Economist.com
Raising finance in America
October 26, 2002
Doors now closing
"TWO months ago, I would have said the chances of a credit crunch were too small to measure," says the head of syndicated loans at a big American bank. "Now, they are better than evens."
The signs are ominous: low new-issue volumes for corporate securities, both debt and equity; falling amounts of loans extended by commercial banks; and a higher price for borrowing. A fairly benign explanation of the low volumes is falling demand for money among companies, after a surge of investment in the 1990s. Few companies, after all, want to build factories these days, or invest so much as they once did in information technology. Overcapacity remains. Meanwhile, the suspicion that consumers must soon cut back on their heavy spending justifies inventories kept as lean as possible, along with their financing.
Yet evidence continues to grow that the supply of capital is being shut off, too. It is a process that started with the riskiest securities--that is, junk bonds and new issues of shares--but is now spreading to the safer parts of the credit markets, including those for bank loans and for high-grade corporate bonds.
In recent months, the decline of the junk-bond market has accelerated. Even if you do not count the large quantity of bonds issued by telecoms companies that are now bust or nearly so, the average junk issue trades at a yield of some ten percentage points above Treasury bonds. That is a larger premium even than during the financial crisis caused by the collapse of Long-Term Capital Management in the autumn of 1998.
A mere $600m of junk debt is now being issued each month, one-eighth the amount of a year ago. The number will now bounce up a bit, but only briefly. Some $1 billion of junk bonds are being offered to help finance the $7 billion leveraged buyout of QwestDex, the yellow-page business owned by Qwest, a telecoms company desperate to raise cash. Another $900m is to be issued to finance the acquisition of a similar business owned by Sprint, another struggling telecoms company. Such directories are a dull, predictable business, and the bonds are rated junk only because of the high levels of leverage used for the acquisitions. After these big financings, little is in the pipeline.
Many companies would love to cut their heavy debt by issuing shares. Yet public offerings of shares ground to a halt in the summer of 2000, and the market has yet to recover. An alternative way for companies with less than stellar ratings to get through tricky periods used to be to set up special entities that would buy receivables from the parent company, using money that was raised cheaply from the capital markets. As bills were paid, so the money was repaid. Yet after Enron's abuse of this structure, special-purpose vehicles have fallen into disrepute.
Earlier this year, the vast market for commercial paper suddenly dried up, but this was not an insurmountable problem for highly rated companies, which could draw down lines of credit, previously arranged with banks, or tap the market for long-term corporate bonds. No longer. Banks have jacked up the price for back-up credit lines, when they offer them at all. And where the best corporate bonds once yielded less than a percentage point above Treasuries, new-issue spreads have now widened to almost three percentage points. In other words, not all of the Fed's cuts in interest rates since the start of last year have fed through to companies.
Bankers once went about marketing loans or bonds of highly rated companies merely by mentioning the name of the issuer. Now they have begun organising road shows for borrowers, complete with the elaborate disclosure of information, in a way once done for equity offerings. It is not an easy sell. The number of possible customers has shrunk. Some loan syndicates for large companies now have half the participants that were in them before. Japanese banks, in particular, have pulled out, along with German ones. But American banks also have less appetite for risk. According to BCA Research in Montreal, the percentage of American banks' assets made up of securities, notably safe government bonds, has grown from 34% at the beginning of 2001 to more than 40% today, with loans falling as a proportion.
That the tightening may continue is clear from recently disclosed results from the annual credit review carried out by the Federal Reserve, the Federal Deposit Insurance Corporation and the Comptroller of the Currency. The review assesses all loans over $20m that are syndicated to three or more borrowers. It amounts to $2 trillion in loan commitments to 5,500 customers, or roughly a third of all corporate lending in America. The review employs five grades, with the best grade, a "pass", signifying a clean bill of health.
Almost 13% of all loans failed to get a pass, compared with 9% of loans last year and just 5% of loans the year before. The practical implication for banks is that they must apply more capital against the loans that have been fingered, or else arrange some other kind of so-called credit enhancement. Either way, the loan becomes less profitable. In effect, they must charge more or reduce their exposure.
Curiously, because the review is supposed to be a matter between regulators and banks, there are strict prohibitions against telling companies that their credit standing has been slashed. Rather, companies guess that this has happened only by facing a testy renegotiation with their lenders. Plenty of such discussions are going on. If companies are unhappy, they cannot challenge the methodology. Nor has any outside work assessed the accuracy of the rating system. A company that has been downgraded can, naturally, seek to arrange a better deal by selling debt or equity through the public markets. This year, that is not much of an option.
Copyright (c) 2002 The Economist
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Jim Devine [EMAIL PROTECTED] & http://bellarmine.lmu.edu/~jdevine
