Thirsting for Credit

With banks focusing on profits and mergers, and with markets in a whirl, a credit crunch looms.

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When Keith McBride and his treasury team at The Mead Corp. sat down last year to renew the Dayton-based company’s $500 million revolving line of credit, they had fewer lenders than hoped for. Two of the 12 banks supporting the revolver had announced they were dropping out– 1 just five days before the meeting. The reason? Credit products no longer were their priority, they explained. And as European institutions, the 2 banks were intent on reducing U.S. involvement.

“Our relationships with those banks go back 15 years,” says McBride, associate treasurer for the $5 billion forest-products company, “but they were determined to move away from credit products. If banks want to get out of the credit business, what the heck are they–and we–going to do?”

Once, A-rated companies like Mead were a banker’s dream. Banks offered them bargain- priced credit in the hope of securing more- profitable business, such as cash management, trustee assignments, and foreign-exchange work. Lately, however, banks are evaluating the overall profitability of each client. They’re finding that the margins on their transaction activities don’t compensate for the skimpy returns on credit. The result is stiffer credit pricing, less-flexible terms, and, in some extreme cases, termination of relationships.

“Money and credit have been commoditized,” declares Peter Davis, a partner in the banking and capital markets group at Booz-Allen & Hamilton Inc., management consultants based in New York. “From the bank’s perspective, it has been unprofitable to serve the corporate customer, unless you are the lead banker. And it’s particularly hard to make money on a creditworthy company.”

Companies fear that banks’ increased focus on profitability–coupled with a consolidation wave that has reduced the number of banks in the United States to 8,000 from 12,000 some 20 years ago–could lead to fewer choices and higher prices for banking services. Increased volatility in the capital markets, which is drying up the downstream sell-off of loans to money managers, adds to their concern. In addition, the market for high-yield commercial paper has shrunk, making bank financing the only option for many below-investment-grade companies. One more cloud on the horizon: With hundreds of millions of dollars of emerging- market losses, big money-center banks may be forced to reduce lending. A near-term credit crunch now looms as a real possibility.

Already there are signs of a slackening market. “Lending volume is down overall,” reports Meredith Coffey, an analyst with Loan Pricing Corp. in New York. In September, the Federal Reserve Board conducted a special survey of senior bank loan officers, to assess the impact of widespread financial turbulence on the bank loan market. The survey found “a fairly widespread tightening of standards and terms for commercial and industrial loans to larger firms.” (Not so affected were smaller companies, those with less than $50 million in revenues.)

“With the flight to quality in the capital markets, we will experience [a] greater credit crunch,” predicts Frederick Militello Jr., president of Finquest Partners Inc., a Cornwallville, New York, corporate finance consultancy. As for the present, credit is available, since banks are still flush with funds. But it’s going to cost more.

The end of relationship banking?

It’s hard to find a corporate customer that hasn’t been affected by bank consolidation. For at least a decade, middle-market companies have seen their regional banks fold into one another. Now, the megamergers of 1998 are affecting bigger companies, too.

According to analyst Robert Albertson of Goldman, Sachs & Co., who tracks primary banking relationships among the Fortune 500, Chase serves 42 percent of this group, BankAmerica 28 percent, Citibank 26 percent, and First Chicago­NBD Corp. 26 percent. All of these banks have recently undergone a major merger or are in the middle of one: Chase Manhattan acquired Chemical Bank in 1997; BankAmerica is joining up with NationsBank; Citibank’s marriage to Travelers Group was approved this fall; and First Chicago­NBD, itself the product of a sizable merger, plans to link up with Banc One.

“Two of the 17 banks on our line of credit are merging with each other,” says Betty Beaty, vice president and treasurer of Honeywell Inc., a global controls company based in Minneapolis. In the case of $8 billion Honeywell, an A-rated company, the newly formed institution is willing to accept the double exposure. But to less-creditworthy entities, that may not be the case. “Banks aren’t willing to exceed a certain amount of exposure to one customer,” observes Beaty.

Consolidation strains relationships, as newly merged institutions bow out of services that corporate customers have come to depend on. “When one bank merges with another and suddenly decides cash management or credit are no longer key priorities, all of a sudden you find yourself without those services,” says Militello. “Relationships are in a constant state of disruption.”

Having fewer banks limits options, too. “At one point, we had 10 banking relationships in the United States. Now we’re down to 4 or 5,” says William Boehmler, vice president and treasurer of International Paper Co., in Purchase, New York. “It is more comfortable dealing with a wider universe of [bank] decision makers,” he says. “Our financings are complex, with many different terms, and many of the major banks are shying away from complicated transactions. The more banks there are, the more opportunities you have to convince someone that what you’re doing makes sense.”

As consolidation thins the ranks of bankers, it’s difficult to establish relationships, says Mead’s McBride. He estimates that turnover of bank relationship managers for Mead has soared to 80 percent, from 25 to 30 percent just a few years ago. “Only a few of our account people were on our account a year ago,” he says. “Continuity is important to understand the company’s needs.”

On the positive side, most people, including corporate customers, acknowledge that consolidation has strengthened the banking industry, resulting in healthier banks with robust balance sheets. Consolidation may even increase competition, not stifle it, suggests Gene O’Kelly, vice chairman and head of KPMG Peat Marwick’s financial services practice in the United States. “Consolidation has brought bigger players into markets that traditionally were the purview of just one major player and smaller participants,” O’Kelly points out. “Now you have the new BankAmerica competing in the same markets with the new Banc One and the new Wells Fargo. That’s actually a pretty positive thing.”

RAROC is King

Increasingly, banks are focusing on a key measure of client profitability: risk-adjusted return on capital (RAROC). The RAROC calculation permits a bank to determine not only whether it is pricing an individual loan correctly, but whether its overall portfolio of loans is priced correctly or if it is carrying too much risk. Within the past year, banks have installed risk-rating tools and models that calculate the probability that individual borrowers will default. “Banks used to say that IBM is less risky than a mom-and- pop operation, but couldn’t quantify that,” notes Jeff Reichert, senior vice president of Loan Pricing, which sells risk-rating software. “Now they know that by lending to XYZ Corp., they are taking on some basis points of risk and can price accordingly.”

“Banks are using better information to target risk,” agrees Edward Furash, chairman of Furash & Co., a Washington, D.C., financial services consulting firm. “They see up front if they’re getting better borrowers that they know how to control and monitor. At the same time, they can internally place comprehensive controls on the total amount of risk they can take.”

These tools can separate the swans from the mere ducklings. “Before, banks would place borrowers in broad categories and price them at that,” says James R. Barth, a finance professor at Auburn University and a consultant for the World Bank. Now, banks can determine the characteristics of loans that are likely to go into default or not pay on time, and price them accordingly. Notes Reichert, “Historically, banks have overcharged good borrowers and undercharged bad ones. This will bring more efficiency.”

In general, credit has become more costly and more restrictive. Coffey of Loan Pricing says BBB­ revolving-credit spreads increased 60 percent between the second and third quarters of 1998, from LIBOR plus 42.5 to LIBOR plus 68.5 over the same period. In the BBB one-year- plus market, spreads are up 37.3 percent over the same period. Such companies as Nortel Networks, long accustomed to annual reductions in the price of its $1.5 billion revolver, this year accepted terms that held the price at last year’s level. “We’ve heard that in some cases bank pricing is increasing, but we were able to smoothly execute an amendment to existing pricing,” says Katharine Stevenson, vice president, corporate finance, and assistant treasurer at the Toronto-based telecommunications giant.

Meanwhile, commitment fees for Nextel Communications Inc. have increased by up to 75 basis points, says Steven Shindler, CFO of the McLean, Virginia, company, whose corporate debt is rated B­. ‘There is a higher commitment fee for the unused portion, even from six months ago,” he says.

What’s more, banks are limiting the amount of Nextel’s undrawn credit. “There has been a fundamental shift in banks’ willingness to provide undrawn credit facilities,” says Shindler. Nextel proposed drawing just $200 million of its $1 billion credit line, but the banks wanted Nextel to draw down $500 million as a term loan, with stiff payback provisions.

Nextel, a rapidly expanding telecommunications company with a voracious appetite for capital, acceded to the banks’ terms. Still, “even with these increases, the bank market offers the lowest cost of capital,” says Shindler. “The costs today are closer to what you can get in the high-yield market when it is open–which it is not right now.”

Investment Bank Wannabes

Profitability is in the eye of the beholder, and perhaps one reason commercial banks view loans as unprofitable is that they see their investment-bank brethren earning fat fees on advisory services and corporate finance. “Providing loans is not the best return on shareholder’s capital,” observes consultant Militello. “There are much better returns in advisory services, with no loan loss reserves and no risk.”

But corporate customers aren’t convinced that banks have sufficient advisory experience, even though regulators have permitted commercial bank holding companies to underwrite securities through so-called Section 20 affiliates since 1987.

“Just because the regulations are no longer there, you can’t expect corporations to turn over the M&A work if the banks don’t have the experience,” Militello warns. He has witnessed the reluctance of corporate customers to choose 1 bank out of 14 or so relationship banks to handle corporate finance. “If you can’t decide which bank to give the business to, you give it to an investment bank.” Nextel’s Shindler, who thinks “one-stop shopping” at banks is a benefit, estimates only 5 or 6 of the 40 or so banks that have obtained Section 20 expansion are fully capable of competing with the major investment banks. (See “Building the Bank of the Future,” CFO, November 1997.)

Nortel’s Stevenson says she doesn’t care about the distinctions made between commercial and investment banks. “What we care about is capability,” she says. “Of primary importance is an excellent understanding of our industry, and where that expertise comes from is irrelevant to us.” As more institutions offer both investment and commercial bank services, Nortel might be better served as “one firm gets to know us and our strategic advantage, and can serve us on a wider front.”

Mead’s McBride may be old-fashioned, but he wants banks to do what banks do best: provide long-term credit that fits the needs of his company, not the capital markets. Like the $400 million bridge loan his bank group assembled in just two weeks, when Mead bought a paper mill from Boise Cascade in 1996. Or a five-year facility, renewable annually, that gives his very cyclical company insurance against down cycles. “Banks talk about their 364-day facilities, which require zero regulatory capital, but for a cyclical company like ours, that is not appropriate,” McBride says.

In exchange, Mead historically has paid banks a few basis points more than what would clear the market, and McBride always gives the banks participating in Mead’s revolving credit first shot at any other business. “We view this as a two-way relationship, and some banks still look at it that way,” he says.

Stevenson also rewards credit banks with other transactions, but she takes a more scientific ap-proach. Last year she implemented a financial supplier library (FSL) program, based on Lotus Notes, that records all bank meetings and telephone calls to create a database of bank performance. “We always hold a quarterly meeting to review our banks,” she says, adding, “FSL formalizes the process. We really know who our strongest banking partners are. Sometimes a bank has done something very supportive, and it deserves to be rewarded.”

Banks also deserve to be paid a fair price for credit, says Stevenson. “Our philosophy is not to search for razor’s-edge pricing and beat up our banks. We treat our banks fairly and pay a fair market price.”

Trouble ahead?

The relentless search for profits has led to some of the well-publicized emerging-market losses now pounding a number of the largest money center banks. For Citicorp, Chase, BankAmerica, and Bankers Trust, the collective count to date is more than $1 billion of announced reductions in revenues. How much more extensive the losses will be is anyone’s guess.

“We don’t know what the damage is,” says Martin Mayer, guest scholar and banking authority at Brookings Institution, in Washington, D.C. “Regulators don’t know the full extent of the losses. The hedge funds are financed by banks, and if the funds go broke, the banks pay for the losses and they can’t lend money,” Mayer warns. “It is not inevitable, but it certainly is possible.”

Right now, however, most bank observers aren’t ready to sound alarms. “By and large, the U.S. banking system is safe, because there is not a lot of international lending other than by the large money center banks,” says O’Kelly of KPMG Peat Marwick. “If you go down the top 10 banks, only 3 or 4 have international exposure.”

Banks have also become more resistant to collapse since the dreary days of the 1980s, when Latin American debt and bad loans racked the industry. “The difference between 1980 and now is the level of loan reserves. The banks are healthy,” O’Kelly says. Adds Albertson of Goldman, Sachs: “There is no danger in the slightest. Russia is over, in terms of impact. The level of cross-border transactions is between three and four times smaller than in the mid-1980s, and we haven’t seen a local bond default in years. If we get into trouble again, the impact will be 10 percent what it would have been in the 1980s.”

The troubled capital markets may be of more concern, particularly for below-investment- grade companies. “It is going to cost corporations more money to borrow from banks than from the capital markets, so if the markets are closed off, credit will cost more,” says O’Kelly. “But there is still more lending capability than there are deals. There is lots of competition. Credit may cost more than it did six months ago, but it will be there.”

Whether or not you find your company in a credit bind will depend on your banker and your credit rating. Money center banks certainly won’t be adding risk to their loan portfolios, and even more-insulated banks will press for stricter terms. But borrowers can still find pockets of opportunity. Use competition to your advantage, advises consultant Furash. “Understand where a bank is in all the services you need,” he says.

“Understand how a bank makes money, so when you negotiate, you know where they need you more than you need them.”

———————————————– ——————————— A Boon to the Middle Market?

After the shareholders, the biggest beneficiaries of bank- merger mania may be the middle-market corporate customer.

Why? As the Goliaths battle it out for the thin-margin business of the Fortune 500, regional and community banks will step up their service of the more-profitable midmarket company. And that service promises to be more cost effective and comprehensive than ever.

“Banks understand that their future business, particularly for the middle market, is a blend of commercial banking and securities financing,” says Edward Furash, head of Furash & Co., financial consultants in Washington, D.C. “Ultimately, smaller and smaller companies will have greater access to comprehensive financing.”

Regional banks also realize that middle-market companies don’t have enough banking business to spread across too many institutions. These companies are thus likely to rely on the banks for advisory services and corporate underwriting, two areas far more profitable than loan making. “Middle-market companies don’t have as deep a wallet and don’t have as much ability to divvy it up,” says Peter Davis, a partner at Booz-Allen & Hamilton Inc., consultants in New York. “They don’t have an investment-banking relationship, so banks can cross-sell other products besides loans.”

As more and more smaller institutions use automated risk-rating tools to evaluate the likelihood of loan default, they’ll be able to better gauge the risk of investing in nonrated entities. “It will bring more efficiency to the middle market,” says Jeff Reichert, senior vice president of Loan Pricing Corp., which analyzes loan risks for banks. “Banks will be able to quantify who their better borrowers are and charge them less.”

Furash adds that since competition is so intense for loans, only banks that can offer creative financing solutions will gain new business. “They should say to your company, ‘These are your financing problems as we see it. We’ve put together a package that will lower your cost and increase your flexibility.’ The bank that can provide the most creative financing wins.”

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