Suzanne Miller looks at why banks are signalling the end of cheap loan trade-offs by turning the screws on potential credit risks.
In late April, David Coulter, global head of investment banking at JP Morgan Chase, stood before a large gathering of institutional investors and rattled off a shortlist of trouble spots that the bank is tackling, including the languishing cash equities business. That was no surprise. But the fact that Mr Coulter included loan pricing in his target list should have turned some heads.
It is no secret that US banks have done a poor job for years in pricing their corporate loans. The unspoken trade-off between bank and borrower has always been cheap loans in exchange for lucrative corporate and investment banking mandates. Now banks are starting to turn the screws on companies that pose a credit risk or have already become one.
Mr Coulter says the aim was to force companies to pay more for their loans if their credit rating went down – as an historic number did last year – or if they drew down on unfunded loan facilities. This is an emerging practice that bankers have dubbed “relative value pricing”.
A sure sign of trouble, bankers reason, is when borrowers start drawing down revolving loan commitments that were intended to be undrawn and which are commonly put in place as backstops for commercial paper programmes.
Change is welcomed
Those who have long tracked the banking industry’s fight to fatten pricing have welcomed the nascent change. “This is one small step for bankers and one giant leap for bankerkind,” says Meredith Coffey, director of analytics at Loan Pricing Corp.
The new pricing model will be linked to the bond market. “In other words, banks will be paid market rates for the risk if risk increases considerably. A very rational step,” Ms Coffey says.
As a result, a company will have to match the spread on a bank loan to that of a bond spread if, say, the bond spread widens to 1000 basis points over the relevant benchmark. “It will be a tough sell,” Mr Coulter conceded to the crowd. So far, JP Morgan has tested this pricing model on just one corporate customer – Dominion Resources, a Virginia-based gas and electric holding company that cut its profit forecasts for 2003 last September. Bank of America is also a lead bank on that financing, which was still being finalised in early May.
Only three other companies have agreed to similar terms: Tyco International, Teco Energy and Oncor, the Texas utility group. They are dicier credits than Dominion, which means the practice could start spreading to more plain-vanilla credits.
“People were surprised that JP Morgan did this with Dominion because the company is still relatively strong," says the head of one major US syndications desk. “JP Morgan is trying to lead the market in increased pricing at a potential sacrifice of market share.”
If so, there’s no bank better placed to lead the charge. JP Morgan Chase is the world’s single biggest loan syndicator, with some 16% of last year’s global market share, followed by Bank of America and Citigroup. Leaders like JP Morgan have long fought tooth and nail to preserve their market share, but a look at last year’s bloodied trail of bankruptcies is making key credit providers rethink the wisdom of being the biggest volume-runners.
Five banks now control roughly 70% of the loan syndications market, where global issuance was $1100bn last year compared with $234bn a decade ago, according to Loan Pricing Corp.
If it turns out that banks like JP Morgan are willing to sacrifice market share for credit safety, life for non-investment grade companies could get tougher when Basel II kicks in by 2007.
The new international capital accord will force banks to put more capital behind non-investment grade loans. In other words, banks will weight non-investment grade loans 150% instead of the 100% weighting they now enjoy with investment grade credits.
Banks fight blanket requirements
Banks are fighting for the right to assign their own capital ratings rather than be forced to adhere to this blanket requirement. If they lose the fight, though, the commercial loan spigot for a big part of the market could run dry because some 35% of the commercial and industrial loan market in the US is now non-investment grade. In 1970, it was a mere 5% or so.
“Clearly when you look at the borrower universe, more and more are moving into higher risk categories,” says Keith Leggett, senior economist at the American Bankers Association. “If that’s the case you may find that the cost of credit becomes much more expensive under Basel II in serving lower credit quality.
“This is going to change the nature of that relationship between banks and borrowers because banks are going to charge higher fees or demand more rights to be compensated.”
Regulation concern
This could make credit more scarce on the riskier end of the spectrum. “If you go back to 1991 or 1992, one of the reasons that recovery languished is because banks had to build capital in response to Basel I going into effect,” Mr Leggett says. “That was a regulatory-induced lending crunch. One of the issues we’re concerned about is this: do the regulators shoot the economy in the foot?”
That is a question that many originating banks admit they have not considered yet. Certainly, JP Morgan and its brethren never want to see another year with a scandal like that of Enron again. That will be a powerful incentive to dish out more pricing ultimatums to historically recalcitrant corporate CEOs.
If that means tighter credit, it might also mean better discipline all around.
