Recently, investors in two Bear Stearns hedge funds with substantial subprime mortgage holdings were informed that their investment had essentially evaporated, along with the credit of the less than creditworthy borrowers who took those mortgages. On July 18, Federal Reserve Chairman Ben Bernanke predicted that losses among subprime investors could dramatically worsen, reaching as high as $100 billion. Well, that's the capital markets for you. But should U.S. companies be concerned about a similar meltdown in the markets backing a substantial amount of corporate lending? You can bet your collateralized loan obligations (CLOs) they should be.
Many of the same investors who are now losing money in the subprime market, also provide liquidity to credit markets that are tapped by corporate borrowers, and they are now pulling back across the board. The result has been a dramatic reversal in loan market conditions. The pipeline is full, but deals aren't getting done because investors are jumpy, say loan market observers. "Credit that's provided by the capital markets may be cheaper, but it's more volatile," says Meredith Coffey, director of analytics with Reuters Loan Pricing Corp. in New York. "You just have to look at what happened in May compared to June and July. You could get anything done–absolutely anything–in May. We had an institutional loan pipeline of about $120 billion, and we were routinely doing $10 billion in institutional loans. Spreads were coming in and loans were pricing well. It was a very, very attractive time to be borrowing. In the space of a couple of weeks, everything changed."
And that disruption only reflected a hiccup in the subprime and Chinese stock markets. The prospect that should keep CFOs and treasurers up at night, is the kind of stampede that might be produced when corporate defaults–a rarity for the last four years–once again start to rise. "No one is sure where risk is residing, and when there is a reversion to the mean default rate, we don't know what the reaction will be among investors–many of whom have not experienced a substantial credit loss for several years now," says Brian Ranson, the Toronto-based managing director of the credit strategies group at credit risk analytics provider Moody's KMV (MKMV). The fear is that investors will flee corporate credit, draining the market of liquidity and making it harder for companies to get hold of capital at exactly the time they need it most.
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Until recently, that scenario couldn't have seemed further away. In fact, the last four years have been one long party for borrowers. The cost of new loans for many companies has halved and, despite the market's current jitters, is still lower than it has been for around a decade. Chief executives might see that as a feather in their caps–high profits and low rates of default have certainly played a part in making loans cheap. But others argue that the thanks should go elsewhere–to an abstruse array of financial products that transfer credit risk from lenders to investors. "Back in the dark days of the 1990′s, the lending capacity of the economy was pretty much determined by the balance-sheet capacity of the commercial banks," says Stein Berre, head of the European corporate risk consultancy practice at Oliver Wyman in London. "Now, we've been able to tap into a huge additional source of capital."
Markets for products, like default swaps and CLOs that were cooked up by bankers in the 1990′s, have exploded in recent years as fixed-income investors have turned away from low-yielding government bonds in search of something racier. In the credit derivatives market, where bilateral contracts transfer risk between a protection buyer and a seller, outstanding notional volumes hit $34.4 trillion at the end of last year. Five years previously, the market was worth $918 billion. Meanwhile, this year, the average monthly issuance in the U.S. of CLOs–structures where investors buy differing levels of risk on an underlying pool of a hundred or more loans–topped $10 billion. In conjunction with these more complex products, the market for loan syndications and loan sales has also grown massively.
Greater availability and lower cost has meant that, in some segments of the market, loans have overtaken bonds as the main form of financing. Institutional loan issuance in the double-B and B-rated grades has totalled roughly $450 billion in the last 12 months, compared to $147 billion in similarly rated bonds. But while annual bond issuance has remained more or less stable, borrowing has mushroomed in size from a mere $50 billion five years ago. "This big net increase in the amount of financing getting done meant borrowers could do bigger acquisitions, and get bigger working lines," notes Reuters' Coffey. "Look at the size of the leveraged buyouts that have happened this year–they would never have been possible five years ago."
Meanwhile, the growing liquidity and transparency of traded credit markets means that it's easier than ever before for companies to keep tabs on how much they need to pay for loans–and ultimately, call in loans and reissue them to get the best price. During the first quarter of this year, Coffey reports, around $80 billion in loans were reissued with that end in mind. That willingness to go back to the market has led to lower borrowing costs. However, she adds, "transparency in the secondary market also meant that when the loan market softened in late June and early July, it became painfully evident that the large pipeline of loans could not clear market at their earlier, thinner spreads. Liquidity and transparency cut both ways."
In simple terms, little has changed–borrowers still go to banks for money. Yet, behind the scenes, everything is different. In the past, strict risk limits governed the amount of credit that banks could extend to any one borrower, industry or region. But in the new paradigm, as long as they can find buyers for the credit risk, banks can keep originating loans. "Many years ago, if you'd said to a corporation that a bank would distribute their loan to a lot of other institutions, Ithink they would have been appalled. It introduces a degree of complexity which they'd rather not have," says MKMV's Ranson.
In exchange for such low borrowing costs, companies have decided they can live with complexity. And for banks, the new paradigm means lots more business opportunities. "Banks today are much more willing to give out big lines of credit than they have been since the end of the Nineties, when they clamped down on credit lines. This is because there are a number of tools available with which they can chop off these tall trees and optimize their credit risk across a whole portfolio," says Ashish Dev, the former head of enterprise risk management at Cleveland's Key Corp., who recently moved to New York to head up a new risk practice at consulting firm Promontory Financial.
The banking industry's need to be able to syndicate, trade, securitize and hedge loans has meant greater standardization in loan terms, which generally translates into fewer covenants and less security. Critics charge that the new system produces not just more credit, but worse credit–that loan underwriting standards are lower, ratings agencies are being overly generous when vetting transactions, and investors lack the skills and rigor to assess some of the more complex structures now being brought to market. Promontory's Dev worries that banks are becoming "complacent" when making loans, simply because they are potentially able to pass much of the risk along. MKMV's Ranson agrees: "There is a good deal of concern in some quarters about excess capacity in loan markets, because history suggests that excess capacity produces poor decisions and higher losses when defaults return to historic averages." Certainly, these predictions have become reality in the U.S. mortgage market, where the same principles of origination and distribution have been applied to the higher-risk borrowers who inhabit the subprime market–and eventually, they prompted Bernanke's warning of catastrophic losses.
The optimistic view for borrowers is that the dispersion of credit risk will spread the pain sufficiently enough to avoid a catastrophic pullback from lending–the so-called "credit crunch" in which rising defaults and scarcer loans become locked together in a mutually reinforcing relationship. Oliver Wyman's Berre says that even if investors retreat from credit markets, banks will have the capacity to step in: "That's why corporates still put a lot of stock in having a number of working capital providers." Promontory's Dev argues that the credit market is so liquid and diverse that, while some investors will retreat, others will see it as an opportunity to make money–like stock market investors who buy on the dips.
Not everyone is so sanguine. Tom Wilson, a credit market veteran who is now chief insurance risk officer for ING Group in the Netherlands, says his own experience managing a portfolio of structured corporate credit assets during the last spike in defaults during 2001 and 2002, should be a warning to both investors and borrowers: "From the investor's perspective, there is so much leverage locked into these structures that you get a much more rapid loss of credit quality than the rating of the tranche would suggest when compared to a more straightforward borrowing. What this means is that structured credit assets may well be more volatile in a downturn than people expect." From the borrower's perspective he argues that, when defaults rise, volatility will increase, the market will retrench, and institutional and hedge fund investors will pull back. Banks are unlikely to take up the slack via traditional balance sheet lending. The bottom line for companies, he says, is that "they should already be looking at this. They should already be managing their funding and liquidity profile with this kind of liquidity risk in mind."
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