With no way of predicting if and when a credit crunch will arrive, can banks’ lending departments afford to continue squeezing profit margins and slackening structures to secure business? Silvia Pavoni reports on the implications for financial stability.

The past couple of years have been great times for corporates: plenty of cash in the till, strong balance sheets and improved credit ratings. Commodity producers, especially, are enjoying super cyclical commodity prices, swelling their cash inflows even more. With so much corporate cash power, banks’ lending departments have been fighting to the last sliver of profit margin to get business.

Profit margins have not been the only things to go down. To win deals in this competitive landscape, lenders have relaxed the loan covenants and weakened the structures they offer to clients previously restricted to borrowing on a highly secured basis. Corporates have borrowed at very convenient terms, while banks have taken on higher levels of risk. The question now is whether the financial system can absorb the forthcoming downturn of the credit cycle, or whether banks should prepare for a particularly painful credit crunch.

Portfolio worries

Some financiers are concerned about what impact the end of the credit cycle and potential defaults will have on their loan portfolios. Many have witnessed the historical credit curve peaks and troughs and believe that the market cannot sustain such a long bull run at this pace without collapsing.

“There is too much cheap money around,” says one structured finance senior manager. “On the one hand, low interest rates plus too many banks and too much liquidity chasing too few assets have fuelled a borrowing binge. On the other hand, there has been less of a borrowing requirement due to strong corporate cash flows – companies have had so much money, they are often now doing share buybacks. Lenders are taking on too much risk to win deals; companies have borrowed too much cheap money. The next credit crunch will be painful.”

Even with a more widespread distribution of credit risk, facilitated by the increasing use of credit derivatives, some fear the financial stability implications of this risk transfer, says Lorenzo Isla, head of credit derivatives research at Barclays Capital. “When you increase the amount of derivatives in the market, you are creating the potential for trouble,” says Mr Isla. “While creating more stability, the transition from a balance sheet-based credit allocation model to a market-based one exacerbates volatility in some parts of the credit markets during a credit downturn.”

Cycle optimists

Others are less concerned about the impact in the short term because they believe the market is still at the crest of the cycle, and no-one can predict beyond the next 12 months. “Despite rising interest rates and high commodity prices, the market is likely to continue to be buoyant in the near term,” says Kristian Orssten, head of loans capital markets, trading and sales for EMEA at JPMorgan. “The million-dollar question is when the cycle will change. There are, however, no signs that we will see any material changes in the near future.”

Some argue that banks have already started to correct the sort of overly aggressive lending behaviour that led to a number of deals with longer tenors than in the past, a number of transactions priced lower than in the past and transactions with weaker structures – such as fewer financial covenants or looser documentation overall.

David Bassett, global head of loan markets at RBS, says: “The loosening or weakening of such factors is dramatically slower than it was a year or a year and a half ago. Then banks were literally falling over themselves to do anything, and now you do find a number of banks that are starting to walk away from structures that they think are not wise, so there is some sanity still in the system.”

Peaks and troughs

To exacerbate the ups and downs of the credit cycle, the loans trend in some emerging markets is heavily influenced by the value of commodities. Improving sovereign ratings, stronger corporate balance sheets and rocketing commodities prices have tilted the balance of power between borrower and lender.

Russia is a fitting example. There are two forces at work: the first is improving corporate and sovereign credit quality, which is bringing down margins, cutting costs for borrowers and profits for lending banks; the second is liquidity, which is reducing corporates’ borrowing needs and is forcing lenders to reduce margins even further to win deals.

Improved profitability and higher credit ratings have encouraged borrowers to refinance deals to obtain better rates. Structures have been more relaxed, if not lax, and it is unclear how much protection there is for lenders in the case of default.

Growing loans volumes

The number of unsecured loans has increased in the past few years, especially in countries such as Russia, where they grew from 24% of total syndicated loans in 2003 to 60% in 2005, according to data provider Dealogic. Loan volumes in Russia have been growing steadily in the past five years, but they exploded in 2005. Citigroup figures reveal that in 2005 the oil and gas sectors accounted for 64.8% of the Russian loans market, up 41.2% from 2004.

“Abundant liquidity was looking for higher yields, especially in Russia and Kazakhstan, where yields were attractive,” says Steven Fisher, managing director and emerging market corporate bank head, Russia and CIS at Citigroup.

“Right now, I think that the market has entered into a new phase, where some transactions are so tightly priced that they are no longer attractive to many market participants on a risk-reward basis. Some people think that the decline of margins has already stopped, without the occurrence of any negative credit event in the market.”

In an emerging market, the repercussions of a default event are more wide-ranging than elsewhere. International banks that have been encouraged to lend at favourable conditions to weaker borrowers may quickly lose their appetite for such deals and leave the market. Also, emerging markets can prove problematic for some players, such as hedge funds. It can be difficult to hedge exposure because of the illiquidity of the market in times of turmoil and the less developed derivatives markets.

“You see a separation between banks that are more relationship driven and the banks that are investment yield driven,” says Mr Fisher. “Purely yield-driven banks are the ones that will step back first when margins become too tight.”

If there were defaults, they would not just slow but end the decline of margins because banks would become more cautious: not all banks would go for the same deals, new international players would lose interest.

Opportunists ready

If less established financiers lose appetite in a credit market that is descending into a crisis, there are players who would be more interested, too. Situations that are likely to trigger losses are increasingly becoming opportunities for speculation and hedging. Many hedge funds are expecting that rising interest rates will soon lead to a credit crunch, when the low rates deals that are now available to corporates would terminate. This seems to have led to an expansion of their distressed debt expertise and an increase in recruiting in that area, with hedge funds even approaching banks’ credit experts.

A survey of hedge funds’ clients by Swiss consultancy Tara Capital confirms an increased interest in the distressed debt area, with investors anticipating bigger allocations to funds investing in distressed debt.

Hedge funds would not be the only ones busy in a period of market turmoil. Distressed debt departments of investment banks would also be in the front line. Some of them have been building their teams during the past years. In London alone, Morgan Stanley has a 40-strong distressed debt team, while Deutsche Bank employs 130 people in this area.

Risk management

What saved lenders’ portfolios in the last downturn of the credit cycle, in early 2000, was more sophisticated credit risk management and more developed financial tools, which kept on growing from the late 1990s. Credit derivatives, securitisation, collateralised loans obligations (CLOs) and collateralised debt obligations (CDOs) can absorb part of the credit crunch’s hit.

How much a series of defaults will damage lenders depends on how much risk they have taken on and, most importantly, on how effectively they have managed their risk. Overall, banks’ risk profiles seem positive, according to rating agency Fitch.

With derivatives markets deeper and more liquid than in the previous low of the credit cycle, those who are positioned to pass on the risk will do so and those who are better equipped to take the risk will take it. Financiers can shift a big portion of their weak structured deals’ risk to other markets; in particular to the credit default swap (CDS) market.

It is not as simple as that, however. Credit derivatives encourage lenders to take on more risk when the market is up. They also facilitate the creation of CLOs and cheapen the cost of debt in that market, further allowing corporates to leverage themselves. But this increased exposure to the debt market also amplifies the magnitude of default events and the volatility of credit derivatives prices when the market is down.

Forecast and strategy

Economists find it difficult to forecast which credit market will be the first to blow. The current expansion is the strongest since the 1960s, and the theme that makes it special is not only its strength, but also that it has been similarly generous across the globe.

Given the near impossibility of a long-term forecast, lenders are ‘making hay while the sun shines’ on the loans market and exploiting it as a first step in building business relationships with corporates.

The temptation to build relationships based on watered-down terms and conditions is strong and may work in the upward curve of the credit market. Longer-term market players, however, need to look beyond the deal at hand.

With clients searching for increasingly sophisticated borrowing structures, the loans market alone does not always offer the most effective solution. And lenders believe that the real competition is played on their ability to offer tailor-made solutions to potential clients.

The point is to use the loan market for what the loan market is best suited for, says Mr Bassett. “If you need quick financing, the loan market is the right place to go, but is not necessarily right for a longer-term financing strategy. I tend to believe that we will eventually have a small group of multi-product global players, who are the core drivers of the loan market and of the financial market overall. Ultimately, the number of second-tier players will be forced to the sideline or to niche areas, and will be participating in smaller and smaller numbers of financings because they don’t have the scale, size and breadth to compete.”

What will be interesting to see in the next few months is how the loan market will react to the anticipated increase of global interest rates. And in the long term which banks will be more effective at winning deals and bringing loans clients to other, more profitable product areas.

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