Rethinking Debt… A shake-up in the credit markets

The corporate finance world is in a state of flux: Banks continue to retrench after a disastrous 2008, tightening credit standards and following borrowers more closely. Borrowers also are rethinking their capital structures and lending decisions. For now, conservatism is the name of the game.

Examining the supply side

Last year many financial institutions were hurt because they’d made poor lending decisions. The credit market was overheated, but now the pendulum has shifted and banks are re-evaluating risk and finding ways to prevent future losses. New policies include:

Higher interest rates.

Banks have increased interest-rate spreads over their cost of funds. For example, interest rates for firms rated B or lower are at least two percentage points higher than in summer 2007.

Shorter durations.

Shorter loan terms mean more frequent renewals. Borrowers must continually prove their creditworthiness and lenders have more opportunities to revise loan agreements or deny credit

Stricter covenants.

Banks are raising the bar for new applicants and renewals. Examples of borrower concessions include personal guarantees, higher collateral requirements, lower debt-to-equity ratios and more arduous independent review (for example, audits, midyear financial statements, and agreed-upon procedures engagements).

More due diligence.

Bank executives expect loan officers to conduct more frequent, in-depth due diligence. If not, frontline employees may become scapegoats for poor lending decisions and customer defaults.

More than ever, you need to understand how to analyze financial statements, identify troubled borrowers and seek corrective action. An outside financial expert can help bridge the gap between loan officers’ accounting know-how and their bank’s expectations.

Eyeing the demand side

As banks retrench, debt seems increasingly less attractive, so many borrowers are adopting a more disciplined approach to leverage. Some are reducing debt loads or building reserves from operating cash flows to fund major purchases. Other borrowers worry that their lenders will freeze their revolving lines of credit and are drawing down revolvers to preserve liquidity. The trade-off is that customers must pay interest on the drawdowns, even if the money is just sitting in a bank account.

Additionally, the tables are turning on lenders: Now borrowers are evaluating the creditworthiness of their lenders. Skittish customers may choose more financially sound institutions to preserve access to loans and lines of credit and frugal ones may change banks for lower rates or preferential loan terms. Long-term customers should be reminded that they might lose their priority status if they switch, however.

Playing tug-of-war

Customer defections are costly: Your bank loses income, and you must invest time and effort to find replacement business. Until the credit markets reach equilibrium, banks must tend to customer relations. Periodic meetings serve not only to check up on your borrowers’ financial performance but also to address their concerns — especially if your bank is the subject of negative publicity.

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