year, raising corporate borrowing costs.
Now, ratings agencies have ratcheted up their oversight even further. "We've accelerated and heightened our credit-review process," says Edward Z. Emmer, executive managing director of Standard & Poor's, which, like BusinessWeek, is owned by The McGraw-Hill Companies. S&P is spending more time looking over company accounts and broadening its review to include customers and competitors. In the wake of Enron, ratings agencies are also paying more attention to equity and corporate bond prices as early warning signs that a company may be in trouble.
This wide rethinking of risk probably won't send the economy back into recession. But the post-Enron environment will temper growth and delay the onset of a full-fledged expansion. Just tack it on to the growing list of migraines that Enron has wrought.
By Rich Miller in Washington and Heather Timmons in New York, with Andrew Park in Dallas, Charles Haddad in Atlanta, and bureau reports