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A Change of Season

Don't let a turn in the credit cycle catch you napping.
Randy Myers, CFO Magazine
October 1, 2006

Darren Wells knows a good deal when he sees one. The senior vice president for business development and treasurer of $19.7 billion Goodyear Tire & Rubber Co. seized on favorable credit-market conditions in 2003 to restructure approximately $3.3 billion of credit facilities. Wells swung into action again in 2004 when he refinanced much of that debt on even better terms, then again in 2005 when still better terms could be had. Ultimately, the tire maker wound up with five- and six-year facilities on terms a Single-B-Plus credit could only have dreamed of a few years earlier.

Given some signs that the good times were coming to an end, Wells was understandably a little surprised when bankers began showing up at his door again in early 2006, encouraging him to refinance for the fourth time in four years. "I saw what might have been the most aggressive credit market we had seen," he recalls. The company was receiving regular offers to refinance all that debt yet again at lower interest rates and with fewer financial covenants. Interest-rate spreads over Libor were compressed to levels Goodyear had never seen before. "These things," says Wells, "were indications of the loosest credit requirements you could hope for."

But good times do come to an end. While bank credit remains readily available today, Wells noticed that by the middle of this year, many of those bankers had stopped showing up. With more evidence of an economic slowdown and more concern about inflation, Goodyear was no longer the recipient of generous offers. "People weren't coming to me and saying, 'Here it is, but it's much worse,'" he says. "They just stopped coming, which means they probably couldn't provide enough benefit to make it sound worthwhile."

A Turning Point?
Wells has seen other signs that the tone of the credit market may be changing. Part of his job involves estimating the prices various Goodyear businesses might command on the auction block. As part of that, he analyzes how much leverage potential buyers might be granted. "What we have heard," says Wells, "is that there may be a marginal reduction in the amount of leverage that financial buyers can get to purchase businesses." He estimates that the amount of financing banks are willing to provide in terms of multiples of EBITDA has fallen from earlier levels by roughly 0.25 times. That's not a dramatic change, but it may indicate that the credit cycle has reached a turning point.

There are other hints, as well. Fitch Ratings currently has about 15 percent of the industrial companies it rates on negative outlook, up from 11 percent a year ago. And Meredith Coffey, director of analysis for Reuters Loan Pricing Corp., notes that the supply of high-yield loans being brought to market by corporate borrowers has jumped dramatically in the past year, threatening the tenuous balance between loan supply and investor demand. Most of those loans are sold to institutional investors, such as hedge funds. Last year at this time there was about $19 billion of such loans in the pipeline, Coffey says. This year, there is about $57 billion. Because of the shift in the supply-demand equation, she says, her firm has observed spreads increasing on these leveraged institutional loans, which tend to presage spreads on bank-only leveraged loans. In addition, she says, "we've also seen pushback on doing deals without covenants, so deals will be more heavily covenanted going forward. And there's no more squishiness around what defines EBITDA, where projections are going, things like that."

Gauging a Downturn
Some observers have been predicting an end to easy credit for some time, and have likened recent conditions to a bubble not unlike the one in the equity markets during the 1990s. With the Fed driving rates higher, these observers fear that it's just a matter of time before weaker and more highly leveraged companies begin to default on their debt, prompting banks to set aside larger loan-loss reserves. That, in turn, would squeeze bank profits and lead to higher-cost loans with stricter loan covenants. Slowing economic growth — U.S. real GDP rose at a 2.9 percent annual rate in the first half of 2006, down from a 5.6 percent rate in the first quarter — would exacerbate the problem.

Thus far, that scenario has failed to play out. Through the first half of 2006, default rates on high-yield bonds remained at below-average levels, according to Fitch Ratings. Meanwhile, banks continued to reduce, not raise, the number of covenants they were imposing on loans, both to investment-grade and non-investment-grade companies. According to data compiled by Fitch, only 60.9 percent of loans to non-investment-grade companies included any sort of debt-coverage covenant in the first half of 2006, down from a recent peak of 83 percent in 2003. And only 65.4 percent included any sort of leverage covenant, down from a recent peak of 78.2 percent in 2004.

Covenants are even less prevalent in the investment-grade market. Laurie Stewart, vice president and treasurer of $8.1 billion Air Products and Chemicals, notes that her Single-A-rated firm refinanced its revolver in May, bumping its size up to $1.2 billion from $700 million and eliminating one financial covenant while softening the language of some others. The revolver has a five-year term. "We've been talking to our banks recently, getting some updates, and the market seems just as good as ever from a corporate-borrower's standpoint," agrees Terry Rasmussen, assistant treasurer of $11.2 billion Arrow Electronics.


A variety of factors are conspiring to keep things that way. For starters, the easy credit conditions of the past few years have allowed many corporations to lock in very low spreads with very few covenants for long periods of time, Coffey notes. From 2000 to 2002, she says, about 70 percent of corporate lines of credit for investment-grade companies had a 364-day term. Today, only about 20 percent do. Because few of those lines of credit are drawn, changes in interest rates don't have as immediate an impact as they've had during some previous economic cycles. Finally, says Howard Atkins, senior executive vice president and CFO of Wells Fargo & Co., "Most businesses in the U.S. are much more liquid, more flush with cash, than they were at comparable points in prior business cycles."

Advance-warning Signal
Still, no one is predicting that easy credit conditions will continue forever. "Bank credit always moves in cycles. It's one of those things you know will change," says Rasmussen. "I'm just not sure we have any crystal ball to say when."

Historically, it has been a material uptick in loan defaults, usually in the riskier high-yield market, that has served as the most obvious precursor to a tightening credit market. However, there may be an earlier warning sign: bank-loan amendments. In a new study released in August, Fitch Ratings examined seven years since 1997 in which loan-amendment activity increased, and found that in six of them, bank-lending standards tightened.

Fitch theorizes that when a company sees that its financial situation is becoming precarious, one of the first things it does is request an amendment to its loan covenants so that those covenants are not broken. Yet if its financial situation has become so tenuous that its covenants are in jeopardy, its odds of default must be high. In fact, the research bears that out. Over the past decade, 62 percent of the firms that defaulted on high-yield bonds also had amended loans in their capital structure. One-third of those firms had received a loan amendment within a few years of their default. Of those that received a loan amendment, 50 percent negotiated them within six months of defaulting, 75 percent did so within one year of defaulting, and 90 percent did so within two years of defaulting.

This advance-warning signal can work its way through the banking system even before it becomes obvious to the public, says Fitch, since banks that see a pattern of loan amendments among their clients in various industries can be expected to act on that information by tightening their loan requirements. But here's the current problem: with banks reducing the number of loan covenants, there are now fewer opportunities to use loan amendments to detect deteriorating credit quality.

All this leaves credit-market analysts wondering when conditions will change. Fitch managing director of credit market research Mariarosa Verde, for one, is willing to hazard a guess. "Because the economy does appear to be slowing, I think conditions will become more challenging in 2007," she says. "It will reflect the accumulated effect of higher rates and slower economic growth, to which high-yield companies in particular are sensitive. Even a moderate slowdown will probably start to drive up leverage for those companies, and the loan market will start to pick up on that and modify its risk appetite accordingly."

Randy Myers is a contributing editor of CFO.


How Green Is Your Bank?

Think it can be tough satisfying your banks, rating agencies, and Wall Street analysts when you want to take on new debt? Try answering to the Rainforest Action Network.

For years, environmental activists have been a thorn — or conscience, depending on your point of view — in the side of the business world. The Sierra Club was founded in 1892. Greenpeace organized its first boatload of protesters in 1971. But it's only recently that such groups have begun to target the financial institutions that help fund business activities that the groups regard as environmentally unsound. This could have a ripple effect on companies that rely on such firms for credit.

Few organizations have been more vocal than the Rainforest Action Network. Founded in 1985, it launched a global campaign in 2000 aimed at convincing financial institutions to stop funding environmentally destructive business activities. It is not subtle. It went so far as to criticize Wells Fargo & Co. for lending to companies that practice clear-cut logging and mining that involves the leveling of mountain tops. In May, the group took out a full-page advertisement in The Washington Post accusing Dutch banking giant ABN Amro of "outstanding environmental hypocrisy" for bidding to fund the controversial Sakhalin II oil-and-gas project beneath Russia's Sakhalin Island.

Rainforest Action Network executive director Michael Brune cites Citigroup, Goldman Sachs, and JPMorgan Chase as being at the forefront of embracing sound environmental practices, and names Wells Fargo and Wachovia as two that could do more.

Wells Fargo CFO Howard Atkins counters that "the environment is important to us," but adds, "you have to be careful how you categorize what's environmentally friendly and what's harmful. I doubt very much we would do anything we felt was harmful to anyone."


Wachovia environmental affairs manager Patrick Mumford says his bank has spent the past 18 months developing an environmental strategy, still in draft form, that addresses not only its own building and procurement activities but also its lending practices.

Brune says pressure from his organization and other activist groups has already had an impact on some business projects. Strong stands taken by Citigroup, JPMorgan Chase, and other banks have encouraged the consortium pursuing the Sakhalin II project to take additional steps to mitigate its effect on salmon-bearing streams, local communities, and endangered wildlife species. "It certainly has delayed the project, and could very well stop it from going forward altogether," he contends. Brune says Citigroup and other lenders also have pushed a number of clients in Papua New Guinea and other areas to certify that their logging practices meet stringent environmental standards.

Corporations, accustomed or not to hearing complaints directly from environmental activists, may encounter more of this sort of pressure from lenders. "You need to take this very seriously," says Mumford. "You may find that banks will suggest you need to modify how you do business or you may not be able to continue the relationship you had with them, because banks are very sensitive to the risks associated with these issues." — R.M.


How to Cope

What should corporate borrowers be doing? The most obvious course of action is to get while the getting is good. Consider refinancing credit revolvers and other bank loans to take advantage of current market conditions. Extend terms. Consider boosting the size of your credit facility and negotiating less-stringent covenants. Many CFOs and treasurers have already done that, and if they've done it recently enough may find it counterproductive to do so again. Goodyear Tire & Rubber's Darren Wells says he declined to do a fourth refinancing this year because the upfront fees generally outweighed the savings from the lower interest rates he was being offered.

Mike Gallanis, managing director of consulting firm Treasury Strategies, in Chicago, encourages companies to do everything they can to strengthen their relationships with their credit banks so that if and when a tightening does occur they're positioned to deal with it. "It's a relationship-management issue," he says. "It involves doing things like having an ongoing dialogue with the banks, including them in deals when there's an opportunity to include them, and maybe doing something on the investment-management side and awarding noncredit kinds of business to them. Companies also should take a hard look at what they're spending on noncredit services to ensure they are adequately and equitably rewarding the players they want to appease."

Firms unsure about whether they can handle this wallet-share balancing act with sufficient acumen may want to consider using a risk-adjusted return on capital, or RAROC, model to evaluate the profitability of their business to their banks (see "Inside Your Banker's Head," CFO's Banking & Finance Special Issue, October 2005). Having access to a RAROC model, says John Walenta, director of the corporate and institutional banking practice at consultancy Mercer Oliver Wyman, can give firms leverage in negotiating fees with their banks.

Companies that issue bonds may want to consider refinancing that debt, too, extending maturities and taking advantage of the tight spreads between short- and long-term debt. Wells Fargo has been looking to borrow with longer-term maturities because spreads have been so narrow. It's had opportunities to borrow in sterling, in the euro, in Australian dollars, and in Canadian dollars, and has been issuing debt in a variety of foreign currencies over the past couple of years.

The one thing few corporate borrowers need to do is panic. "There are some signs the cycle is starting to turn, but until we start to get significant default levels, I don't think we'll see any major trends taking place in the market," says Walenta. "It's still very competitive, and banks are still very aggressively bidding for business." — R.M.




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