Asset-based lending at the end of the era of easy credit: best practices for a return to credit discipline.(Company overview)

Over the past decade, global economic expansion and money supply growth unleashed a seemingly endless flood of liquidity into the United States. Fueled by low interest rates and unregulated, easy credit, much of the incremental liquidity was channeled through hedge funds and private equity funds. Hedge funds have a thirst for leveraged investments, including subprime mortgage collateralized debt obligations (CDOs) and developmental stage companies bearing so-called high enterprise value. Private equity firms seek leveraged acquisitions in the commercial sector.

These newly important market players put pressure on commercial lenders of all types to streamline loan approvals and loosen covenants. Now it seems that credit expansion has peaked.

This article describes some of the changes that created an easy market for credit and suggests some ways in which lenders can reexamine credit quality and begin a return to fundamentals.

Financial Speculation Leads to Easy Credit

The evolution of financial markets over the last 30 years has spawned growing financial speculation, beginning in the 1970s. Resulting market bubbles since then have had little effect in slowing this financial market evolutionary process. Excess capital and growing global money supply has outstripped productive investment opportunities in the United States due to economic stagnation. The search for opportunities to employ these excess funds has led to the rapid growth of financial markets and the creation of new financial instruments, giving birth to the derivative markets. The asset-backed securities market has seen spectacular growth over the last five years, during which we have witnessed the creation and widespread growth of subprime mortgage and leveraged credit-risk-transfer vehicles, such as CDOs, collateralized loan obligations (CLOs) and related derivatives known as credit default swaps (CDSs).

Pessimists suggest that these changes have created an out-of-control financial system driven by irresponsible investors and creditors. They believe that these players are capable of creating a high degree of systemic risk, resulting in potentially catastrophic financial or credit bubbles. Optimists believe that adequate diversification will prevent meltdowns. Robust liquidity coupled with easy credit led to speculation in housing, preceded by consumers' widespread tapping into home equity via home equity lines. Subprime mortgages in support of home purchases created a real estate bubble characterized by falling home values and rising default rates. Meanwhile, hedge funds heavily invested in subprime mortgage-related CDOs face cascading devaluation in these illiquid assets, as nervous investors force mass dumping of liquid assets to satisfy redemption requirements and nervous creditors restrict liquidity.

Just as substantial liquidity flowed into subprime mortgages in support of high-credit-risk consumers, the same has occurred--albeit to a lesser degree--in the commercial lending sector due to loose credit controlled by unregulated sources. A speculative commercial credit bubble is feared as market liquidity pulls back in the face of continued demand for liquidity by high-risk borrowers seeking to delay the inevitable: asset deflation on the revelation of anticipated rising default rates and recognition of underlying bad debt. While commercial loan and corporate bond default rates remain low, unregulated financial institutions and investors such as hedge funds and private equity firms hold much of the debt in the latest credit expansion. Consequently, historical commercial bank commercial and industrial (C&I) default rates and rating agency (Standard & Poor's [S&P], Moody's) default rate trends, currently near an all-time low, may not be reliable bellwethers of overall commercial credit quality. The unregulated sources are less likely to disclose troubled credits quickly or may lack traditional default triggers due to the recent tendency toward covenant-lite loans.