The Hard Consequences of Easy Loans
There's plenty of blame to go around for the New Economy's boom and bust. But most of the attention has focused on the role of equity markets. Largely overlooked are debt markets, which also have played a role in the drama.
Little-noticed changes in the ways banks indemnified their lending risks during the 1990s have left huge loans in the portfolios of bond mutual funds and hedge funds -- loans that are turning out to be far more volatile than anyone expected. Many of them were concentrated in the troubled telecom and energy-trading sectors. While the loans' losses don't come close to those experienced in the stock or high-yield bond markets, pressure could rise to require more disclosure to investors of the terms and conditions attached to company debt.
The escalation of borrowing during a time when the economy was growing and investors had a high appetite for risk is easy to understand. Companies like Enron and WorldCom needed a lot of money to keep them afloat while they were busy fictionalizing their earnings. Even dot-com outfits that never pretended to have earnings wouldn't have been able to stay in business for as long as they did, attracting millions in equity investment, if they hadn't been able to borrow a heck of a lot of money.
As the 1990s progressed into the New Millennium, an increasing amount of that borrowed money came from banks. In 1991, a total of $234 billion of syndicated bank loans was issued, according to bank-loan information company Loan Pricing Corp (LPC). In 2000, issuance peaked at $1.2 trillion before slipping back in 2001 to $1.1 trillion.
That amount outpaced corporate-bond issuance, which totaled $879 billion in 2001, according to the Bond Market Assn. In the first half of 2002, $527 billion in bank loans were granted, far outstripping bond issuance.
PASSING THE BUCK.
One reason why banks were willing to lend so much money was the process of loan syndication: A bank originates a loan, then divvies it up among different banks and investors, thereby fronting only a small portion of the total loan itself. This way, financial institutions are able to offload much of the risk of underwriting the loans while still reaping lucrative fees for originating them.
"It certainly puts less stress on the due-diligence process than it would if the bank were holding the loan forever," says Peter Andersen, a high-yield-fund manager for Delaware Investments. He says his fund doesn't invest in bank loans, but many high-yield mutual funds do.
The syndication process has many benefits -- mostly for banks, which can then do more deals because less of their capital is tied up in huge loans. Businesses benefit because they're able to access more capital. The broader financial world has also benefited from having a new kind of investment vehicle, with new risk and reward properties to buy, sell, and evaluate. For example, Standard & Poor's noted in a February, 2002, report that it now rates the loans of about 1,200 companies. Six years ago, it didn't rate any.
The syndication process also has some drawbacks, however. First and foremost, it seems to have allowed higher-risk companies to obtain more debt than they could have otherwise, increasing the potential for defaults and bankruptcies down the road. "To the degree that you can diversify risks, then credit becomes more widely available," says John Lonski, chief economist at Moody's Investor Services.
Indeed, the amount of "leveraged," or below-investment-grade loans, has made up an increasingly large percentage of total syndicated loans over the past decade, according to LPC. Bank lending is still very dependent on relationships between the lender and the borrower, so these loans are often structured much more intricately than stock and bond offerings, including little-known covenants that don't need to be reported in financial statements.
Several of this year's high-profile bankruptcies were triggered when a company failed to meet a specific hurdle, and its bank loan or line of credit was suddenly withdrawn. At Pacific Gas & Electric, banks withdrew financing when the utility's debt rating was downgraded, causing it to default on its bonds and notes. Some of the covenants are equivalent to telling a homeowner that if he or she loses his or her job, the mortgage must be repaid in full, says Lonski.
Before bank loans were syndicated and then traded on the secondary market, a company could quietly call its banker and ask for more lenient terms if it were in danger of triggering a debt covenant. Now, renegotiating is a lot harder, and the process takes more time. "The public needs to pay far more attention to the power of banks," says Peter Cohan, a former bank strategist who's now an author and management consultant in Marlborough, Mass.
Meanwhile, those riskier -- and higher yielding -- syndicated loans have frequently ended up in the portfolios of bond mutual funds and hedge funds. The 1990s saw the creation of several "prime rate" funds, which invest mainly in bank loans. Leveraged bank loans are attractive to investors because they're often secured by the corporate borrower's real assets. Because such debt is higher up in the capital structure of a company than bonds or equity, the risk of losing all your money is small.
Nonetheless, prices of bank loans trading on the secondary market have been especially volatile in the past two years, according to LPC's data. They were slipping in 2001, then fell about 2% following September 11. Prices recovered, ending 2001 down 2.2%, and climbed 3% this year through June. But since June, they've slid another 1%.
Many prime-rate mutual funds, bought by investors as alternatives to low-yielding money market funds, have negative returns in the past year. For example, Eaton Vance Prime Rate Reserves (F0000F), which Morningstar calls the best of the prime-rate funds, is down 0.5% in the past year. "These sound like small changes, but for the loan market, these are big movements," says Meredith Coffey, LPC's director of analytics, who adds that the loans have performed better and remained more stable than corporate bonds (down 9% in the past year).
Were lenders slack in exercsing due diligence? The general environment of the late 1990s would suggest that to be the case. "During a period of credit expansion, people are much more worried about not getting in on the deal than they are about the quality of the credit on their books," says Cohan. He thinks part of the problem is that loan officers get compensated on the volume of deals brought through the door, not on the their long-term performance.
However, "sooner or later, it will come back to roost that the originator of some of these loans had flawed credit evaluation," says Delaware Investments' Andersen, who thinks structural changes in the loan market aren't necessary. "We've all seen that in a roaring bull market: Standards are dropped as people get excited about the latest deal, and people tend to cut corners. That's what we're suffering through now."
Inflated equity markets also encouraged more lending, points out Lonski, since many companies could boast low debt-to-equity ratios -- even though they were losing money. "The gross overvaluation of U.S. common stock made it possible for companies to take on so much debt," says Lonski. Corporate debt outstanding as a percentage of the market value of stocks in the first quarter of 2000 was actually quite low -- just 28%. In contrast, in the third quarter of 1990, debt totaled 94% of the market value of common equity, says Lonski.
In the debt markets, as in their equity counterparts, many of the excesses of the '90s are already in the process of self-correcting. In an effort to repair their balance sheets, businesses are cutting back on debt, not asking for more. Because the lending process is so clubby, banks that syndicated sour loans will be hurt by being shut out of future deals. "Banks really don't want their loans to go bad," says LPC's Coffey. "That's their reputation."
Nonetheless, some changes are in order. Cohan thinks it would help if loan officers' compensation were tied to the long-term performance of the loans they issued. He also thinks regulators should require more public disclosure of the terms of bank lending -- especially the covenants that can trigger defaults.
LOOK AND LEARN.
Erick Maronak, research director at investment firm NewBridge Partners, says he increasingly calls debt analysts to find out about the terms of loans before buying stock, something he concedes individual investors can't do. Credit-rating agencies are examining the role that rating downgrades can play in triggering calls on bank loans.
Most of the fixed-income community is quick to point out that so far in this recession, debt losses have been minor compared to earlier cycles. Of course, if the economy deteriorates and syndicated bank loans trigger more bankruptcies, investors will be less forgiving. For now, the process of syndication, which allowed banks to lend risky companies huge amounts of money, is one piece of the New Economy puzzle investors should understand -- and watch closely.
Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column
Edited by Douglas Harbrecht
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