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.
Grim Numbers
The result, of course, has been a crisis. As of early April, 21 banks had failed. This compares to 25 during all of 2008 and three in 2007, according to the FDIC. Net loan and lease charge-offs at FDIC-insured commercial banks skyrocketed 60 percent between 2006 and 2007, according to the FDIC. Figures from Thomson Reuters show that investment-grade lending in the U.S. fell by 16 percent between the first quarters of 2008 and 2009. Non--investment-grade lending ended the quarter at less than half of its 2008 level.
Banks that are lending are making greater use of original issue discounts, or OIDs, Bavaria notes. As the name implies, these are discounts that the bank subtracts from the amount it's lending. Say a loan is set for $1 million at 8 percent interest. Instead, the bank hands over only $950,000, bumping up the effective interest rate.
These have become more popular because many loans are selling in the secondary market for a good chunk less than par value. As of late March, average bid levels on liquid U.S. loans were at about 70 percent of par, according to the Loan Syndication and Trading Association. Banks don't want to issue new loans at par, only to get one-fourth less than that in the secondary market.
The drag in the loan market extends to the equity markets, Bavaria adds. Investors can buy companies' debt at a discount, collect the interest payments, and also get a healthy capital gain at maturity. (While some of the loans will default, it's unlikely that many of the loans trading at such steep discounts will.) As a result, right now investors can get better deals in the bond market than in the stock market.
The lackluster secondary market also has prompted more banks to keep their loans on their balance sheets rather than sell them, says Henry M. Fields, a Los Angeles--based partner with the law firm Morrison & Foerster LLP. As a result, they're less likely to make new loans.
This is the case even though bank reserve capital has risen significantly. The Federal Reserve shows excess reserves jumping from about $2.9 billion in March 2008 to $725 billion a year later.
"Bank liquidity as we usually measure it is pretty high," says Richard Herring, professor of international banking at The Wharton School. However, two factors are keeping banks from lending, he says. Some banks may have losses they haven't yet declared; they don't want to lend and deplete their capital. At the same time, worries about which other institutions might fail are causing bankers to pull back from lending in the interbank market.
More than a few CFOs have pretty much abandoned the commercial loan market and gone straight to the bond market. Figures from Thomson Reuters show bond issuance rising from next to nothing during the summer and early fall of 2008 to just shy of $140 billion in March.
The increase in the issuance of corporate bonds "is a good sign," Herring notes. "Companies may not have to wait for the full recovery of the banks," in order to access capital.
Of course, both the Bush and Obama administrations have put in place an alphabet soup mix of programs to support the banking sector and revive lending. TALF, or the Term Asset-Backed Securities Loan Facility, offers three-year loans to borrowers purchasing U.S. consumer, small business, and commercial real estate asset-backed securities. The idea is for the government to create a secondary market for the loans so that banks can sell the ones they've got and make new ones, Bavaria notes.
Through the Temporary Liquidity Guarantee Program, or TLGP, the government guarantees balances on non--interest-bearing checking accounts. Businesses don't have to worry about losing their money if they have several million dollars in an account, Fields says.
PPIP, or the Public Private Investment Program, offers banks a way to sell their toxic loans and securities to funds established through the program. Getting these off the banks' balance sheets should boost investors' confidence in the institutions. This should get capital flowing to the banks and act as a catalyst for lending.
This new program is a solid solution for bank liquidity," says Bill Bartmann, chief executive officer with Bartmann Enterprises and author of Bailout Riches (Wiley, May 2009). And, by generating lending activity, the program will reduce the number of bank failures that otherwise would occur, he adds.
To be sure, Bartmann, whose company purchases bad loans, has a vested interest in seeing the program succeed. However, others support the programs' intent. "It's designed to provide the ability for banks to offload their loans to make new ones," Fields says.
Of course, not everyone agrees with the current administration's actions. Given that the cause of the crunch was an excess of leverage and an overreliance on short-term debt, adding more liquidity doesn't make sense, says Thakor of Washington University. He proposes more limited use of public/private partnerships to boost capital, with both the banks and government participating equally. (Under PPIP, the government takes on more risk.) In this way, Thakor says, capital is provided to the banks without hitting taxpayers quite so hard. Moreover, by pumping such extraordinary amounts of liquidity into the system, the current programs will lead to either hyperinflation or a devalued dollar, he adds.
The current solutions offer only short-term fixes, adds Peter Morici, professor of international business at the University of Maryland. He proposes a "bad bank" to which bankers would move toxic assets at market value. Bankers might not like it, as they wouldn't get as much for the loans as they'd like. However, the idea has worked before, Morici says. "This is what the RTC [Resolution Trust Corporation] did," with assets held by insolvent S&Ls during the 1980s. To further safeguard taxpayers' money, Morici recommends strict compensation reform as well. "Pay $2 million to the top dog," with no bonuses or options. If a bank doesn't comply, the Fed's reserve window closes, he adds.
No matter what programs are enacted, it's difficult for politicians and regulators to show taxpayers how efforts to stabilize banks can contain unemployment and help the economy, Fields notes. "It's not an easy political message."
Down the road, an overhaul of the regulatory structure for the financial services industry seems likely. As a start, the regulations should be extended to nonbank financial firms that that have been deemed too big to fail, Fields says. AIG, of course, clearly is a case in point: "If we're going to spend government dollars to protect financial institutions, then government should regulate those institutions so that they don't fail."
And, both consumers and businesses would benefit by shifting to more sustainable levels of consumption that also let them build up cash cushions, says Peter Crane, president and publisher of Crane Data LLC, a provider of information on money funds. Doing so decreases the likelihood that these kinds of crises will happen again.
At the same time, CFOs looking for loans will need stronger stories than they would have needed just a few years ago, Bavaria notes. They need to show that taking on the obligation makes sense, and that their firms will be able to service the debt.