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Why Banks Still Won't Lend


News January 7, 2009, 5:00PM EST

Why Banks Still Won't Lend

Despite more than $1 trillion in federal largesse, they still may not have the capital cushions to bear the risks of making fresh loans

American Apparel (APP) executives should have been focused on the sales of their leggings and T-shirts this holiday season. Instead, management spent most of the critical shopping period worrying about $125 million of debt due on Dec. 19. After weeks of intense meetings with major banks, the trendy retailer landed a last-minute extension on a loan. The onerous strings: a $2.3 million fee and limits on capital spending. "The credit markets are still frozen," says Chief Financial Officer Adrian Kowalewski. "Even companies that are performing well can't get loans at reasonable terms."

The financial challenges facing Kowalewski and other corporate executives pose a major quandary for the incoming Obama Administration and Washington policymakers, who are trying to kick-start the economy. Despite all the government's best efforts in recent months, big banks still aren't lending money freely. One sign of the crunch: New loans to large companies slumped 37% in the three months ending Nov. 30 from the preceding three months. "Banks are being extremely cautious," says Edward Wedbush, chairman of the Los Angeles brokerage Wedbush Morgan Securities.

The industry is getting flak for hunkering down. After all, the Treasury has injected $187.5 billion into the nation's largest banks, including Citigroup (C), Bank of America (BAC), and JPMorgan Chase (JPM). The recipients of taxpayer money, say critics, should be required to open up their coffers. "The bad news [is] Treasury has no way to measure whether taxpayer funds are being used to increase lending," Representative Barney Frank (D-Mass.), chairman of the House Financial Services Committee, said in December. "The much worse news [is that Treasury] does not even have the intention of doing so."

Banking chiefs defend their position. They argue that the government funds are designed to shore up capital and support lending, but that they have no obligation to make new loans. "It's not a one-to-one relationship," says BofA CEO Kenneth D. Lewis. "We don't write $15 billion in loans because we got $15 billion from the government."

Right now there's little financial incentive to make fresh loans. In the current unease, new corporate loans are immediately marked down to between 60¢ and 80¢ on the dollar, forcing banks to take a hit on the debt. It's more lucrative, then, for them to buy old loans that are discounted already.

At the same time, some banks no longer have the appetite to use leverage, borrowing money to amplify returns. Others say they would like to use leverage but can't easily find willing lenders who offer attractive terms. Leverage has long been a critical factor in profitable lending.

Whether the industry's stance is justifiable or not doesn't really matter. Either way, companies are having a tough time getting credit. And without additional intervention, the lending climate could remain cloudy for a while, threatening companies' prospects and weighing on the economy.

Consider El Paso Corp. (EP). As commodities prices have cratered, the nation's largest natural gas pipeline operator has slashed capital spending by 16%, which means its overall production will remain flat this year. El Paso's higher debt costs will further crimp profits. Anxious to lock down financing amid lenders' woes, the energy company sold $500 million of junk bonds in December at an interest rate of 15%—more than twice its overall borrowing costs. "It was expensive," says Chief Financial Officer D. Mark Leland. "We weren't confident [about] when things would get better."

Banks don't seem to know, either. They also are hoarding capital out of fear. Under federal rules, banks are required to maintain a certain level of capital based on their assets. When they incur losses, they either have to raise more capital or sell assets to keep those ratios in check. After raising money from outside investors and receiving bailout money in recent months, most big banks comfortably meet the federal capital standards.

But those calculations don't necessarily take into account all the problematic assets on banks' balance sheets. For example, they don't include securities whose losses seem to be temporary. In this environment, those losses can quickly become permanent, notes Stuart Plesser, an equity analyst with Standard & Poor's (MHP).

Meanwhile, big banks face another wave of losses, which may only further erode their capital. Companies have already taken huge hits from subprime mortgages and other risky debt. But other problems loom in credit cards, commercial real estate, and traditional home mortgages. In an interview with Maria Bartiromo, economics professor Nouriel Roubini of New York University's Stern School of Business said that credit losses will top $2 trillion, up from around $1 trillion today.

Even if the government forks over the remaining $350 billion of its Troubled Asset Relief Program to banks, the capital will still be a drop in the bucket compared with the industry's total losses. Given that, Roubini and others figure it's only a matter of time before the government creates another bailout fund. "Banks don't have enough money to bear the risk," says Anil Kashyap, a University of Chicago Booth School of Business professor. "We're going to need Tarp II and Tarp III."

With Matthew Boyle in New York.
Der Hovanesian is Banking editor for BusinessWeek in New York. Palmeri is a senior correspondent in BusinessWeek's Los Angeles bureau.


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