When a British Airways Boeing 777 crash-landed just short of the runway at Heathrow Airport a few weeks ago, there was a lively debate about why its twin engines had suddenly lost power at the same time. People might well ask the same question about the twin engines of America’s credit system—the capital markets and the banks—whose simultaneous misfiring has helped drive the country close to, or into, recession.
The extent of America’s economic woes was underlined on February 5th when signs of abrupt shrinkage in service industries in January helped push the S&P 500 stock market index down by 3.2%, its worst one-day fall in almost a year. The previous day, the Federal Reserve published its latest quarterly survey of bank-lending officers, which showed that the credit crunch was getting even crunchier. According to the Fed, a good number of banks had imposed stricter lending standards and higher rates on loans since the previous survey, carried out in October.
Although bankers are always stingier in a downturn, the Fed noted that lots of banks said they had also cut back lending because of a slide in their current or expected capital and liquidity. For that, blame the chaos in markets for leveraged buy-out (LBO) debt and complex mortgage-backed securities. Blame, too, the state of such bread-and-butter businesses as consumer and commercial-property lending, which are blowing new holes in banks’ balance sheets.
Hopes that the stalled capital-markets engine might roar back to life in early 2008 have been dashed by grim news from, among other areas, LBOs. Until recently, banks had lent merrily to finance huge private-equity deals and then unloaded all or part of the debt into a deep and liquid secondary market. Often they accepted ropey loan covenants that offered little protection against default. Now, with recession looming, the number of borrowers defaulting on these loans is almost bound to increase. Appetite for LBO debt has dried up, as a group of banks discovered this week when they failed to syndicate $14 billion of debt used to pay for Las Vegas-based Harrah’s Entertainment.
This hiccup means other big deals, such as a sale of the $15 billion of debt linked to the buy-out of Clear Channel Communications, are now in jeopardy. That could leave banks choking on a glut of loans whose value is falling fast. According to Standard & Poor’s LCD, a unit of S&P, a rating agency, even relatively liquid leveraged loans are trading at roughly 88 cents on the dollar, compared with face value in the middle of last year. Some large loans syndicated last year, such as those used in the $29 billion buy-out of First Data Corp., are also trading at big discounts to face value, which will further put off potential investors.
Put that in your pipeline
How much of this unwanted debt could banks be saddled with? S&P LCD reckons $148 billion of LBO loans are in the syndication pipeline, most of which belong to banks, plus another $64 billion of high-yield bonds. If they are unwilling to accept bargain-basement prices, bankers may have to increase their provisions against the debt they keep. “This zombie cohort will trouble the markets for a while,” reckons Mark Howard, head of credit analysis at Barclays Capital.
Another source of trouble is the moribund market for mortgage-backed securities and that for collateralized-debt obligations (CDOs), which are backed by such securities. On January 30th S&P downgraded or threatened to downgrade more than 8,000 bonds and CDOs, noting that financial institutions’ losses tied to them could more than double to a mind-boggling $265 billion.
Add to this the potential bill from the monoline bond-insurer debacle. Banks bought protection on credit derivatives from monolines in the form of credit-default swaps. But the insurers’ capital base is now so thin that they may not be able to pay any claims. On February 6th MBIA, one of the biggest insurers, announced that it would raise an extra $750m via an equity issue to try to preserve its top-notch credit rating.
That leaves banks facing another potential hit. Quite how big this might be is tricky to estimate, as banks use different approaches to assign value to their hedges. But in the unlikely worst-case scenario of a bankruptcy of all of the monolines, Matt King, an analyst at Citigroup, estimates that the total bill could reach $34 billion.
Thus far, the credit crunch has been seen as a Wall Street phenomenon—understandably so given the Croesus-like sums that the big banks have frittered away. But it is fast becoming a Main Street one, too. “Regulators and bankers should be teaming up now to look at the next levels down in the system,” says Michael Poulos of Oliver Wyman, a consulting firm.
He has a point. For one thing, the impact of dodgy subprime-laced debts is being felt beyond the biggest banks: on February 5th Kansas-based US Central Federal Credit Union, a backstop for the nation’s co-operative banks, lost its AAA rating from S&P because of the fall in the values of its mortgage-backed securities. For another, many banks’ consumer and commercial-property lending businesses have been affected by the slowdown.
Strikingly, the Fed’s loan-officer survey showed that 70% of respondents expect the quality of their credit-card and other consumer-loan portfolios to get worse. Some firms are already feeling the pinch: the fourth-quarter profit of Wachovia, a big regional bank based in North Carolina, shrank to just $51m compared with $2.3 billion in the same period of 2006, in part because of sharply higher losses on residential property and car loans. Shares of some credit-card companies fell this week after analysts at UBS told investors to sell their holdings of American Express, Capital One and Discover.
Coming to a bank near you
Commercial property is an even bigger headache. True, it is also a problem for Wall Street’s finest: for instance, Deutsche Bank recently had to take over some Manhattan buildings belonging to Harry Macklowe, a well-known developer, after he failed to refinance $7 billion of short-term debt used to pay for them. But the property story has a uniquely worrying twist for banks across America.
That’s because, in addition to offering commercial mortgages, regional and local banks also make huge numbers of “construction loans” to developers building malls, condominiums and other properties. A business the big investment banks pretty much ignored, construction lending was wildly profitable during the property boom, but now a growing number of these loans are turning sour in the bust. Chicago-based Corus Bankshares recently reported that its fourth-quarter earnings were virtually wiped out by a big provision against construction loans.
Regulators are getting nervous. In a speech to Florida bankers at the end of January, John Dugan, the Comptroller of the Currency, noted that more than one-third of America’s community banks—and more than three-fifths of Florida’s—have commercial-property loans that are more than three times their capital. And he went on to predict increases in loan-loss reserves and a rise in bank failures. How bad could things get? Gerard Cassidy of RBC Capital Markets estimates that between 50 and 150 banks with assets of up to a couple of billion dollars each could fail in the next couple of years, the highest rate since the savings-and-loan crisis of the late 1980s.
Painful though that would be, a more general constriction of credit—if banks’ capital bases were sapped by soaring provisions and declining earnings—would be worse. This worry helps explain the Fed’s recent alacrity in cutting interest rates. But given the fiddly problems of America’s credit engines, it may take more than an injection of monetary fuel to get them humming again.