Credit and Economic Update
Businesses with credit needs will find the lending environment with banks to be very good, and
with bankers searching for new customers, senior debt financing will continue to be readily available.
To put it bluntly, this is about as good as it gets—the lending environment is rarely
as friendly to business borrowers as it has been over the past year. Nevertheless,
the appetite of bankers for new commercial and industrial (C&I) loans is not even
close to being sated and that portends a continued favorable borrowing environment.
The economy seems to be on pretty solid footing. In spite of some intermittent sputters,
particularly with regard to energy costs and the weakening dollar, real business
investment has been growing, employment numbers are up significantly, and industrial
capacity utilization hit a three-year high in November. Even though the Fed has
bumped up the discount rate on five separate occasions since last June by a total
of 125 basis points, interest rates remain exceptionally low. Overall, the economy
seems to be humming along. As a consequence, the prospects for brisk business credit
demand would appear to be excellent. One might suspect that this would be one of
those heady periods for bankers, when clients are knocking down the door to find
the capital they need to fuel business growth.
After a 20% slide in C&I loans held by U.S. banks since early 2001, the evidence
indicates that credit demand has begun to strengthen a bit. But, it is not nearly
as strong as bankers would hope at this stage in the cycle. In fact, the total volume
of C&I loans held by U.S. banks is still $200 billion, which is 18.5% off the 2000
When the economy is growing, most firms are quite eager to make the capital and
inventory investments necessary to meet customer demand. So why isn't loan demand
stronger? In part, anemic C&I loan volume can be explained by the strength of corporate
cash flow. Since early 2003, most industry sectors have generated sufficient cash
to internally fund the investments necessary to meet customer demand. As illustrated
by the accompanying charts, the general absence of a financing gap between capital
spending and internal resources has resulted in an accumulation of liquid assets
(cash and short-term securities) by non-financial U.S. corporations, and a surge
in the ratio of liquid assets to capital expenditures. In 2003 and the first half
of 2004, corporate liquid assets grew by $244 billion, more than 20%, to $1.3 trillion.
The October 2004 Senior Loan Officer Survey published by the Federal Reserve reports
that credit standards for large, middle-market, and small business loans have continued
to ease and pricing has softened, as banks have sought to stimulate C&I loan volume
and compete for market share.
Loan Pricing Corporation, which monitors syndicated loan markets for the large middle-market
(deals > $100 million) and traditional middle-market (deals < $100 million), reported
a bit of a split story in their third quarter review. Sponsor (private equity group)-related
lending activity for the first three quarters of 2004 was at a five-year high and
up 105% over 2003. The dollar volume of traditional senior debt financings by corporate
clients, including acquisition deals, has grown, but by a less robust 40% over the
same period in 2003, and has not yet rebounded to the level achieved in 2000.
The gap between credit demand and lending enthusiasm is evident in spirited competition
among bankers. The standard measure of lender aggressiveness is how liberally the
limits on financial leverage are set. The routine financial leverage benchmark is
the ratio of total debt (senior, mezzanine and second lien) to trailing 12-month
EBITDA. Lenders are pushing the leverage envelope back towards the levels that prevailed
in the late 1990s. LPC's data suggests that borrower/deal size and institutional
investor involvement have had a meaningful impact on how "sporty" financing structures
have become over the first three quarters of 2004. More than 50% of large middle-market
and sponsored deals have financial leverage covenants in excess of 4X. For the subset
of large middle-market financings in which institutional investors provided a portion
of the debt, leverage covenants were 5X or greater about 50% of the time. In contrast,
total leverage in about 73% of traditional middle-market financings has been limited
to 4X or less. Just 18 to 24 months ago, the average leverage covenant was 3.5X
The appetite of lenders for risk is clearly illustrated by risk and return curves
in the nearby chart. According to LPC, returns, as measured by average spreads over
LIBOR, are down about 60 basis points this year, as compared to 2003 on the most-leveraged
transactions in the market. Bankers are taking more risk at significantly lower
pricing in order to land deals.
HERE IN THE GREAT NORTHWEST
Sadly, there is not an abundance of hard economic data available on a regional basis.
But, anecdotal evidence tells a similar story. Conversations with numerous lenders
are animated by their hunger for assets, yet most are having difficulty finding
enough opportunities and only a few have achieved the loan growth goals that their
institutions set for 2004. A good number of bankers have told us that they will
not be beat on price, and a few have posited that they will not be beat on price
At the small end of the market there also seems to be an abundance of optimism.
A host of community and regional banks have emerged in the Northwest in the past
two years, and several more are in the works. Most of these banks have styled themselves
as small business lenders (loans < $10 million) and have attracted a number of experienced
lenders from larger institutions. Conventional wisdom has it that there is a void
in the market left by the mega-banks that increasingly rely on a mass-market approach
to small business lending based on highly standardized loan products, credit scoring
systems and limited personal interaction. It is rumored that at least one of the
mega-banks is contemplating a redefinition of small business to include companies
with credit needs of $20 million and below. If so, the other behemoths are likely
to follow suit, as the pressure to take cost (people are the largest controllable
expense) out of their systems is unrelenting. The value proposition is that the
emerging small banks can provide the customized credit arrangements and personalized
service that the national banks are less inclined to provide.
Our expectation is that the current market situation–willing lenders outweighing
willing borrowers–will be sustained through 2005. Assuming that the economy remains
on track, a weaker dollar should stimulate domestic and export demand for U.S. products
and services. There should be a corresponding increase in business capital and inventory
investment to meet this demand. At some point, the capital spending and corporate
internal cash flow trend lines will cross again and companies will need to borrow
in order to fund growth. Credit pricing and underwriting standards probably will
not be driven a whole lot lower. But, bankers will continue to be very accommodating.
If it makes sense from a strategic and market perspective to expand or restructure
existing obligations, this is a very good time to sit down with a couple of lenders
and work out attractive financing arrangements.