The Credit Crunch in Commercial Loan Syndication
Commercial lending by banks has fallen to double-digit, negative growth rates, both on- and off-balance-sheet. The current financial crisis has also impacted the market size and composition of syndicated loans, which are a unique type of commercial loans.
A syndicated loan is a credit facility arranged for a commercial borrower, by a group (“syndicate”) of banks. Member banks within the syndicate share the lending commitments, risk exposure, fees and interest revenues. Through syndication, banks are able to comply with regulatory limits on risk concentration (such as a minimum capital-asset ratio and a maximum size of a single loan relative to a bank’s equity capital) and avoid excessive exposure to individual companies. Meanwhile, participating in syndicated loans gives banks opportunities to diversify their loan portfolios and maintain or develop relationships with greater numbers of corporate borrowers.
Providing many benefits to both lending institutions and borrowing firms, the syndicated loan market has experienced tremendous growth since the early 1990s and is now one of the most significant sources of corporate finance. According to loan origination data from Thomson Reuters DealScan, the amount of newly originated syndicated loans in the U.S. market increased 7 times over between 1992 and 2007, from $242 billion to nearly $2 trillion. The increase outside the U.S. was even more dramatic, growing 42 times in volume over the same period. However, syndicated loans were down sharply in 2009, with only about $1.3 trillion originated worldwide that year, from a peak of $4.5 trillion just two years prior. This 70 percent decline shows that this market was every bit as susceptible to the reassessment of risk as other credit markets following the financial crisis.
Commercial loan syndication worldwide is concentrated primarily in North America (nearly 95 percent of it in the U.S.) and Europe, with both markets having recently experienced the same boom and bust. The Asian market also fell to less than 40 percent of its 2007 peak, though this market utilizes syndicated loans to a far lesser extent than either the U.S. or Europe.
As U.S. volumes have fallen, banks have also been charging significantly higher interest rates in the syndicated market. Risk spreads—measured over LIBOR, the cost of funds for banks borrowing among themselves—were on average flat at 236-237 basis points during 2005-2007, before jumping nearly 20 percent to 282 basis points in 2008 and then almost another 40 percent in 2009, to 391 basis points. Because these are spreads over LIBOR, the increase can be attributed to a distinct reassessment of risk within the syndicated loan market itself, not simply to an increase in arranging banks’ cost of funds.
The kinds of companies that receive syndicated loans have actually been fairly constant over the past five years, although absolute levels of credit extended have dropped off. Typically, about half of syndicated loans flow to public companies that are rated by the major rating agencies. These tend to be larger firms with a lot of publicly available information. A significant share (30-40 percent) also goes to privately held companies. A small share of loan syndication credit goes to unrated, public companies. Following the crisis, credit extension contracted more sharply for public, rated companies than for private companies.
Interest rates rose as syndicated loan originations fell. Historically, the spreads on these loans have been correlated to the amount of monitoring a lender would have to do to limit its credit exposure. Private companies generally are subject to the fewest requirements for providing standardized financial documentation, and so are generally charged the highest interest rate. Publicly owned companies must meet a minimum of documentation requirements, and therefore are easier to analyze and monitor (which means a lower interest rate).
Interestingly, those companies that produce voluminous amounts of required financial statements and carry an outside credit risk grade—public, rated companies—saw the biggest spike in their interest rates following the crisis, even exceeding private and public, unrated companies in 2009. Although all companies saw their perceived riskiness reassessed upward in 2008 and 2009, the marked leap in interest rates for public, rated companies may have been due to concern about the ratings themselves, which came under closer scrutiny following the torrent of mortgage security downgrades. If official ratings were called into question, their contribution to lowering interest rates would have to have been partially or completely withdrawn.
In addition to restricting credit through higher interest rates and lower volumes, syndicates are also offering credit primarily to larger borrowers than in the past. Since loan volumes are falling and the value of real annual sales by syndicated loan borrowers is rising quickly, the average company size per loan must be rising. Larger, more established companies may give lenders more confidence about repayments, and their business models and financial conditions are likely to be better known and understood than those of smaller firms.Finally, we ask where the funds from syndicated loans are being put to use in the economy. Over at least the past five years, the majority of loan proceeds have been used for “corporate” purposes, which means for working capital and general business operations. In the late 1990s and early 2000s, a lot of these loans were used for refinancing arrangements, such as restructuring a firm’s balance sheet (for example, by adding a new source of debt or buying back shares) and rolling over or paying down other debt. This practice has declined in past years with the continued development of the corporate bond market—including the high-yield (“junk”) market—which serves as a financing alternative to commercial loan syndication. Historically, syndicated loans were also used as a form of credit enhancement, standing behind commercial paper and other loans as a source of payment if the borrower defaulted. Loans for that purpose have all but disappeared in the last two years. Acquisition loans—used to finance the takeover or merger of another firm by the borrower—experienced booms first during the late-90s Internet bubble and again from 2004 to 2008 at the height of the credit bubble. They have since been reined in, and today most syndicated loans (over 70 percent) are going to companies planning to use the money for general business purposes.
In summary, banks use syndicated loans to limit their credit exposure to a single firm or market while still meeting their clients’ borrowing needs. This loan category—like every other credit market—swelled in the mid-2000s, but the credit crunch and its attendant risk environment led to a contraction in this type of credit. The contraction has come in the form of lower volumes, higher interest rates, and an emphasis on lending only to large firms. Meanwhile, borrowers in the syndicated loan market have moved away from more aggressive or speculative ventures like mergers and acquisitions, and are now using loan funds primarily to operate and develop existing businesses.