Financial Partnerships in the Face of a Distressed Market
As we continue to experience exceptionally turbulent and uncertain markets resulting from the Covid-19 crisis, we focus this piece on the credit markets for borrowers. During the financial crisis in 2008-2009, it became clear that borrowers had not sufficiently considered or analyzed counterparty risk, nor had they placed sufficient value on the strength of their relationships with financial partners.
Prior to the 2008 crisis, the credit markets had become fairly commoditized. There was an abundance of low-cost credit from both domestic and foreign banks, as well as bond insurers. As a result of the 2008 crisis, faced with their own credit challenges, increased capital requirements and even failure, many financial institutions quickly scaled back their commitments. The quickest to retreat were financial institutions that were; 1) not well capitalized relative to their risk exposure, or 2) providing credit for sectors or geographic markets that were not part of the core business (i.e., European banks retreating from providing liquidity support in the U.S. municipal market).
As we transitioned out of the financial crisis, taxable and tax-exempt borrowers, with turbulence fresh on their mind, placed greater emphasis on their financial partners, both in terms of their strength and relationship support. During this period, we saw borrowers gravitate to larger banks for credit, either via liquidity facilities to support variable rate debt, lines of credit and/or direct loans. In the municipal market, the top 10 largest commercial banks went from providing $36 billion in loans in 2009 up to $113 billion by the end of 2016. Additionally, borrowers were much more willing to conduct more of their ancillary non-credit business with their core credit providers in order to deepen the relationship and support.
Over the course of the last few years, credit once again became abundant and historically inexpensive in both the bank and fixed income/bond markets. Borrowers started to deviate from relationship banking practices. Credit requests increasingly came in the form of competitive bid processes with the lowest cost providers prevailing regardless of the broader relationship. Non-credit commercial banking business was also moved to low cost providers as borrowers were no longer attached to their prior credit providers.
For example, as the direct loan market grew over the last five years, the number of credit providers expanded dramatically, with many smaller regional and community banks taking on larger and more aggressive risk positions. In the tax-exempt markets, unlike the liquidity support and letter of credit market, these banks did not need to meet minimum credit rating requirements to support variable rate public market debt. Additionally, following the tax reform in 2018, many borrowers started to move to the public fixed income market to take advantage of lower-cost, longer-term and covenant-light structures.
Today, borrowers are now abruptly facing a new credit market picture with disruptions caused by COVID-19. We are experiencing large fund outflows from the public market, with many investors converting to cash positions. As such, credit spreads have materially widened, particularly for high yield borrowers. Banks are also facing uncertainty as it relates to their exposure to the hardest hit business sectors and what those potential losses may mean for their ability to deploy capital in the future.
As borrowers face an uncertain market, it will be important to understand that things have changed dramatically just over the last 2-3 weeks. A greater emphasis will need to be placed on the strength and expertise of their potential partnerships. Further, institutions and partners that can be nimble in providing multiple alternatives will be important as markets will shift quickly and frequently.
Fortunately, we are not so far removed from the 2008 crisis to have lost tools, lessons and, in many cases, the people, to help to navigate these troubled waters. The actions of the Fed to support both the markets and the broader economy over the last two weeks are clearly indicative that there is significant “muscle memory” from the 2008 crisis.