THE BANKS RUSH IN WHERE REGULATORS FEAR TO TREAD
When Philip Morris set out to acquire General Foods in 1985’s biggest M&A deal, two members of its treasury department did some preliminary scouting. They telephoned 50 banks to arrange a $6 billion credit before the Morris board came to rubber stamp the takeover. They corralled 12 of the largest banks in the US and seven Japanese banks, which committed from $50 million to $350 million each.
But the deal did not stop there. Within weeks, many of the banks had sold off portions of their loans to other financial institutions, skimming a few points off in the process as a fee for their trouble. The buyers were, invariably, the US branches of foreign banks. As a result, banks on the periphery of Morris’s financial vision, such as the Bank of Scotland, Kyowa Bank, and the Hokkaido Takushoku Bank ended up with the Philip Morris credit on their books. They could not have brought such a highquality name onto their books any other way.
This is an example of the sweeping changes taking place in US banking. Major US banks are leveraging off their ties to America’s top corporations to make money without lending money. It is a business that also suits the hundreds of foreign banks with offices in the US, all anxious to get some top quality assets on their books.
But the volume of loan sale activity is bothering regulators and infuriating borrowers. The authorities fear that the market will produce the same sort of credit problems that dogged the syndicated credit market. They are alarmed that banks are rushing into deals and not analyzing the reasons for doing them. The Penn Square debacle was due partly to that. Banks relied on Penn Square’s credit analysis rather than doing their own homework and consequently suffered monumental losses when the energy loans issued by Penn Square soured.
As large originating banks increasingly seek to transfer all rights to the loan — not just principal and interest, but disclosure and covenants — credit worries are increasing. Treasurers simply do not like loan sales. They claim such deals are just further evidence that banking in the US is changing from being based on relationships to being simply transactional. Borrowers rarely know if, or to whom, their loan has been sold. The treasurers say that they want to know who is buying their loans because they might not want some banks as creditors if their corporations got into trouble. “Banks were once careful about sharing their credits,” complained one treasurer, “but no longer.”
Some of the bigger corporations even refuse to allow their debt to be sold. “I’m not willing to do business on that basis,” said C Raefod Minix, treasurer of EI-Du Pont de Nemours. “I think it’s important to know where your loan is and who you are doing business with.”
Bankers counter by claiming that this attitude is unusual. They point out that as corporations try to raise funds quickly and cheaply, client relationships become more flexible. “Loan sales are increasingly acceptable to our clients,” said Hugh Kempner, who heads the syndicate desk at Morgan Guaranty. “But it wasn’t always like that.”
Philip Morris’s treasurer, Hans Storr, was not bothered by banks selling on his company’s paper. Indeed, he was rather pleased. “Loan sales did not concern us. There was nothing negative about it and it really worked to our advantage, since it allowed domestic banks to market the paper.” Over 70% of the merger’s financing came, ultimately, from foreign banks. “We couldn’t have done the deal in the US market alone,” added Storr.
Most bankers are convinced that loan sales are a good thing. “Loan sales, directly or indirectly, are a great benefit for the US market and the economy,” said Antonio Sussi, manager of Banco di Napoli’s branch in New York, which posted a 287% increase to $1.3 billion in business loans outstanding last year, according to a recent survey. Some 20% of that amount is due to loan sales. “We can make a spread and get a customer we would not be able to get otherwise,” Sussi said.
Few disagree that loan sales are an easier and cheaper way to collect business than calls on cost-conscious corporate treasurers, who are cutting down their banking relationships. “A foreign bank is a foreign bank, and the US is a competitive market,” said Philip Gardiner, a vice president with Dresdner Bank in New York, with $586 million in loans outstanding. “A well-priced loan sale can be an immediate source of income and a way to put assets on the books. Used properly, it is also an effective marketing tool.”
As a German bank, Dresdner’s first concern is to maintainits customer relations with the US operations of German companies. The bank does not maintain a large calling staff in the US, making it more difficult for the bank to pick up new US corporate customers. For Dresdner, loan sales are also a method of asset management. Like other large banks of its kind, it plays both sides of the market, buying from others and originating loans which it then sells.
Most of the largest foreign banks, however, are reluctant to talk about the US loan buying activities because, according to one banker, a branch would prefer to attribute its profitability either to loan origination or by direct participation in a loan syndicate. But for medium-sized banks with a less established US business base, loan buying is a way of life.
“The big foreign banks have such an opinion of themselves, they would not admit to buying loans, even if they are active in the market, because they wouldprefer direct relationships with the corporations,” explained the banker. “It’s the newly arrived banks still developing their customer bases that are hungry for the loans.”
The Commonwealth Bank of Australia, which has operated in the US for 10 years, finds sub-participations a good source of income by buying $5 million to $10 million chunks of loans offered by the US money centre banks, the longer established Swiss bank and German banks. It also generates a small number of its own loans, but loan buying has built the bank’s business loans outstanding to $66 million.
However, several large well-established banks, both European and Japanese, said very little growth in their assets was due to loan sales. They preferred to think of themselves as providers, claiming that many of their largest branches unloaded their loans in the same way as their US counterparts.
But the growth in foreign bank activity in the US has been dramatic, with the Japanese taking more than one-third of all business loans on their books. Foreign banks on the whole now supply more than one-fifth of all loans made to US business, doubling their share of the market in less than eight years.
Their success has been particularly obvious in the US commercial and industrial loan market. According to data from the Federal Reserve, business loans at the large US branches and agencies of foreign banks grew by more than 50% to $30.5 billion at year-end 1985, compared to $20.3 billion a year earlier. They also accounted for more than half of the growth in business loans booked by all banks in the US last year.
But thisis just part of the story, since foreign banks seem to be absorbing the loan business of the nation’s largest banks. For example, the nation’s top 10 banks reported a 6.1% decline in commercial and industrial loans on their books last year. That means they have been selling off a portion of every new loan and then some. In 1985, banks extended about $18 billion in loans that were later sold, according to the Federal Reserve. But the sales volume reported to the regulators by the big banks was much larger because many of the loans, particularly shorter-term, were sold more than once in strips.
Loan stripping combines a lot of what is fashionable in international finance. In some ways it is the US banks’ answer to RUFs. The market was pioneered by Citicorp and Bankers Trust. Essentially, it involved stripping a medium-term loan into short-term strips, usually in 30 days to three months maturities. When they first came out these instruments — because they were often issued by less creditworthy corporations — yielded more than comparable money market instruments, such as Euro-CDs ro Bankers’ Acceptances. The Japanese banks, which are always anxious to book assets, were the major buyers. “It’s a telephone game and very easy,” said Masanori Ebihara, vice president of corporate finance and investment at Dai-Ichi Kangyo Bank in New York.
But the market has cooled off. Banks are increasingly worried that buyers might not roll over their investments when they mature. If that happened, a bank would be forced to sell the loan elsewhere, or to put up the money itself. “Banks aren’t looking [to do strips] if they’re going to come back on to the balance sheet as a financing instead of a sale,” said Donald Layton, a senior managing director at Manufacturers Hanover. “I think the market has had its heyday.”
“Loan selling is the most acute manifestation of commercial banks’ evolution into investment banking,” said George Salem, a banking analyst with Donaldson, Lufkin & Jenrette Securities, who completed a landmark study on the topic last year. According to Salem’s research, Citicorp, Chase, Manufacturers Hanover Trust, JP Morgan, Chemical and Bankers Trust, sell, on average, 22% of all the commercial and industrial loans they book.
And, although the data is still sketchy because banks account for the transactions differently, by most reckonings loan sales are increasing at a spectacular rate, and could, according to industry experts, quintuple in the next five years, “I consider loan sales to be one of the most significant structural changes in banking,” said Salem.
There are several reasons for the sale of business loans by the nation’s top banks. Within the last two years, federal regulators have imposed new capital adequacy requirements on commercial banks. The loan sales market heats up around year end so that banks can meet these ratios. The Federa l Reserve Board and the Federal Deposit Insurance Corp have ruled that both regional and multinational state member banks and all bank holding companies raise their minimum primary capital to assets and their total capital assets ratios to 5.5% and 6% respectively.
As a result, capital has become a constraint on asset expansion. Also, these loan-participation sales produce revenues for the bank without increasing loan risk. This is especially important to the large banks who have experienced problems with their foreign loan and energy related loan portfolios.
Moreover, banks have found that they can no longer earn an adequate return on loans to large, blue-chip corporations that pay extremely low rates when they borrow. So rather than lose that business altogether, banks are making the loans and selling them, charging fees when they continue to collect on the loans and keeping some of the interest as compensation for originating them.
While US regional banks, thrifts and institutional investors have also been eager to purchase loans, the buy-side of this market is still dominated by foreign banks. Although the business loan sales market is booming, the volume of commercial and industrial loans in general is low, particularly for top quality corporate names. Many companies are finding cheaper financing through bonds, equity, or commercial paper.
But the middle market has been simmering, which is why loan sales mostly occur for corporate names rated triple B to double A -. These are the kind of names that the major banks are most anxious to get off their books and they are pushing them out at thin spreads – sometimes as little as 1/8% to 1/16% over Libor. Some banks are not desperate en ough to jump at that bait. “Rates are so thin that some loans – 1/8% – aren’t worth booking,” said H Clifton Whiteman, executive vice president at the Bank of Tokyo Trust Co in New York. “Earnings in absolute terms are so small that you can’t afford to analyze the credit. To do so would eat up earn ings.”
The Bank of Tokyo, unlike many of its competitors, puts loan sales through a regular loan committee analysis. As a result, less than $100 million of its total assets are due to loan sales or participations, said Whiteman. And, since the bank has been in business in the US for several decades, it is not highly dependent upon loan sales.
But other banks are willing to accept the thinner spreads through loan participation sales, because their alternatives are limited. The pecking order is often determined by domestic correspondent banking relationships. For example, Dai-Ichi Kangyo Bank, the biggest foreign branch in terms of lending in the US, took a $150 million stake in Philip Morris and then sold off one-third of that amount to three other medium-sized Japanese banks it regularly does business with. Those banks, however, were prohibited from selling their stakes further downstream.
Loans usually come to rest with the mid-sized Japanese, French, and Italian banks, who buy sub-participations which are not disclosed, and do not automatically allow the bank access to the corporation. While they would prefer to share a loan from the outset through participation in a loan syndicate, the size of such loans is usually too big. So a loan sub-participation, which generally falls within a $5 million to $50 million range, is better than no loan at all.
“We are aggressive in loan sales because we have few opportunities to lend to US borrowers,” said Akaishi Narikazy of Hokkaido Takushoku Bank, a medium-sized Japanese bank, which attributes 10% of its $800 million in total exposure to asset sales. “We are basically restricted as a sub-participant. It is an undisclosed basis, but I think the market here is in a primitive stage and that we can directly access those corporate names in the future,” said Narikazy.
But, although a huge volume of loan sales can mean greater fee income, many foreign banks are hesitant to buy just any loan that comes onstream. Employees in many branches have been scrambling around trying to understand the ins and outs and credit risks involved in megamerger deals like Philip Morris and leveraged buyouts (LBOs) like Beatrice. “It’s a little like opening Pandora’s box because all sorts of policy questions arise,” said Dresdner’s Gardiner. “You have to decide spreads and credits. You also have to decide if the commitment is the best use of your resources.”
“We decide whether there is the possibility for additional financing, so that is one thing that determines our exposure,” said Ebihara, of Dai-Ichi Kangyo. The bank was anxious to sell sub-participations in Philip Morris, for example, because it has other relationships with the company. “We found once we participated, there was no reason to retain the whole portion.” On the other hand, a leveraged buyout such as Macy’s requires a $50 million commitment from the bank, and one that is likely not to be sold, he said.
Beatrice’s $2.3 billion credit to take the firm private quickly sold out; but it’s an example, said many bankers, of how badly a loan sale can go. Beatrice paper flooded the market, and there was so much subsequent uncertainty about the merger that banks who had intended selling out portions of their loans ended up with the full amount on their books. James Drumwright, the chief executive officer of Credit du Nord’s New York branch, said he passed up a Beatrice sub-participation the first time around, but has since picked up the credit. “Compared to other things, it is attractive.”
On the other hand, the Bank of Scotland took a $10 million stake in Beatrice, but turned away a $25 million sub-participation in the current Macy’s LBO deal and last year’s buyout of Levi Strauss. “there were not enough assets left to pay of the debt,” said Michael Stewart. The bank has six staff members dealing with credit analysis and has been in the US for five years. “We’ve been very active in the market in the last year, and 5% to 20% of our total assets are due to buying loans,” said Steward. “But we turn down a lot because they don’t meet our criteria.”
“Some of the banks have a very difficult time understanding the deals because of accounting differences,” said Granville Bennett of Dresdner. “They find the concept of a leveraged buyout hard to put a number on, and there’s resistance initially from the head office. I think when more of these LBOs look like they are working, which will educate the head office, the reluctance will pass. It will be better the second time around.”
Many branches do not have the expertise or staff to do a credit analysis on a loan and sub-participants usually do not have access to all the originator’s information. “We usually gather some additional information by ourselves, from the rating agencies or annual report,” said Narikazy of Hokkaido Takushoku Bank, which increased its business loans outstanding by nearly one-third last year to $616 million.
And, for that reason, said one originator, sub-participants are selectively chosen. “We try to select banks which we know have credit expertise and someone familiar with the industry,” said James E Cotten, a managing director at Chase.
Jeffrey Colquhoun, a vice president at Chemical, said the LBO takes time and judgement in structuring participations in a more complex credit, such as a joint pro-financing. “It takes onerous documentation,” he said. “But we can’t standardize loans to an infinite degree. We’re not in the securities business.”
Legal issues and standardization are two roadblocks to a liquid secondary market, particularly as more foreign banks demand that their sub-participation be disclosed to the borrower. “We must disclose for us to buy into a medium-term position,” said Drumwright of Credit du Nord.
