Monday, July 31, 2006

The evolution of the credit cycle.

The most recent FDIC Outlook (Summer 2006) is now available and highly recommended. This quarter's issue is devoted to topic of credit cycles. One of the most fascinating things about finance is how the markets constantly forget and relearn the lessons of the past. The biggest macro-economic issue facing the US economy is the current state of the credit cycle.

The notion of the credit cycle or a periodic fluctuation in the volume and quality of credit has a long and colorful history. Cycles of expanding, and then contracting, credit volumes are observed in virtually every type of lending, but they may differ markedly across the various bank loan types. Following the late-20th century deregulation of financial services, some argue that cycles in bank lending and loan performance are rising in importance as drivers of banking industry performance. This issue of FDIC Outlook first discusses the credit cycle in conceptual terms, and then examines how applicable the concept may be to the three most important loan types for FDIC-insured institutions.

As British Prime Minister Harold Macmillan noted in 1957 "You've never had it so good". Since the mid 1990s there has been a huge expansion of credit fueled by historically cheap capital, increased demand for borrowings, and higher risk tolerance on the part of borrowers and lenders together. Hence a massive growth in residential mortgages, commercial loans, and commercial real estate lending. Because of strong economic growth, credit performance has been excellent so far. What will happen when economic growth weakens is unknown.(NB: Historical experience is that it ends in the collapse of the over-leveraged party.)

As Fitch ratings noted in their April 5th 2006 report "Loan Volumes Surge, Covenants Shrink in 2005":

One result of this risk receptivity and "borrower-friendly" funding environment has been visible erosion in covenant usage. This trend has been most acute among non-investment grade loans despite a steady decline in the credit quality of newly originated deals.

Loan covenants don't change the credit profile of the obligor. But they do ensure that management behaves responsibly. This is important to equity investors because if any part of the capital structure is at risk, then all of it is at risk.

This is one of the big problems with many recent leveraged IPOs. If the quality of the senior capital is poor, the quality of the equity capital cannot be better. This makes overleveraged companies, weather old or new, uninteresting to risk-averse value investors.

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