Lucent Technologies, Xerox, Marconi, Swissair, Railtrack, Sabena, Enron – the list of once highly creditworthy companies suffering sudden and precipitous declines in credit quality grows longer almost by the day and no-one knows how many more angels will fall nor how many more junk-rated companies will disappear before the global economy recovers. Moody’s Investors Service calculates that in the first three quarters of 2001, 185 rated and unrated corporate bond issuers defaulted on $76 billion-worth of bonds, compared with $49 billion-worth for the whole of 2000. The credit-rating agency’s models forecast that defaults will rise to a peak in the first quarter of 2002.
Bond investors have to mark their positions to market and take their licks now, but the effect on banks, which can hold loans even of severely damaged companies at par until they are finally written down, is much harder to discern. But it’s not going to be good. Indeed it’s precisely such sudden bursts of failures on substantial loans by large and once highly rated companies that can crush banks. So a lot of chief executives and chairmen, a lot of regulators – and a lot of investors in banks’ shares and bonds – are now suddenly eager to know what kind of job has been done by those they’ve put in charge of managing their banks’ portfolios of loan and other credit exposures. Assuming that anyone has been put in charge at all.
Many banks have appointed loan portfolio managers in recent years, but it’s almost impossible for any outside analyst to gauge how they have transformed the quality of loan books. You can see the size of them, but little about their average credit quality, diversification or risk characteristics. And some loan portfolio managers are sceptical about how effective they and their peers have been.
Managing a portfolio of loans is a distinct discipline to managing a portfolio of debt and equity securities. Most obviously a bank loan never trades above par value: it can only lose value from the moment the bank makes it, or at best can maintain its value and pay interest and principal on time. Unlike a manager of a high-yield bond fund, who knows that bonds of a sub-investment-grade issuer that is upgraded might trade up to 110% or 115%, a loan portfolio manager doesn’t have to bother about trying to spot the winners. He only has to worry about reducing the likelihood of loss.
That might make the job sound easy. It isn’t. Events such as Enron’s troubles are almost impossible to predict. Indeed many banks don’t even try to predict them – though some watch for warning signals such as sudden falls in the share price – and devote themselves instead to rigorous credit analysis before a loan is made and then perhaps to removing excessive concentrations of exposure to individual obligors, or to borrowers from the same country, region or industry sector.
That doesn’t sound too demanding, but it is. Most banks are designed and built to generate huge concentrations of credit risk, with loan officers paid to produce asset growth and net interest margin by extending loans. And who do they extend them to? Why, the credits they know best, often those in their home countries and in the industry sectors in which the banks have strong relationship managers.
“Our bank is built around specialist industry marketing groups – industrial growth, technology, telecoms, media and entertainment, consumer and business services,” says Jim Gertie, director, portfolio management at FleetBoston. “Sure, you can have very diversified lending where you have a generalist sales force, but then you don’t have much specialist knowledge of what’s going on inside those borrowers either.” He adds: “By having many specialist units you get the specific knowledge of the industry risks and structures while attaining broader portfolio diversity.”
But once concentrations build up, how can a bank use that specialist knowledge to protect itself? It’s no simple matter to unwind concentrations in the illiquid loan market. One credit portfolio manager points out that, as a rough yardstick, the global equity market turns over 200% of its capitalization in a year, while the loan market probably turns over around 5% of its value. Steven Jones, director of portfolio management at Citigroup, says: “You often hear that many banks are now aggressively managing their loan portfolios, but where’s the evidence that it’s really happening? There’s still only scant liquidity even in the investment-grade loans market relative to its total size.” Portfolio managers say that it’s only when the markets post tight bid-offer spreads in loan assignments of $5 million and below that the banks will really be able to contemplate building desirable target portfolios.
But there are at least signs of improvement. Following the LDC, real estate and highly leveraged loans losses of the late 1980s and early 1990s many large banks have at least tried to manage their concentrations – and as they have sold, the secondary loan markets have grown. KMV, the leading provider of quantitative techniques for modelling risk and returns in portfolios of credit and for modelling expected default rates, reports that 40 of the 50 largest banks in the world and 70 of the top 100 now use its services. The Loan Syndications and Trading Association estimates that secondary loan trading volume in the US has grown from $8 billion in 1991 to $40 billion by 1996 and $102 billion in 2000. The Loan Market Association suggests that secondary trading volume of Euroloans has grown from $20 billion in 1997 to $35 billion in 2000. And though separate loans of a single issuer, each with their own covenant packages and pricing structures, will never have liquidity comparable to the same company’s homogeneous equity securities, credit derivatives may yet provide a single, liquid instrument for trading its credit. Their use is growing exponentially, albeit from a low base.
Can the banks be saved?
So can loan portfolio managers, using all the wonderful new tools at their disposal – credit derivatives, securitization, loan trading, portfolio modelling – save the banks?
The answer is not entirely reassuring. One of the leading exponents of bank loan portfolio management, who requests anonymity, says: “it’s ironic that when banks suddenly get most focused on how to reshape their loan portfolios – during a downturn – they’re least able to do it. Many banks are scrambling now, but they can’t change the shape of their portfolios in these circumstances, when credit markets become distressed and illiquid. And even if you can deal in any size, there’s an obvious danger of being a forced seller at the bottom of the credit cycle.” Banks can’t suddenly protect themselves now, he argues. The key question is how well they have conducted the entire process of granting, holding, and managing loans in the months and years running up to the credit downturn.
And that raises another disquieting issue. What is most surprising about talking to banks’ loan portfolio managers is not the disparity of approaches to the discipline – substantial, given the different starting points of their underlying businesses. Nor is it the glaring absence of any useful knowledge about correlations in likely default and recovery rates between different industry sectors and geographies. Nor is it even the more extreme and damning conclusions to which many are led – that loans are a dire investment and banks execrable vehicles for owning them. Beyond all these, what is particularly disquieting is how nascent efforts in portfolio management are. Even the supposed experts in loan portfolio management haven’t been at it very long.
“We started looking at portfolio management three years ago at the time of the merger between NationsBank and Bank of America. Each bank had large domestic portfolios and were active in syndications, but not active in hedging the portfolio risks,” says Chan Martin, managing director of portfolio management for global corporate and investment banking at Bank of America. That’s a dangerous-sounding portfolio, but the newly merged bank didn’t jump in and slash it all at once. “At the time of the merger we did not want to significantly reduce without much notice our exposures with clients who were banked by both institutions. In the past 18 months we have taken a much more active approach to managing our concentration risk.” says Chan. Bank of America hasn’t yet gone to the extreme of some banks, where portfolio managers charge other businesses for taking on loans that those businesses believe will produce other revenues. But it has reduced the value of loans on its balance sheet from $99 billion in August 2000 to $75 billion in the third quarter of 2001 and it has been quite aggressive in divesting problem loans at well below par, selling $1.15 billion of these this year.
Jones at Citigroup says: “We started this about a year ago, partly because we could see the impending turn in the credit cycle, partly because we were striving to perfect cross-selling. The demands for our capital are huge and it’s become more important to manage commitments from a return point of view.” Citigroup, like many banks, wants to take on many times more loan commitments than it used to without consuming any more capital. That’s its new business model and this requires it to sell down and hedge those commitments much more actively.
ABN Amro, one of the largest European wholesale banks, is also relatively new to the discipline, which it is now embracing as part of its declared drive to reduce the capital it allocates to wholesale banking by 20% by 2004. “The bank set up the loan portfolio management function as part of its restructuring last year,” says Gary Page, global head of portfolio management at ABN Amro. Should investors in ABN Amro’s shares be worried by this? “When you’ve got a loan book like ours, spread across 50 countries and borrowers of all sizes and industries, it’s already pretty diverse,” says Page. “In fact the bank is trying to reduce the numbers of clients we do business with and allocate capital to those relationships that add value. We now use economic profit as a metric for every product.” So during the course of this year the bank has started to evaluate every new loan proposition over a certain size and screen it according to this metric and also to examine the legacy portfolio for the economic profit of individual loans and loans that support overall relationships. “We then target disposals of loans that are destroying value,” Page says. “So we’ve been more active in the secondary loan market and credit derivatives.”
If it sounds as if ABN Amro has been a little slow, remember that many other large European banks haven’t even started this process yet, or have hired people to try to introduce portfolio management but have not yet empowered them to enforce the discipline. “Too many people claim to be bank portfolio managers, but they don’t have the authority to really do it,” says Brian Ranson, executive managing director at BMO Monegy, the specialist credit investment management group at Bank of Montreal.
Barclays Capital is reckoned to be one of the front-runners in loan portfolio management in Europe and it enforced the separation of loan origination and loan portfolio management – a crucial step in portfolio management – in July 1998, ironically just before its heavy losses in Russia. JP Morgan was seen as the front-runner in the US. It became so keen on treating loans in the same way as securities that its executives privately supported efforts to introduce mark-to-market accounting for loans. Such a change would bring an enormous volatility to banks’ reported earnings. The securities firms have lobbied hard this year for banks to be subjected to this at a time when lenders have been using their balance sheets to win capital markets and corporate finance business from the investment banks. Interestingly most loan portfolio managers inside the banks support the concept of marking to market, apparently siding with the enemy. But outsiders detect a change at JP Morgan following the merger with Chase and a less radical approach. Evidently it had become so rigorous in working down its loan exposures that the old JP Morgan found its earnings coming under pressure. It found it difficult to win capital markets business from companies to which it was less willing to lend.
“We separated ownership of the loan book from origination in 1995,” says Ian Drew chief credit officer at UBS Warburg. “We also introduced pricing transfers and made our first attempts to hedge credit risk.” At last – a veteran and someone who sounds reasonably on top of what he’s doing. What made this approach possible was the introduction of the O’Connor risk management culture to SBC following its acquisition of the Chicago boutique in 1992. It later purchased Warburg in 1995. So by the time SBC merged with UBS in 1998, it brought a radical approach to loan exposure management. “The merger brought a doubled exposure to just about every big corporate name in the world, and some large individual concentrations,” recalls Drew. “We made a massive effort to reduce our loans-held position: in fact, we more than halved it.”
Of course UBS Warburg is more a securities firm and investment bank than a commercial bank. It doesn’t regard lending as a viable stand-alone business. It doesn’t have branch managers pressuring its credit portfolio managers to book and hold assets. But it does have corporate financiers and relationship managers who want the firm to take on commitments – sometimes loans – to support their business with corporates. “We have a large credit trading business that at any time can be long or short certain credits,” says Michael Hutchins, managing director in credit fixed income at UBS Warburg in New York. “And we’ve applied some of that mentality to hedging the loan book. There’s no perfect answer to how you manage a loan book. Though the loan book is just one part of a very large overall credit exposure, we spend a lot of time on it because the markets are so illiquid. Loans are important to customers. And when a relationship manager wants to do a big loan for a customer, you may have a debate and very senior management may have to take a franchise decision. At various times you can hold, sell or hedge – but you also have to know upfront that there are sometimes loans which you simply can’t hedge.”
And how does that leave him feeling now? “We’ve got a big credit portfolio that’s standing up well to a global recession: so we’re not in a particularly defensive posture right now.”
UBS Warburg is among those firms, unlike traditional lenders, that seeks constantly to free up and re-use its capital rather than tying it up against a static portfolio of loans held to maturity. Its risk managers use an internal scoring list for credits, using inputs including secondary market credit spreads, equity prices and KMV models that are constantly updated on their screens. If a movement in one of these inputs – a rising bond spread or falling equity price – suggests an imminent deterioration in the credit score, it triggers an alert message on the responsible manager’s screen. The manager has to respond – he may decide that no change to the credit score is warranted and no action is necessary, but that has to be justified. Deciding to sit tight is just as big a decision as choosing to downgrade the credit, sell it, or hedge it.
It’s a world away from the traditional bank still governed by the mentality of accrual accounting for its loans. This suggests that banks should hold loans to maturity and that they are worth par until the moment a borrower collapses and the loan is in work-out. It ignores the process by which passively managed loan portfolios naturally deteriorate. Strong borrowers can prepay good loans pretty much whenever they like, while weaker borrowers never do and will even seek to extend banks’ exposures – many one-year revolving credits often give the borrower the option to extend for a year which those in trouble will always grab. Even if banks do keep exposures to strong credits, these will often be renegotiated at ever finer and ultimately value-destroying terms for the banks. A lot of quite intelligent people in banks have operated within this dreadful system for years.
The UBS Warburg credit risk managers probably feel right at home next to the market-driven bond traders. But loan portfolio managers brought into large commercial banks can find themselves trying to overturn an entire culture. “The traditional credit process is high-cost, time-consuming, usually a committee decision, focused on regulatory capital or a poor internal rating system that’s out of date and probably gets arbitraged. It produces a low turnover loan book, with sub-par pricing, assets booked at par that aren’t worth par and accumulations of risk concentrations,” says the anonymous loan portfolio manager. Right away you can tell that he’s not a fan of the traditional process.
It’s all based on the mistaken belief that a really rigorous credit-approval process when a loan is first granted can hold good through the five-year life of the typical corporate loan. Recent sudden falls from grace of once high-rated companies show that this is plain wrong. Credit quality is not static. A well-constructed loan portfolio today may look terrible in six months’ time because any company’s creditworthiness can change quickly – and what’s more in extreme market downturns the credit standing of many borrowers can dip sharply and suddenly all at the same time.
If that traditional credit process is bad enough in the good times, it gets far worse in a deteriorating credit market. “It’s the accrual trap,” the portfolio manager says. “The asset is booked at par, if the secondary market goes to 99 but you don’t have to mark to market no-one wants to sell now and take a loss on something that was only approved three months ago. Then it goes to 95 and 90 and still no-one takes responsibility. Before you know it the loan has been passed over to the bank’s work-out group and it’s trading in the secondary market at 50.” He concludes: “Portfolio management isn’t about ducking and diving now, it’s about changing that entire credit process.”
Haven’t banks done this before?
That potentially pits the lonely portfolio manager, armed with his KMV risk models and portfolio theories, against the rest of the bank and, in the absence of determined support from the chief executive and chairman, possibly being overwhelmed by armies of people paid to make loans.
It seems extraordinary that banks should only have introduced portfolio management in the last couple of years. In fact many US banks first embraced the concept 10 years ago, after the near life-threatening losses of 1989-91. Citibank, Bankers Trust and JP Morgan, for example, had portfolio managers who undertook many of the early studies into rating migrations and pricing grids that formed the building blocks for the credit derivatives market that grew up from 1994 onwards. What happened to that generation? Many of them became proprietary credit traders and analysts. But the determination to apply portfolio management discipline to banks’ whole loan exposures mysteriously dissipated as the US and world economy boomed and the good times rolled.
Brian Dvorak, managing director at KMV, acknowledges that though his cutting-edge company has many bank customers that doesn’t mean that they have all fully implemented active portfolio management. “I think most banks are using these tools for risk measurement but not yet for actual active management – though some have started and many more say they do intend to.”
Why the hesitation? “When there are no loan losses, the lenders inside the bank get the upper hand because they bring in the revenue,” says Ranson, who used to manage the Bank of Montreal’s own portfolio. “Banks only turn to portfolio management when things are bad, but when the good times come again, they’re like alcoholics – back on the bottle.”
It’s instructive that many of the banks that now claim to be active portfolio managers only took up the practice after a key event transformed the business – mergers bringing huge concentrations, sudden unexpected losses – and forced senior management to confront the concentration problem.
There are a couple of things that all banks should be doing with their loan portfolios, even if they don’t embrace a full mark-to-market mentality, separation of loan management from origination and cash transfers from business groups to portfolio managers for taking on sub-par priced relationship loans. Most important, they should reduce concentrations. If the watchwords of real estate are location, location, location, for banking it’s concentration, concentration, concentration. “Most people see the benefits of diversification,” says Dvorak at KMV, “but they tend to diversify across industry sectors and that doesn’t always work so well because correlations across industries can be quite high.”
KMV reckons that banks get greater benefits from geographic diversification. But they must still be wary of thinking that the best strategy is taking large exposures to the best credits in each country, because the biggest problems always come from the large loans that looked safest when banks first put them on. Dvorak says: “Large companies are exposed to the systematic risk of global economic slowdown. And remember, if you keep your credit portfolio static its diversification properties will not stay the same: they will deteriorate as credit quality deteriorates because that’s when default correlations go up.”
The second most important change is that banks should be much readier to act quickly when the quality of a borrower first starts to deteriorate, by selling, hedging, or securitizing away exposures before there’s a significant fall in the secondary market price. Indeed Jones at Citibank suggests: “You really should act even when you just suspect that there might be a problem arising that’s perhaps being signalled in the equity market.” If the problem never develops, a bank can easily put the exposure back on, at little additional cost.
Gertie, at FleetBoston, says: “We probably should have been doing a lot more as certain angels began to fall – selling off chunks of credits that we scored on our internal system as a two [the best quality credits being rated one on a one to 10 scale] when they fell to a four, rather than waiting and acting when it was a four falling to a six, where it costs a lot more.” Indeed financial reporting sometimes provides a disincentive for banks to take the first and smallest loss. Small loan losses on sales in the 90s may be accounted a P&L loss and hit the bank’s and the business unit’s operating income. Much steeper losses of loans sold out at below 70 cents on the dollar may be paid for out of the loan loss reserve portion of the bank’s capital, which somehow seems to be less of a blow than a hit to the annual P&L.
The good news is that there are new investors to which banks can offload loans. To investors with hefty exposures to equities and bonds, loans can bring some diversification. Specialist arbitrageurs can extract value because they are not subject to the same costly regulatory capital requirements as banks. And if banks really want to get a few rotten loans of their books, they can sometimes do this by parcelling them up with sounder assets.
Gertie explains: “Say an investor buys 100 loan assets of $10 million each and figures that 20 might default and go to 70 cents, so he’ll lose $60 million. If the portfolio pays 200bp per year, he’ll earn that $60 million in three years. Now say he buys that portfolio by putting up $100 million of equity and he leverages the rest, and also say that only 10 of the loans default. His loan loss is only $30 million and he makes $30 million profit.” And why would a bank sell that portfolio? Because it thinks that maybe as many as 30 of the loans will default and go to 70 cents. It’s setting up a short credit position and is happy to lose some good assets to get rid of the bad.
Such portfolio structuring and sale – as distinct from real and synthetic portfolio securitizations – is a new technique for banks. They have plenty of incentive to explore all such possibilities. KMV calculates that expected default rates in Europe have doubled in the last year – an extraordinary move and they have risen sharply in the US. The table above splits companies from the safest 25% to the riskiest 25%. It’s the rising likelihood of default in the middle ranks that’s worrying.
Say a sizeable bank is running a $100 billion loan portfolio paying 140bp on average in margin against 100bp of expected losses. Now say it’s actual losses are 200bp: that turns a $400 million profit into a $600 million loss. “Holding a portfolio of loans is like holding a series of short out-of-the-money options positions,” says Dvorak. “That’s fine when the premiums are rolling in, but when those options are suddenly in the money, the risk of being short options suddenly becomes very large – there’s a very fat tail risk, especially since defaults are correlated.”
Time will soon tell which banks have really managed their loan portfolios well, and which have only been talking a good game.
A lousy way to own credit
Although bank loan portfolio managers talk a lot about managing down concentration peaks, none yet goes so far as to try to pick up loan assets in industries or regions where the bank does no lending, just to fill in the empty spaces in ideal, diversified target portfolios. “We understand the portfolio optimization theory, but we have not yet gone to buying exposures where no relationship exists,” says Martin Chan, managing director of portfolio management for global corporate and investment banking at Bank of America. Steve Jones, director of portfolio management at Citigroup, sees the rationale but his bank doesn’t do it either. “We probably should be doing that, but I don’t think anybody is. Partly that’s because you would have to be very confident about your understanding of correlations and our credit risk analysts aren’t.”
Jim Gertie, director of portfolio management at FleetBoston, is suspicious of where such wholehearted adoption of portfolio theory might lead. For as long as a bank can say to regulators and accounting bodies that its loans are not routinely held for sale, it doesn’t have to mark them to market. Indeed right now, in a deteriorating credit market, American banks that have bought credit derivatives may enjoy a strange accounting benefit under FAS133. This may force them to mark credit derivatives to market – so recording a gain – but not the loans they are hedging. Fair-value accounting would recognize mark-to-market accounting for both the credit derivative and the portion of the loan it hedges. But right now banks don’t want to mark loans to market if they can help it. “If you constantly trade portfolios then you’re a mutual fund, you’re no longer a bank,” says Gertie. “Some of the more extreme approaches to portfolio management could basically put banks out of business.”
Precisely, say those within banks on the cutting edge of portfolio management. Banks are a lousy vehicle for investors in bank securities to derive earnings from loan portfolios, because of double taxation. Banks hold large portfolios of loans on their balance sheets and earn net interest margin. Then they pay corporate tax and only then dividends to shareholders. Shareholders then have to pay income tax on those earnings. It would be better if investors simply bought into mutual funds or other asset management vehicles to derive earnings from loans. “Banks have asset management arms that are paid to manage equity assets, they don’t put them on their own balance sheets,” says a portfolio manager. “Why should loans be any different? A fund structure would bring lower regulatory capital, lower infrastructure cost and no corporate tax rate. Introducing the portfolio management function at banks is not the end game: a new model for the industry is.”
It’s easy to see why banks don’t want to go that far. The ability to extend loans provides a massive advantage in winning other business – bond, equity and M&A mandates. And that has helped such banks as Citigroup, Deutsche Bank, UBS Warburg and JPMorgan take on the bulge-bracket investment banks.
Banks’ function in society is to recycle money from savers to users, but Goldman Sachs does that every time it arranges a bond deal for Ford and no-one bats an eyelid if Goldman sells down the entire deal to fund managers. Now that loan funds are fast establishing themselves in the US – providing half the volume in certain sectors of the loan market – isn’t the same structure likely to prevail in the loan market?
“Certainly the business is moving away from just putting loans on the book and holding them,” says Gary Page, global head of portfolio management at ABN Amro. “We don’t look at lending as a standalone business but as a support to client relationships. But right now having a large annuity business like the loan business underpins the whole bank.” A shift to mark-to-market accounting would change all that. It may well come but it would have to encompass all sides of the balance sheet – deposits as well as assets. The accounting profession won’t be rushed into such radical change. Big lenders have a few more years left in them yet, as long as excessive concentrations don’t blow them up. And there’s always the comfort, for the biggest banks of all, that even then the taxpayers would end up bailing them out.
