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Why companies will need to work harder for credit.
Karen M. Kroll, CFO Magazine
March 1, 2008
FADE IN: a bankruptcy court in downtown Manhattan, late January, minutes before the close of business. The equity markets have taken a nosedive, and nervous bankers are putting pressure on executives of Quebecor World, and Judge James Peck. The commercial-printing company is just days away from running out of cash. One of a team of lawyers sprints in with a document detailing $750 million in debtor-in-possession financing for the company. Quebecor World attorneys ask for an extra 15 minutes to review the 40-page agreement. Nothing doing, say lawyers for the company's lenders. You have until 5 P.M.
Welcome to the new rough-and-tumble world of corporate finance, where banks' markedly different posture on lending money is affecting businesses of all stripes — not just those in default.
During the last quarter of 2007, one-third of banks hardened credit standards for midsize and large businesses, according to the Federal Reserve's senior loan officer survey, and two-fifths increased loan spreads over their cost of funds. Not one of 56 eased standards. The January numbers are the highest since the first quarter of 2002, when 45 percent of banks tightened terms and conditions.
CFOs have run this gauntlet before — higher financing costs, choosier lenders, the scramble to renew loans ahead of further market souring. But in the last credit crunch, in 2001, high corporate default rates and fraud spurred the retrenchment. This time, the problems have arisen within the financial sector itself, making this market contraction fundamentally different.
"The crunch today resulted from poor lending decisions," and that has been exacerbated by the securitization of the loans, says Coleen Pantalone, associate professor of finance at Northeastern University. In other words, banks have structural issues to work through. So they will be even more cautious than they were seven years ago, she says, especially with non-investment-grade credits. But it also means CFOs have to start taking a hard look at the financial conditions of banks, to protect their options for accessing capital.
The Big Pullback
What makes this credit crunch more severe than the one following the dot-com bubble is the dramatic turnabout from the days of easy-to-access credit. Prior to 2001, banks had been in credit-tightening mode for 9 straight quarters. Banks then pulled back drastically the next 10 quarters. But prior to 2008, banks had been easing or remaining neutral on commercial and industrial loan underwriting for almost four years. That suggests corporations have a lot of sweating to do before the credit markets find some kind of historical equilibrium. Indeed, more than 83 percent of bankers expect the quality of business and commercial real estate loans to weaken in the months ahead, according to the Fed.
"CFOs need to recognize that spreads will tighten and loan sizes may have to decrease, as the funds from nonbank lenders simply aren't there," says Meredith Coffey, director of analysis at Reuters Loan Pricing Corp. Companies may be constrained from borrowing to invest in their businesses or to conduct merger-and-acquisition transactions.
Banks are capital-constrained as well, driving them to shorten commercial loan terms. This year, banks will curtail origination of five-year loans, for example, to reduce risk and avoid having to carry the high level of regulatory capital they require — 50 percent, Coffey says. Instead, they will prefer lower-risk, 364-day maturities, which require only 20 percent regulatory capital. To CFOs, it means annual trips to visit their banks to prove they deserve funding — not an ideal situation in a credit environment that is weakening.
Non-investment-grade companies may have trouble corralling any funds at all. Skittishness has plagued the secondary market for leveraged loans, where banks sell corporate debt to investors such as hedge funds. The spread for such loans lingered in the 400-basis-point range in early 2008, and bidders were buying them at more than a 10 percent discount to par value, according to Reuters LPC. But banks would rather hold such loans on their books than unload them at that price. "If no one will buy loans — even perfectly good loans — the market gets stuck," Coffey says.
There is still plenty of demand for investment-grade credits, however, as evidenced by the fact that their spreads "are not blowing out," says James Malick, a principal in the New York office of Boston Consulting Group (BCG). "But the junk is frozen."
"A lot of banks essentially are off the playing field," is how David Lifschitz, executive vice president and CFO of Gehr Enterprises, sums it up. "They are licking their wounds and regrouping."
Within banking, the reach of this credit crisis is also longer. So far, the upheaval at U.S. financial institutions has hit businesses tied to housing the hardest. But now commercial-property investors are feeling the pain. Real estate and residential construction lenders such as $52.9 billion (in assets) Zions Bancorp are "being extremely cautious," says Clark Hinckley, a senior vice president at the Salt Lake City–based bank. Zions's nonperforming assets have tripled in nine months. Overall, commercial real estate lenders will lose as much as $180 billion over the next few years, says Goldman Sachs analyst James Fotheringham, in part because of a 20 percent–plus drop in property values.
The new risk aversion is driving up costs at Gehr, a holding company of manufacturing and real estate operations currently working on a New York hotel project. Spreads on loans for real estate development have increased to as much as 350 basis points over LIBOR (London Interbank Offered Rate), and loan-to-value limits have dropped, says CFO Lifschitz. If Gehr had to resort to mezzanine financing for 15 percent of the debt, for example, it would drive up the financing cost by a full percentage point. "We are able to attract competitive financing at our original leverage, albeit at higher costs," he says.
The crisis involving bond insurers has hurt federally funded nonprofits such as The Aerospace Corp. When the El Segundo, California-based research center embarked on a building expansion several years ago, CFO Dale Wallis used bond insurance from FGIC Corp. to guarantee the organization's $100 million variable-rate debt. Using such insurance lowers financing costs.
But in January, Fitch Ratings and Standard & Poor's cut FGIC's ratings two levels, to double-A, after the carrier missed a deadline to raise $1 billion of capital. The company had been a triple-A credit for 17 years. Due to the downgrade, Aerospace's bonds will fall, as buyers discount monoline insurance coverage in setting a price.
"The market doesn't have much faith in bond insurers at the moment," says BCG's Malick.
That could slow Aerospace's plan for additional construction, forcing it to remain in leased facilities. For now, the company can only watch and wait. "We won't jump overboard," says Wallis. "We're hopeful, based on history, that this is cyclical and our financing strategy is still sound. If it's not, we will adjust accordingly."
Well-capitalized companies are in a better position during credit crunches, including this one. Commerce Township, Michigan-based HoMedics, a designer and marketer of personal-care products and blood-pressure monitors, adds diversity to most local banks' auto-heavy lending portfolios, says CFO Bill Carroll. "As a result, we get good rates on loans."
Alamo Group, in Seguin, Texas, is just as sanguine about its attractiveness to banks, but that partly stems from good timing: it arranged an unsecured, five-year term loan for $125 million with four banks in May 2007, just before the capital-market shutdown, says Alamo vice president, treasurer, and secretary Bob George. An "accordion feature" allows the company to extend the loan to $175 million without redoing the entire agreement.
Even for fully funded companies, though, this credit cycle requires managing. One tricky issue is the number of banking partners a company should have.
As of mid-2007, about one-third of respondents to a Greenwich Associates survey said they were consolidating cash-management providers. Financial executives felt that credit was freely available, making it unnecessary to retain a large pool of banks, says Greenwich Associates managing director Don Raftery. "But CFOs are now asking if they have enough credit available at reasonable prices to operate in the way they'd planned," he says.
That requires turning the tables on banks and evaluating their financial performance. At Alamo, George is concerned about the overall banking environment and spends more time watching banks' credit ratings. He also monitors the state of banks interested in being part of Alamo's credit facility, just in case he has to replace one (see "Taking the Measure of Your Banks" at the end of this article).
Fortunately, by the end of January, large U.S. financial institutions had shored up their balance sheets by raising $102 billion through forms of common stock and hybrid capital instruments. But if regional banks need to raise capital, they could run into difficulty due to a lack of name recognition and presence in global markets, says Standard & Poor's credit analyst Scott Sprinzen.
Switching banks just because an institution's credit slips a notch can mean throwing out the negotiating leverage you've accrued as a long-standing customer.
Mentor Graphics treasurer Ethan Manuel feels comfortable staying with battered banks like Bank of America. His decade-long relationship with BofA means it is more likely to extend Mentor's $120 million line of credit two years past its due date of mid-2009 without covenant changes. Manuel would like to put more time between the credit crunch and the renewal. "Without this [relationship], we would be more exposed to unfavorable market dynamics," he says.
Those unfavorable dynamics could last longer than they did seven years ago. Given history, banks will continue holding back capital and refusing to deal with non-investment-grade credits or companies in a tailspin. Quebecor got its DIP financing in the end, but other overleveraged companies may not be so lucky. "There was a tremendous concentration of risk at banks," unlike in the dot-com bubble, when all kinds of investors incurred losses, says Achim Schwetlick, a partner at BCG. "Banks will overshoot in their conservatism toward corporate borrowers before the market starts to balance out."
Karen M. Kroll is a freelance writer based in Minnetonka, Minnesota.
Given a lack of visibility into counterparty risk, many CFOs are scrutinizing how they are investing precious excess cash. Investor focus has shifted from yield to risk, says Sarah Jones, co-head of liquidity and investment products at JP Morgan Treasury and Securities Services.
Driving this is the discovery that short-term cash funds and even some money-market funds — an investment heretofore thought highly liquid — are exposed to structured investment vehicles (SIVs) that purchased toxic mortgage-backed securities and collateralized debt obligations. CFOs are shedding investments in funds with SIV exposure that don't offer complete transparency or daily liquidity.
In August 2007, Ethan Manuel, treasurer at $800 million Mentor Graphics, had migrated the company's short-term investments from asset-backed paper to money-market funds to maintain liquidity while gaining a bit on the return. He switched back to treasuries and commercial paper last November. "We went away from money-market funds, because we weren't sure if there would be write-downs or liquidity concerns," says Manuel. "Right now, we're being very careful." — K.M.K.
Taking the Measure of Your Banks
Given the rockiness in the financial sector, CFOs would be remiss if they didn't question the stability of their banking partners. However, determining just how strong a specific bank is can take some doing.
To evaluate large banks' capital adequacy, many analysts look at "tangible common equity," a measure of net worth relative to assets, says Brent Christ, an analyst with Fox-Pitt Kelton. Tangible common equity, a non-GAAP measure, is common shareholders' equity, less intangibles and goodwill. The ratio of TCE to assets (less goodwill and intangibles) is generally considered more healthy if it is at least 6 percent for smaller banks and 4 percent for larger ones, Christ says.
To track a bank's exposure from all kinds of activities, Institutional Risk Analytics (IRA), a bank-ratings firm, uses a barometer it calls "economic capital." EC is intended "to compare the riskiness of a bank's on- and off-balance-sheet activities with its regulatory capital," says Christopher Whalen, the firm's managing director. The EC uses a theoretical estimate of a bank's potential future losses from trading, investing, and lending. That estimate is then compared with a bank's Tier-1 risk-based capital (the metric used by regulators) to determine if a bank has enough funds to maintain its credit rating in the event of a financial setback.
According to IRA's third-quarter 2007 ratings of banks with more than $10 billion in assets, Bank of America, Citigroup, JPMorgan Chase, and Wachovia were the worst positioned to absorb heavy capital losses. — K.M.K.