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National Regional Outlook, First Quarter 2001
In Focus This Quarter
Credit Problems for U.S. Businesses Continue to Increase
IntroductionContinuing increases in problem commercial loans have focused the spotlight on business lending conditions. On September 30, 2000, commercial banks reported the highest relative level of noncurrent1 commercial loans-at 1.52 percent of total commercial loans-since third quarter 1994. In fact, commercial banks have been reporting steadily higher rates of noncurrent domestic commercial loans since the second quarter of 1999. The first quarter 2000 edition of Regional Outlook identified several factors contributing to the decline in business credit quality despite the strong economic indicators then in place. These factors, which are still relevant today, include the rise in financial leverage for domestic corporations, greater investment risk appetite and looser underwriting standards from 1996 to 1999, and increasing financial stress within various industry sectors. More recently, an apparent slowdown in economic growth increases prospects for further deterioration in business credit conditions.
1 Nonaccrual loans plus loans 90 days or more delinquent.
Large Banks Experience a Reversal in Commercial Credit Quality Trends
Through much of the 1990s, a sustained period of economic growth produced improving commercial loan credit quality indicators for insured commercial banks. This trend reversed itself in 1998, when banks began experiencing a steady rise in nonperforming and delinquent commercial loans. While the initial catalyst for this reversal was related mainly to events abroad,2 a slowing domestic economy has since taken center stage as the underlying driving force behind worsening commercial credit quality trends.
2 Significant events that contributed to higher levels of problem foreign loans in 1998 include the collapse of Asian currency exchange rates and default by the Russian government on its sovereign debts. Some domestic industries that were highly dependent on exports (steel, for example) were also adversely affected by these events.
As of September 30, 2000, noncurrent commercial and industrial (C&I) loans held by commercial banks stood at $15.6 billion, a 46 percent increase over the previous year. Roughly 97 percent of this increase is attributable to the rise in nonaccrual and delinquent credit to U.S. domiciled borrowers. Net C&I loan loss rates are also rising. Through the first three quarters of 2000, annualized C&I loan loss rates reached 0.64 percent, up from 0.58 percent in 1999. The last time banks saw C&I loss rates this high was in 1993 (0.74 percent).
Larger banks, which have the greatest exposures to large- and middle-market corporate credits, have been hardest hit by the turnaround in business credit conditions. As shown in Chart 1, banks with over $1 billion in assets have experienced most of the recent deterioration in C&I noncurrent loan rates. Since the fourth quarter of 1997, the noncurrent C&I loan rate of large banks has increased from 0.74 percent to 1.50 percent. Over the same period, noncurrent C&I loan rates at small banks were unchanged at 1.64 percent. While the increase in noncurrent loan rates at larger banks is significant, these higher rates remain well below those that preceded the 1990 to 1991 recession, when noncurrent loan rates at large banks were in the 3.40 percent to 3.60 percent range.
Much of the recent deterioration in banks' business credit quality is attributable to the seasoning of credits underwritten during a period of relaxed lending standards. Each of the three bank supervisory agencies has recognized and warned about the potential impact of loosened loan underwriting standards in the event of a slowdown in the economy. For example, just over a year ago, the Office of the Comptroller of the Currency (OCC) issued a warning to banks about the "...cumulative effect of the past four years of easing standards..." for commercial loans.3 The shift toward more liberal credit standards from 1996 to 1999 was fueled by various factors, including a robust economy, intense competition to originate syndicated credits, and an increased appetite for risk. During this period, a number of banks moved aggressively into non-investment-grade lending to combat narrowing interest margins and declining investment-grade yields. According to a recent Standard & Poor's commentary, several banks have acknowledged the role of 1997 and 1998 vintage credits in producing higher levels of problem loans.4
3 Office of the Comptroller of the Currency Press Release. October 5, 1999.
4 July 20, 2000. "U.S. Bank Loan Portfolios Reflect Rise in Corporate Bond Defaults." Standard & Poor's Commentary.
Business Loan Performance Is Not Likely to Improve Any Time Soon
Prospects for any near-term reversal in deteriorating commercial loan trends are dimming as signs of slower economic growth and tighter credit conditions emerge. Economic indicators suggest an aging economic expansion that is losing momentum. In third quarter 2000, the U.S. economy recorded its 39th consecutive quarter of growth. However, real gross domestic product growth for the third quarter was only 2.2 percent, well below the previous quarter's growth of 5.6 percent and below the 4.9 percent average quarterly growth rate during the past eight quarters. Corporate earnings also appear to be slowing. Annualized corporate profit growth in the third quarter slowed to 5.1 percent, down from a 15.6 percent annualized growth rate in second quarter 2000 and a 10.4 percent average growth rate over the past eight quarters.5 Corporate earnings are widely anticipated to slow even further based on the number of companies that have warned of profits falling below expectations in the fourth quarter.6
5 These figures are taken from the U.S. Department of Commerce's statistics on corporate profits with inventory valuation adjustments.
6 According to First Call/Thomson Financial, 505 companies released warnings that fourth quarter 2000 earnings would fall below expectations, up 96 percent from the 257 companies with negative profit warnings for fourth quarter 1999.
Prospects for slower economic growth prompted the Federal Reserve to lower its target for the federal funds rate (the rate charged on overnight lending) by 1/2 percentage point to 6 percent on January 3, 2000. This cut follows a 175-basis-point increase in the targeted federal funds rate since the end of June 1999. Although higher interest rates have undoubtedly raised borrowing costs for U.S. corporations, business borrowing rates-even before the Federal Reserve cut interest rates in January 2001-are well below those prevalent during much of the 1980s (see Chart 2). Moreover, changes in rates have been far less volatile in the latter part of the 1990s than they were during the 1980s and early 1990s.
Tolerance for risk on the part of investors and lenders is waning. In a November 2000 survey of underwriting practices, the Federal Reserve Board noted that 44 percent of U.S. banks tightened credit terms for large- and middle-market borrowers in the past three months, the highest incidence of tightening since fourth quarter 1990. This tightening of credit terms is primarily in response to economic concerns, industry-specific problems, and a lower tolerance for risk. Banks appear to be especially apprehensive about taking on additional credit risk related to merger and acquisition financing deals, new borrowing prospects, and specific industry segments such as health care, movie theaters, and communications.7
7 See the Federal Reserve Board ’s November 2000 Senior Loan Officer Opinion Survey on Bank Lending Practices.
Tighter credit terms by banks will have the greatest impact on high-risk companies, which have fewer financing options in an environment of slumping bond and stock prices. Moreover, there appears to be a significant increase in the volume of maturing debt that could be forced into default if capital market or bank funding is not available. According to Moody's, some $108 billion of rated speculative-grade corporate debt held by banks matures over the next three years, a 40 percent increase over year-earlier levels.
Higher-risk companies also have a lower capacity to absorb the cost of higher interest rates. Yet many companies with debt maturing in the near term will likely be forced to pay higher risk premiums than in the past. For example, Moody's notes that in November 2000, speculative-grade bond yield spreads over seven-year Treasuries reached their widest level since February 1991, at 771 basis points.8 Chart 3 illustrates further how credit spreads between just-investment-grade bond issues and near-investment-grade bond issues have widened considerably compared with spreads between lower-investment-grade bond issues since the beginning of 2000. Some of the most significant increases in credit spreads have been observed in the high-yield telecommunications sector, where credit spreads over seven-year Treasuries widened by 688 basis points in 2000.9
8 December 2000. Moody's Leveraged Finance Commentary.
9 Merrill Lynch Global Bond composites. Issues facing the telecommunications industry are explored further in the article entitled "Three Industries Navigating in a Competitively Charged Environment" in this issue of the Regional Outlook.
The effects of tighter credit conditions and a reduced appetite for risk are beginning to emerge in loan origination volumes. According to Loan Pricing Corporation, originations of highly leveraged loans10 through the first three quarters of 2000 fell to $117 billion from $140 billion for the same period in 1999.
10 Loan Pricing Corporation defines highly leveraged loan transactions as those carrying interest rates of 250 basis points or more over the London Interbank Offer Rate (LIBOR).
Corporate bond trends provide further evidence of financial stress in the domestic market and suggest more near-term deterioration in problem business loans. Corporate bond default rates have climbed significantly since 1997 (see Chart 4). Through November 2000, trailing 12-month default rates on speculative-grade corporate bonds reached 6.8 percent, up from 3.5 percent at the end of 1998. Higher default rates have been accompanied by an accelerated pace of negative ratings revisions, which, according to Moody's, reached a rate of 3.2 speculative-grade downgrades for every speculative-grade upgrade through the first 11 months of 2000.11 More significant, Moody's projects that speculative-grade corporate bond defaults will continue to move higher to 9.1 percent over the coming year. Given a fairly strong correlation between speculative bond default rates and banks' noncurrent loan rates, these projections suggest a continuing rise in the relative level of problem commercial loans.12
11 See Moody's Credit Perspectives, December 4, 2000.
12 There is a strong correlation between historical speculative-grade corporate bond defaults and noncurrent loan rates. The correlation coefficient between these two variables for the period 1984 to the present is 0.67.
Loan Default Risk Is Rising in a Number of Industry SectorsEvidence from Corporate Bond Defaults
Corporate bond defaults provide clues as to which industries may experience a higher rate of defaults. Chart 4 shows the historical trend in speculative-grade bond defaults since 1988. The initial upward spike in default rates in 1998 was largely the result of events abroad, when 74, or 59 percent, of 126 defaulted issues were attributed to foreign-domiciled issues.13 In 1999, the distribution of defaults shifted decidedly toward domestic issues, with U.S. firms accounting for 99, or 67 percent, of 147 defaults. Of the U.S.-domiciled defaults in 1999, 64 percent were related to industrial sectors, with concentrations in price-sensitive commodity and trade-dependent sectors such as oil and gas, shipping, and steel. Other domestic sectors that experienced a noteworthy rise in defaulted issues in 1999 were telecommunications and health care. Year-to-date 2000 defaults continue to be dominated by U.S. firms.14 According to Moody's, year-to-date defaulted bond issues have been concentrated in health care; telecommunications; and textiles, leather, and apparel.15
13 Indonesia alone accounted for 32 defaulted issues in 1998, and sovereign issuers accounted for 36 percent of defaulted debt volume. Historical Default Rates of Corporate Bond Issuers, 1998. Moody's Investor Service.
14 Historical Default Rates of Corporate Bond Issuers, 1999. Moody's Investor Service.
15 Moody's Credit Perspectives, December 11, 2000. Issues facing the health care and textile industries are explored further in the article entitled "Three Industries Navigating in a Competitively Charged Environment" in this issue of the Regional Outlook.
Evidence from Syndicated Loan Trends
Past growth in syndicated loans may be another indicator of default risk. Many lenders appeared to increase their appetite for risk from 1996 through 1999, judging by the growth in leveraged loan and highly leveraged loan volumes during this period (see Chart 5).16 Because rapid loan growth can be an indicator of aggressive risk taking, it is important to review some significant borrowing industries that experienced rapid credit growth from 1996 to 2000. It is also worthwhile to review industries where higher-risk (high-yield) borrowing accounted for a substantial proportion of syndicated loan transactions.
16 Loan Pricing Corporation defines leveraged transactions as those that carry interest rate spreads of 150 basis points or more over LIBOR and highly leveraged transactions as those that carry spreads of 250 basis points or more over LIBOR. Because these definitions are spread-driven, the rise in the proportion of higher-yield issuance is attributable in part to a general increase in credit spreads. This was the case particularly during the 1998 period, when credit spreads rose significantly.
Table 1 lists selected industries17 that accounted for a significant proportion of syndicated loan volumes from 1996 to 2000, according to Thomson Financial Securities Data. Industries that experienced some of the most rapid growth rates in syndicated loan volumes during that time include utilities, telecommunications, and real estate investment trusts (REITs). Industries that recorded a particularly significant proportion of high-yield transactions during that period include real estate and construction, REITs, health care, and entertainment/lodging/leisure.
17 This list is taken from a group of 50 sectors defined using Standard Industrial Codes (SICs). Only industries that accounted for more than 2 percent of 1996 to 2000 origination volumes were considered for inclusion.
Evidence from Corporate Profit Trends
Industry sector earnings trends may also be an indicator of industry default risk, because higher defaults are more likely in sectors with weak earnings. As noted above, profit growth rates of domestic firms appear to be decelerating following two years of strong earnings growth overall. Rapid growth in previous quarters appears to have been driven in large part by high-tech and related sectors, such as electronic equipment and communications. These sectors have to a large extent overshadowed noteworthy declines in profit growth in other sectors, such as metals, chemical production, medical services, property casualty insurance, apparel and textiles, manufactured housing, agriculture, transportation, and wholesale trade (see Table 2).
Evidence from Credit Risk Models
Credit default models have proliferated in recent years because of advances in technology, data availability, and financial theory. One such model is KMV LLC's Credit Monitor®. This model, which uses publicly available information to estimate the likelihood of default for individual firms, is widely used by lenders to monitor and evaluate obligor risk and credit risk trends. While it is not the only model available, the KMV model can be applied consistently and easily to the analysis of industry sector credit risk across a broad range of industry groupings.
In brief, the KMV model uses options-pricing theory to derive market-based expected default probabilities or an expected default frequency (EDFTM).18 The model relies mainly on three pieces of information: (1) a firm's asset market value; (2) the volatility of a firm's asset market values; and (3) the firm's capital structure or financial leverage. Although EDFTM scores are company-specific, median industry expected default probabilities can be constructed and compared across industries and across time to discern relative rankings of industry risk and industry risk trends. These median EDFTM scores also can be mapped to other default measurement scales, such as external rating agency ratings, based on individual EDFTM scores of firms with rated debt.
18 Typically expressed as the probability of default over the coming year.
Since the second quarter of 1998, median EDFTM scores have risen significantly across a wide range of U.S. nonfinancial industry sectors (see Chart 6). The service and trade sector includes the greatest proportion of firms with high default risk. The median probability of default for the manufacturing sector firms is lower, but it is rising and roughly equaled that of Standard & Poor's BB-grade (sub-investment-grade) obligors as of December 2000.
Although no one factor can explain the rise in expected default measures for U.S. nonfinancial firms, rising financial leverage is clearly a major determinant. U.S. corporate debt burdens continue to rise in conjunction with the longest-running economic expansion in U.S. history. The debt-to-net-worth ratio (book value) of nonfarm, nonfinancial businesses rose to 83 percent in the second quarter of 2000, up from 72 percent at year-end 1996. Although these figures remain below the relative debt levels experienced in the late 1980s and early 1990s,19 U.S. businesses are nevertheless becoming increasingly vulnerable to rising credit costs and disruptions in credit availability. Higher asset value volatility20 has also played a role in rising EDFTM scores, which, as in any options-based credit risk model, leads to a greater likelihood of default.
19 The debt-to-net worth ratio for U.S. nonfarm, nonfinancial businesses averaged slightly under 87 percent from 1988 to 1992.
20 Implicit in changes in stock prices.
Chart 7 shows eight of the highest-risk industries in terms of changes in median EDFTM scores over the past two years. These industries were drawn from a list of 50 financial and nonfinancial sectors segregated by Standard Industrial Codes (SICs). For each of these 50 sectors, median EDFTM scores were determined for December 2000 and compared with median EDFTM scores for the same sector in December 1998. Consistent with general industry observations, entertainment and leisure, health care, and telecommunications are among the sectors where default risk has risen most significantly over the past two years.
21 Syndicated loan originations are an imperfect measure of actual loan exposures in the financial industry. For example, it is not possible to determine the level of outstanding exposures simply by summing up origination levels from year to year, because payments on long-term debt are not considered. Moreover, a substantial volume of debt represents revolving lines of credit where credit exposures roll over on a periodic basis. Nevertheless, trends in originations do contain some information on the relative level of industry exposures, because they show which industries are borrowing more or less during any given year.
While Chart 7 illustrates sectors undergoing financial stress, it does not provide information on the relative importance of these sectors to lenders. Thomson Financial Securities Data provides information on the volumes of syndicated loan originations by banks and nonbanks. Matching industry-expected default trends with syndicated loan origination trends by industry is one way to determine the relative importance of higher-risk industry credit exposures.21
Chart 8 shows median EDFTM and syndicated loan origination pairs for selected industries during the past three years. Of the industries shown, the telecommunications industry appears to present the greatest degree of risk, given a nearly $50 billion increase in loan volumes from 1998 to 2000, coupled with a 170 percent increase in median expected default levels over the same period. In contrast, loans to securities brokers and dealers can be considered relatively less risky-despite a $17 billion rise in originations from 1998 to 2000-because of a fairly modest rise in median expected defaults. It is also interesting to contrast the health care and entertainment and leisure sectors. Firms in both sectors have experienced a dramatic rise in expected defaults. However, since 1998, Thomson Financial Securities Data shows a significant curtailment in lending to health care companies, while entertainment and leisure originations have held steady over the same period. Because banks appear to be reducing credit exposures to health care firms, banks should eventually see a decline in the level of defaulting debt related to this sector.
Chart 8 illustrates how U.S. syndicated loan issuance and expected default measures can be linked to produce a better sense of risk-weighted industry exposure volumes held by lenders. On the basis of this type of analysis, producing a list of industry sectors that appear to pose the greatest degree of syndicated loan default risk is relatively straightforward. Perhaps not surprisingly, industries such as telecommunications, wholesale and retail trade, entertainment and leisure, health care, and apparel and textiles rank high in terms of risk-weighted industry credit exposures using this analysis.22
22 Fifty sectors, grouped by SIC codes, were considered.
Many U.S. banks are experiencing deterioration in business loan quality measures. The adverse effects of higher interest rates, a tightening of credit terms, slowing profit growth, and industry sector weaknesses are the primary contributing factors to this deterioration. Several indicators-including a projected increase in corporate bond default rates, rising expected default trends in certain industry sectors, and evidence of lax underwriting practices in previous periods-suggest that banks could experience substantial further deterioration in business loan quality in the near term.
Although worsening business loan quality is a concern, these negative trends must be put into perspective. In relative terms, current indicators of business loan problems do not approach the experience of banks during the last economic downturn of the early 1990s. Moreover, continued strong earnings and capital provide a significant buffer for banks to weather the effects of higher levels of nonperforming business loans and business loan losses. Nevertheless, the prospect of a slowdown in the economy raises concerns about the possible severity of commercial loan problems, a situation that will undoubtedly be watched closely by both banks and bank supervisors in the coming months.
Steven Burton, Senior Banking Analyst
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