Tightwads: Why Banks Trickle Nickels

The numbers aren't pretty. Global lending in the syndicated loan market plunged 37 percent between the first quarters of 2008 and 2009, to $379 billion, according to Reuters Loan Pricing Corporation/DealScan. In the U.S., lending in the first quarter dropped 42 percent, to $105 billion, when compared to the first quarter of 2008, Reuters also reported.

While the figures suggest a whole new financial world, it's more accurately described as a "whole old world," says Steven Bavaria, a New York--based managing director in leveraged finance with DBRS, an international rating agency. Banks have returned to traditional bank lending practices: They're more choosey about borrowers because they're holding loans on their books rather than packaging them as securities and selling them. They're also demanding a reasonable rate for risk. "It's the old-fashioned way that banks used to make loans," Bavaria says.

How did we end up back where we used to be? No one event or institution is to blame. As a starting point, both individuals and governments embarked on "a leveraged finance consumption binge," over the past decade or so, says Anjan Thakor, senior associate dean and professor of finance at Washington University, St. Louis. Consumer debt as a percent of disposable income more than doubled between 1980 and 2005, rising from 62 to 127 percent, according to the Federal Reserve. Consumers were continually shelling out more than they had.

Given the laws of supply and demand, these actions should have driven up interest rates, Thakor notes. Greater demand for money, given a relatively fixed supply, should have made it more expensive. This didn't happen, largely because other countries, such as China and India, continued to invest in U.S. treasuries, ensuring that there would be plenty of money to go around. In 2007, China's holdings of U.S. Treasury securities totaled $388 billion, according to a Congressional Research Service report, "China's Holdings of U.S. Securities: Implications for the U.S. Economy."

Again, normally this ever-expanding liquidity would lead to rising prices for everything from T-shirts to sofas. Again this didn't happen, as advances in technology and communication allowed companies to more easily move production to regions of the world with lower costs, Thakor notes.

One area in which this strategy wouldn't apply, of course, is real estate. Not surprisingly, this is where prices took off. The monthly housing price index, for instance, zoomed up by about 70 percent between 1999 and 2007, reports the Office of Federal Housing Enterprise Oversight. Real estate loans at FDIC-insured commercial banks jumped from about $2 trillion in 2002 to $3.6 billion in 2007.

Another shift occurring at the same time was banks' increasing willingness to invest in new types of assets, such as mortgage-backed securities, says John Keyser, a Las Vegas--based managing director with RSM McGladrey, Inc. While many of their early forays into mortgage-backed securities were investment-grade, over time, "to get better yields, banks moved down in the tranches. They were still investment-grade, but at the lower end," he notes.

Also playing into this was the move by some banks in the 1990s to apply investment portfolio theory -- that is, diversifying their holdings in order to reduce risk -- to their loan portfolios, Bavaria says. Previously, banks largely focused their lending efforts within a geographic area or industry. While this allowed them to get to know their customers quite well, it also meant that their risks were concentrated. To remedy this, banks could syndicate, or sell, loans among themselves. Eventually, some banks developed super-sized loan distribution arms that racked up huge fees. Some deals were done not because they made economic sense, but because they made a few individuals a great deal of money.

To a certain degree, banks were scrambling to make up for increasingly tighter lending margins, Bavaria notes. Several years ago, loans for a BB-rated company could be had for about 150 basis points over LIBOR. Today, they run about double that. "Banks kind of had a gun to their heads," Bavaria says.

Even so, all of these actions wouldn't necessarily have led to a financial crisis, Bavaria notes. However, included within the securities that banks were offering were subprime mortgages and other so-called "toxic assets" that eventually had to be written down.