The Dodd-Frank bill — or maybe experience and common sense — are widely believed to have brought home to banks and their regulators the lessons of the financial crisis.
One lesson that has apparently not been learned, however — at least, no one is talking about it — is the need for banks to start applying traditional, sound lending practices to resist the steady flow of poorly structured syndicated loans and bonds that Wall Street keeps sending their way.
It is 2010 and the subprime market is gone, but if the terms found in many bonds and syndicated loans being bought by U.S. banks are any indication, it is still 2005 in those markets. Terms that would probably lead an examiner to classify a loan as substandard if they were found in a traditional first mortgage term loan agreement of a middle-market borrower have somehow become acceptable in syndicated term loans and bonds of larger companies.
America's banks are steadily adding to their balance sheets billions of dollars of syndicated corporate loans and bonds that are presented as "senior secured" and "first mortgage" term debt that should be expected to pay the lender back in full if the borrower defaults.
Contrary to their labeling, the agreements governing many of these credits are laden with terms that violate long-proven fundamentals of sound lending and unnecessarily increase the risk of the banks that buy them. The weaknesses of these credits are often buried in impenetrable legalese the average banker is unlikely to read or understand, and they are ignored in offering documents and rating agency reports.
During the frenzied run-up to the bursting of the credit bubble in 2008, long-accepted bond and syndicated loan terms were changed to favor borrowers and the Wall Street firms that package and sell these deals. Surprisingly, nothing has changed in the post-2008 market. Many senior secured term bonds and syndicated term loans being bought by banks today allow the borrower, without lender consent, to:
• Incur significant additional debt that can only be repaid from the limited amount of borrower cash flow and collateral that the initial lenders are counting on to pay them back.
• Sell or release the collateral securing the debt as long as the proceeds are reinvested in something "used in or useful to the business" — valuable income-producing property can be sold and the proceeds invested in inventory that is soon sold, or the stock of a new foreign subsidiary that has little collateral value to the lender.
• Incur unlimited derivative losses that share equally in the collateral that secures the senior secured term debt.
The result is a growing accumulation of unrecognized risk in bank balance sheets and proof that important lessons from the financial crisis remain unlearned.
As we saw with subprime mortgages, a credit market can exist for quite a long time based on weak underwriting and questionable terms that become accepted by banks and regulators. An unanticipated downturn occurs, and big losses result. At that point it is too late for the banks that loaded up their books with what they and their regulators thought were "safe" credits.
Today's heightened awareness of risk makes it a good time to think about reducing risk to bank balance sheets associated with bonds and syndicated loans containing inadequate, risky terms.
The first line of defense should be the banks themselves. Banks should reconsider the terms they are being offered and "just say no" if they are being asked to ignore fundamental principles of credit underwriting.
Reasonable limits on a borrower's ability to issue new debt, sell core assets without paying down debt and incur derivative exposures are not oppressive. Restraint will not deny badly needed credit to American business — most borrowers do not need these loose terms in order to run their businesses successfully.
If bankers are unwilling to restrain themselves, then it is up to the regulators to recognize the risk and say something about it. Though the regulators have offered some criticism of weak underwriting in recent years, they have held back from taking any clear position on the growth of bank holdings of these risky credits.
Regulators say they are taking a harder look this year, as they have done with other types of credit risk. Tangible evidence of this concern is hard to find. A good place to start would be the production of interagency guidance warning lenders of increased regulatory scrutiny and encouraging some "best practices" for evaluating bond and syndicated loan covenants.
Examiner criticism of loans and bonds with weak covenants would address the issue directly.
Regulators and bankers working together can bring the terms of corporate bonds and syndicated loans purchased by federally insured banks forward from 2005 to 2010, taking a lot of unnecessary risk out of bank balance sheets along the way. That seems like a much better solution than waiting for Congress or the next market collapse to make the point.
