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San Francisco Regional Outlook, First Quarter 1999

In Focus This Quarter Recent Trends in Syndicated Lending A strong U.S. economy, intensifying competition, and the increasing marketability of bank loans have driven record volumes of syndicated lending in the 1990s. After several years of liberalized underwriting, evidence suggests that some banks have tightened standards and terms for loans to large commercial borrowers. Market developments and underwriting trends over the past several years have implications for credit quality, earnings, and liquidity at institutions that hold or originate syndicated loans. Commercial and industrial lending is a major source of revenue for commercial banks, yet this business line has lagged other major lending categories in terms of liquidity, standardization, and commoditization. However, in recent years the transformation of commercial lending has accelerated and is altering the way lenders do business. This trend has been particularly apparent in syndicated commercial lending. This article briefly defines syndicated loans, reviews the 1990s boom in the market, and discusses the implications of competitive pressures and secondary market liquidity for underwriting trends and risk profiles of commercial banks active in this market. Syndicated Lending Overview A syndicated loan is a credit extended to one large or medium-sized corporate borrower that is originated by a group, or syndicate, of lenders. Syndicated lending differs slightly from participation lending, which is common in commercial banks. Although both types of lending allow for flexibility in reducing company-specific risk and adhering to legal restrictions for loans to one borrower, only one lender originates a participation loan, which is then sold in undivided participation interests either concurrently or subsequently to third parties.1 A syndicate usually consists of a group of institutions that work closely on a number of deals that are sold to subscribers at origination. 1 American Bankers Association, Banking Terminology, 3rd ed., 1989, p. 345. Syndicated loans can generally be categorized according to rating, terms, pricing, or target investors. The investment-grade loan market, often referred to as the pro-rata or retail market, is the lowest-risk segment of syndicated lending and comprises approximately 80 percent of all volume originated from 1987 to 1997. These loans commonly take the form of liquidity backstops or lines of credit and are marketed to commercial bank investors. Loan Pricing Corporation (LPC) defines these credits as those rated BBB–/Baa3 or better, or nonrated deals with pricing equal to or less than rated deals in these bands. Near-investment-grade, leveraged, and highly leveraged markets, often referred to as B, C, and D tranche term loans or non-investment-grade loans, include credits with longer maturities, greater risk, and higher pricing. Non-investment-grade loans are typically structured for institutional investors and compete more directly with the traditional high-yield bond market. LPC defines non-investment-grade loans as those rated BB+/Ba1 or worse, or nonrated deals with pricing greater than deals graded BBB–.2 2 Loan Pricing Corporation, Gold Sheets, Third Quarter 1998 Review, p. 2. Competitive Trends in the Syndicated Loan Market A handful of large U.S. commercial banking companies originate the vast majority of U.S. syndicated corporate credits across all quality types. According to LPC, 14 U.S. banking companies were among the top 25 syndicated lenders (based on the number of agent or co-agent transactions) and accounted for half of 1998 syndicated loan transactions to U.S. corporations through mid-November.3 In 1997, nine U.S. banking companies were among the top 25 and executed 36 percent of the market's transactions. Before 1997, the most active domestic commercial banks saw their market share erode from a peak of 45 percent of transactions in 1992 to 34 percent in 1996, primarily because of intensifying competition from nontraditional syndicated lenders such as investment banks and foreign banks. Although U.S. banks have recently recovered market share (as Japanese banks have significantly withdrawn from the market), a strong U.S. economy, expanding liquidity in the bank loan market, and a trend toward one-stop shopping in the financial services industry have attracted competitors to the syndicated market in the 1990s. 3 Loan Pricing Corporation, Gold Sheets, November 16, 1998, p. 6. Syndicated Loan Liquidity U.S. commercial banking companies retain or buy a large volume of syndicated loans, yet estimates show that most of the volume is sold to other institutional investors. Information from the shared national credit program4 indicates that at year-end 1997, FDIC-insured commercial banking companies had extended facilities and commitments totaling $1.8 trillion, of which an estimated $565 billion was funded. To put this figure in perspective, an official of the Office of the Comptroller of the Currency estimated that 57 percent of outstanding syndicated loans were held by foreign banks; 26 percent by originating banks, mutual funds, and insurance companies; and 17 percent by subscribing banks.5 Indeed, according to BankAmerica Corporation, the number of nonbank institutional investors in bank loans, including prime rate mutual funds, hedge funds, and insurance companies, increased from 14 in 1993 to more than 100 in 1998. These investors have played a pivotal role in enhancing the bank loan as a distinct asset class by increasing trading activity, demanding third-party loan ratings, and contributing to the development of loan derivative products. 4 The shared national credit program is a cooperative examination program conducted by the three federal banking agencies and cooperating state agencies to review large, complex credits held at multiple institutions. Loans subject to review are syndicated loans or groups of loans and commitments of $20 million or more shared by three or more supervised institutions. 5"Concerns Mounting Over Risks in Booming Syndication Market," American Banker, January 29, 1997, p. 20. Perhaps the most important new development in syndicated lending has been the deepening secondary market for bank loans as many new investors seek to purchase them. As shown in Chart 1, the volume of secondary trading in bank loans has grown sharply, more than tripling between 1994 and 1997 to over $60 billion. Trading in 1998 through the third quarter was on pace to top the 1997 level. Traded loans are often non-investment-grade issues, which have been the focus of most demand by the burgeoning institutional investor base. One important force behind the development of a bank loan secondary market has been rapid expansion in the number of bank loans rated by third-party rating services. Chart 1 Independent credit ratings of bank loans were initiated in 1995 when "several years of rapid development in the syndicated bank loan market generated a critical mass of interest in the credit characteristics of these instruments."6 Standard and Poor's, Moody's, Duff and Phelps, and Fitch/IBCA are now actively involved in rating bank loans. Through 1997, Standard and Poor's and Moody's combined rated $677 billion in loans. As rating activity increases access to and availability of standardized analysis and research for bank loans, including market analysis, ratings criteria, and historical loss recovery rates, investors are becoming more comfortable with loans as a distinct asset class. Moreover, independent loan ratings allow investors to value a company's loans relative to its other rated loans or bonds. 6 "Bankrupt Bank Loan Recoveries," Moody's Investor Service, June 1998, p. 5. Bank loan secondary market activity and independent ratings have prompted the development of new ways to package and improve the market acceptance of these assets. As a result, the securitization of bank loans and the development of various types of derivative products have proliferated. As discussed in "CLOs Lure Another Major Bank Asset off the Balance Sheet," in Regional Outlook, third quarter 1998, collateralized loan obligations (CLOs) are a major market development allowing for the securitization of corporate loans. A large investor appetite for varied types of asset-backed securities and a desire to move assets off the balance sheet to lower risk-based capital requirements have helped promote a sharp increase in this type of securitization. Loan derivatives also may allow lenders to better manage the trade-off between maintaining borrower relationships and avoiding excessive concentrations of risk. This trade-off has become increasingly important with the trend toward one-stop shopping in financial services. One-Stop Financial Providers For several years, analysts have noted a trend toward financial services supermarkets—financial institutions positioning themselves as providers of a complete array of advisory services and financial products. One aspect of this trend has been the tendency of traditional lenders to improve their ability to offer a full array of equity and debt underwriting, as characterized by the expansion of Section 20 activities among major U.S. commercial banking companies. Traditional securities underwriters view entry into the syndicated loan market similarly. For example, no investment bank had a syndicated loan underwriting department in 1994, but several are now making inroads into the market, especially the leveraged market, and some increased their syndicated loan volume fivefold in 1997.7 In some cases, the desire of commercial banks to move toward one-stop financial services and the resulting approaches to relationship management have affected the underwriting of loans to large commercial borrowers that have multiple financing and advisory service needs. 7 "The New Kids in the Syndicate: Investment Banks Are Moving in on the Leveraged Syndicated Loan Market," Bloomberg, March 1998, p. 35. Historical Perspective on Syndicated Loan Underwriting Trends Increased interest by investors in bank loans and strong competition for business resulted in syndicated lending at historically narrow spreads and on more liberal terms. Accordingly, the syndicated loan market was a borrowers' market for much of the 1990s. As shown in Chart 2, the volume of syndicated loan originations increased almost fivefold between 1991 and 1997, with record volume levels achieved in each of these years. Much of the volume was driven by growth in the origination of loans for the purpose of refinancing existing debt, especially from 1995 to 1997, as borrowers took advantage of increased lender competition and investor demand to reduce funding costs and extend maturities. In some cases, borrowers were able to refinance loans obtained just months earlier at significant savings and more favorable terms. Chart 2 Chart 3 shows that lending spreads compressed sharply from 1993 to 1997, particularly for lower-quality credits. LPC stated that "[e]xcessive competition has driven spreads and fees to all-time lows, with the investment grade market purely a relationship play."8 Consistent with the financial supermarket concept discussed above, as relationship lending proliferated, many lenders were evaluating transactions on the basis of overall relationship returns rather than individual transaction returns. Consequently, borrowers willing to offer an institution ancillary business, such as cash management, securities underwriting, or securitization services, were likely to receive more favorable loan pricing than borrowers seeking to execute just one loan deal. 8 Loan Pricing Corporation, Gold Sheets, First Quarter 1995 Review, p. 9. Chart 3 During the same period, a clear trend toward weakened underwriting resulted in deteriorating risk/return relationships across syndicated lending categories. Financial indicators market analysts use to evaluate whether lenders are being adequately compensated for risk generally weakened. For example, the ratio of debt to earnings before interest, taxes, depreciation, and amortization rose to relatively high levels for an increasing number of leveraged and highly leveraged loans.9 Moreover, lengthening maturities reflected looser underwriting. A decline in the spreads between loans of one-year and five-year maturities made it cost-effective to borrow for longer periods. LPC indicated that the differential between fees on undrawn 364-day revolving loans and undrawn five-year loans had dropped by one-half during this period.10 As a result, many borrowers extended maturities on new credits, and, as shown in Chart 4, the average maturity of investment-grade loans originated in the mid-1990s lengthened significantly. 9 Ibid., pp. 16-17. 10 Ibid., p. 43. Chart 4 Recent Underwriting Developments Beginning in late 1997, lenders and investors began to resist aggressively priced investment-grade and near-investment-grade loans. This resistance led to a leveling of pricing, fewer refinancing opportunities for borrowers, and increased focus on the higher-risk leveraged lending market, where nonbank institutional investor demand was strong and pricing was richer. In response, overall syndicated lending volume declined almost 16 percent during the first three quarters of 1998 compared with the same period in 1997. However, within total new syndicated loan volume, leveraged loan originations grew 77 percent to $200 billion during the same period, accounting for approximately one-third of all syndicated—the largest proportion of the market since 1989. Of particular note was that this growth in higher-risk lending came at a time when losses in speculative-grade bonds had been trending higher and growth in profits for nonfinancial U.S. corporations had been slowing (see Chart 5). Chart 5 Global economic turmoil and the flight to quality that disrupted the capital markets during the third quarter of 1998 spilled over into the bank loan market and solidified a shift to a lenders' market. LPC noted in its third-quarter 1998 review of syndicated lending that "[r]ates and fees are on the upswing meaning opportunistic refinancings…continue to dwindle. Concessions suddenly are going to lenders rather than borrowers, and volume continues the drop [from levels] seen earlier in the year."11 Growth in leveraged lending also declined sharply as the number of institutional investors in the market fell by one-half from the second quarter.12 11 Loan Pricing Corporation, Gold Sheets, Third Quarter 1998 Review, p. 3. 12 Ibid. The shifting dynamics of the market in late 1998 were characterized by the aforementioned slowdown in originations, a sharp increase in pricing (see Chart 3, above), and evidence that underwriting had become more stringent. The volatility in credit markets resulted in deals being rescinded or incorporating "market flex" pricing language that enabled lenders to manage the yield requirements of investors due to changing yields on competing capital markets instruments. The influence of the secondary market on new loan pricing became apparent as investors required underwriters to factor in higher secondary market yields. In addition, as shown in Chart 6, the Federal Reserve Board's November 1998 Senior Loan Officer Opinion Survey on Bank Lending Practices reported that a significant minority of surveyed lenders had tightened lending standards and terms for commercial loans to large and middle-market firms.13 On net, nearly 40 percent of domestic bank respondents had tightened lending standards for these borrowers for the three months ending November 30, and nearly half had increased pricing. These percentages are the highest reported since the last recession. Chart 6 13 Large or middle market firms are those with annual sales greater than $50 million. Underwriting was also influenced by increased borrower demand for bank loans—a secondary effect of the market volatility in late 1998. The aforementioned Federal Reserve Board survey noted an increased demand for bank commercial loans primarily as a result of shifts from other sources of credit, namely the bond and commercial paper markets. For example, one industry participant estimated that the loan market represented roughly 60 percent of capital market financing in January 1998, 40 percent in July as the high-yield bond market boomed, and nearly 100 percent in September as the bond markets stalled.14 14 "Syndicated Lenders Swiftly Surmounted September Dip," American Banker, December 10, 1998, p. 25. Implications for Insured Institutions Although recent evidence suggests that some lenders have tightened standards and terms for loans to large commercial borrowers, market developments and underwriting trends over the past several years have implications for credit quality, earnings, and liquidity at institutions that hold or originate syndicated loans. A slowing economy and stress in industries exposed to weakened international economic conditions could result in increased losses during an economic downturn, especially for banks that are holding higher-risk syndicated loans. Although nonbank institutional investors hold the bulk of the riskier tranches of syndicated deals, some banks ventured into riskier, longer-term issues in response to narrow pricing on traditional loan pieces held by banks.15 Should liquidity become an issue in the secondary market, banks planning to sell these pieces may face losses. For example, as reflected in Chart 7, the rolling 52-week total return on the Goldman Sachs/LPC Liquid Leveraged Loan Index, which measures the performance of a diversified portfolio of the most actively traded performing leveraged loans, has fallen from over 8 percent in early 1998 to less than 4 percent in December 1998. Falling prices have caused reduced returns as required spreads on these credits have risen. Chart 7 15 "Banks Compete with Funds in Buying Long-Term Tranches of Syndications," American Banker, March 19, 1997, p. 1. Downstream subscribers that purchased thinly priced or loosely structured loans may not be adequately compensated for risk. This lack of compensation may be especially important for institutions that do not receive ancillary relationship income. Evidence suggests that downstream lenders became more willing to accept loans during the 1990s without receiving full documentation or making an independent credit analysis. The Office of the Comptroller of the Currency reportedly attributed this trend to a desire to add loan volume coupled with comfort about company prospects because of the strong economy and strong corporate profits.16 As a result, on a risk-adjusted basis, the returns on these credits may hamper the performance of investing institutions. 16 "Concerns Mounting over Risks in Booming Syndication Market," American Banker, January 29, 1997, p. 20. Sustained reductions in syndicated loan liquidity may adversely affect revenues and increase percentages of loan amounts retained by active syndicating institutions. If institutional investors remain withdrawn from the loan market for an extended period, syndicates may have increasing difficulty marketing deals, especially in the non-investment-grade segment. As a result, institutions dependent on revenues generated by this activity may face declining income as fewer deals are executed, or they may have to hold larger percentages of undersubscribed transactions. This situation may be further exacerbated by consolidation in the U.S. banking industry, which has combined several major syndicate agents in the 1990s and has reduced the number of potential downstream investment-grade subscribers in the market. Rising demand from borrowers exploiting relative pricing in the loan and capital markets may have credit and liquidity implications for underwriting institutions. Sustained volatility in the capital markets may increase the demand for bank loans and will likely significantly increase funding costs for many borrowers. For example, LPC recently compared loans that were extended to seven companies in early 1998 with similarly structured loans extended to the same companies after the third-quarter disruption in the capital markets. The analysis revealed significant increases in required yields, ranging from 112 to 388 basis points.17 Rising funding costs combined with a trend toward slower growth in corporate profits may reduce loan repayment capacity of borrowers in more troubled industries. In addition, banks that have extended liquidity backstops or backup lines of credit may be required to fund facilities that traditionally are not heavily used by borrowers. For example, without appropriate pricing adjustments, banks providing backup commercial paper loans may be called upon to fund these facilities as a result of volatility and relatively high spreads in the commercial paper market. 17 Loan Pricing Corporation, Gold Sheets, November 16, 1998, p. 21. Increases in credit spreads on securities and syndicated loans, the recent rise in speculative corporate bond defaults, and slowing corporate profits may portend an increase in commercial credit problems for commercial banks. Now more than ever, those involved in bank risk management should pay close attention to fundamentals, including careful credit analysis, diversification, and maintenance of prudent underwriting standards. Attention to these fundamentals may help alleviate the need to overreact to sudden changes in the market environment. Steven E. Cunningham, CFA, Senior Financial Analyst Ronald L. Spieker, Chief, Regional Programs and Bank Analysis Section Regional Outlook Information Return to Regional Outlook main page