What Happened to the New Reality?

by Dexter Van Dango July/August 2011
As the second calendar quarter came to a close, Dexter Van Dango can’t help but wonder if the old risk-monitoring pendulum hadn’t swung back past center toward the other side — the crazy side — the irrational exuberance, foolish behavior, dumb money side.

Lenders and lessors are scrambling for deals like it was 2007. What’s even stranger is that it appears that banks are leading the charge. Yes, as absurd as it sounds, banks are leading the charge! What gives?

Here is my opinion. After the vertiginous fall of credit markets in late 2007 and throughout 2008, banks now find that they need to lend, much more so than folks realize. This goofy economy has created an imbalance in traditional banking. The bank coffers are full, and they have nowhere to invest but T-bills and overnight funds.

Think of George Bailey and his plight on Christmas Eve in the film It’s a Wonderful Life. George contemplated suicide before an intervention by Clarence Odbody — his guardian angel. It all stemmed from George’s disappointment over the imminent failure of The Bailey Building and Loan Association following a run on the bank and a pending bank fraud investigation. George thought he was worth more dead than alive due to his $15,000 life insurance policy.

The film was released in 1946 when people had indelible memories of the Great Depression and the impact of bank insolvency. The townsfolk of Bedford Falls were worried about the security of their money in The Bailey Building and Loan Association, so they wanted to withdraw their funds — which weren’t readily available because they were being used for other productive purposes like home mortgages, college loans and working capital lines of credit.

My Oh My, How Things Have Changed
Today banks are flush with cash. Blame it on QE1, QE2, fear of regulatory oversight or the unknown impact of the Dodd Frank Act. Banks aren’t lending the way they were four years ago. Meanwhile, companies and individuals aren’t spending. No, they are stashing away their cash until they gain greater certainty that the recovery is real. The net effect is that banks have inordinate amounts of cash and are hungry to lend again.

Major banks are parking billions of excess dollars in overnight funds at the Federal Reserve, where they earn a measly 25 basis points annualized. At the same time, those banks may be paying out 40 basis points to you and me and Aunt Hilda for our savings accounts. The June 15, 2011 rate of return for a 59-month CD at my bank is 2.50%. Today’s rates remain at historical lows. Moreover, take into consideration the reserves required by the FDIC for these bank assets — the equation simply doesn’t work. Hence, banks are feverously looking for places to invest in new earning assets, and the competition for credit-qualified deals is driving down price. The secondary markets are seeing sub-100 basis point spreads when trading investment grade transactions. I had to look twice at my calendar to make sure I was living in 2011 and not 2007.

Have we really returned to the lunacy of 2007? I don’t think so. What’s changed? The one meaningful thing that has changed has been underwriting standards. During 2006 and through early 2008, competition drove some really unconventional behavior. Credit quality standards, documentation standards and asset management standards were measurably relaxed from the founding standards upon which our industry was built. Bizarre structures with abnormally elongated terms or ridiculous deferred payment periods were found to be the norm.

The credit crunch changed the unconventional behavior quickly as lenders “battened down the hatches,” much to the umbrage of small- and mid-sized businesses. During late 2008 and for most of 2009, many banks weren’t lending to anyone but the most pristine credits.

Things loosened up a bit in 2010 and continued to ease through the first quarter of 2011. But the pace slowed as we entered the second quarter. There seemed to be another wave of uncertainty about our future. Grave concerns over the national debt and bickering among congressional members over the debt ceiling created a drop in the stock market and a tightening in spending. The reluctance of the private sector to spend on growth initiatives brought about a severe scarcity of deals on the street and competition was fierce for the few that came to market.

Meanwhile, as I write this in mid-June, economic data for the month of May was released by the Labor Department showing the Consumer Price Index, excluding food and energy, increased 0.3% in May, the largest gain since July 2008. Rising core inflation has the Fed worried about shying away from any further quantitative easing and feeling pressure to hint that rising interest rates are the only known cure for rising inflation.

Concurrently, middle-market companies with mild fluctuation in earnings or uneven cash flow are still struggling to access credit from traditional lenders. Intermediaries, brokers, community banks and some commercial finance companies are helping to fill this gap — but at a considerable premium in price. Even hedge funds are jumping in to fill the gap. As reported June 8, 2011 in The New York Times, “With traditional lenders still avoiding risky borrowers in the wake of the financial crisis, hedge funds and other opportunistic investors are stepping into the void. They are going after mid-size businesses that cannot easily raise money in the bond markets like their bigger brethren.”

The Bottom Line
Banks are still reeling from the wounds of the credit crisis. Despite improving portfolio performance, underwriting standards remain more stringent today than they were in 2007 but not as tight as they were in 2009. Shoddy documentation and exorbitant deal structures continue to be frowned upon, but the combination of excess liquidity and the shortage of deal flow tend to lead to relaxed standards. Albeit the appetite for risk remains tight as banks and other lessors already have enough troubled assets to deal with from their past sins — they don’t need to increase their pain. Nevertheless, they are starving for qualified earning assets. As one banker put it to me, “We used to do stupid things for anybody. Now we’re only willing to do stupid things for good credits.”

The pressure for volume has had the greatest impact on price. We knew it was too good to last … the greedy pricing we got away with during the height of the financial crisis. Case in point: In December 2009 Bank A booked a $5 million lease for an investment grade hospital for a 60-month term at a spread of 388 basis points over their cost of funds. That same month Bank B booked a $10 million deal for an A-rated public company for a 15-month term loan at a 365 basis point spread over their cost of funds. There were many examples of great pricing while the laws of supply and demand ruled the markets. It was good while it lasted. In fact, it was financial legerdemain. Those days are gone.

Fast forward to the end of the second quarter 2011. Volume-voracious lenders — particularly banks — were scrounging the marketplace looking for volume anywhere they could find it. The treasury department of a solid investment grade company could request bids from its banking group for a lease or loan on property, plant, production equipment, software, fleet vehicles, corporate aircraft, computing or networking gear — you name it — and the bids will knock your socks off. Sixty-month fixed term fully amortizing loans for 2.50%. A three-year lease on Class 8 trucks with early buyout option for just over 2.00%. A five-year floating rate quote for a corporate aircraft priced at 65 basis points over LIBOR. The level of competition is mind boggling. It’s déjà vu all over again!

What’s Next? Nobody Knows.
Anxiety over a possible default on Greek debt has European markets roiling. Worries about a rating agency downgrade of U.S. debt have the stock markets down for the past six weeks. We’re more than 16 months away from the next presidential election and there are already nine declared Republican candidates (as of June 15) with more speculated to join the race. Unemployment lingers at 9% and the economy feels like we’re bouncing along the bottom without any real lift.

All this distraction and the pundits claim that the banks still aren’t lending. Following their release of first-quarter financial results, the country’s top four banks — Bank of America, J.P. Morgan Chase, Citigroup and Wells Fargo — all reported a decline in loans. According to FORTUNE magazine, “Average loans outstanding at the fearsome four dropped 7% from a year earlier — a decline of $210 billion — even as deposits rose 5%.” Pundits — I’ve got news for you … the banks aren’t lending because there is no demand for loans. And where there is demand, especially for creditworthy customers, it’s a buyer’s market like we’ve rarely seen before.

Have a different opinion? Share it with me. Drop me a line at [email protected] and connect with me on LinkedIn. Let the debate begin.


Dexter Van Dango is a pen name for a real person who is a senior executive with more than 25 years of experience in the equipment leasing industry. A self-described portly, middle-aged, graying, balding leasing guy in the twilight of a mediocre career, Van Dango will provide occasional insight from the front lines via the Monitor.

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