Greg Ip

Articles by The Economist’s U.S. Economics Editor

Credit Window: Alternative Lenders Buoy the Economy But Also Pose Risk

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Manufacturers, Other Nonbanks Fund Ever More Business, With Little Supervision — GE Capital Rescues a Printer

By Greg Ip

2518 words

10 June 2002

The Wall Street Journal

A1

English

(Copyright (c) 2002, Dow Jones & Company, Inc.)

Last year started badly for Peake Printers Inc. Several firms whose annual reports it had expected to produce perished. Things got worse when Bank of America said the Cheverly, Md., commercial printer would have to repay a $3.2 million loan by year end.

Two other banks declined to lend. “They were trying to back off on printing businesses,” says Joseph Moran, Peake’s chief financial officer.

With the 125-employee firm’s survival at stake, Mr. Moran finally found an eager lender: General Electric Capital. Though Peake had to put up printing equipment, a building, accounts receivable and $1 million of the owners’ cash as collateral, it got the loan it needed.

The financial-services arm of General Electric Co. illustrates how nontraditional lenders are taking over from banks as suppliers of credit to big slices of the U.S. economy. GE Capital aggressively pursues some business that banks have largely abandoned. At $425 billion, its assets exceed those of all but three banking conglomerates.

Twenty years ago, banks and thrifts supplied 40% of the economy’s credit. Ten years ago, it was 26%. Today, it’s down to 19%. Housing financiers Fannie Mae and Freddie Mac own about as many residential mortgages as all commercial banks combined. Household International Inc., which lends to people with less-than-stellar credit, is now the second-biggest issuer of private-label credit cards, ahead of giant Citigroup. Inspired in part by GE’s success, Boeing Co. aims to turn its Boeing Capital unit, which has long financed airplane purchases, into a diversified finance company.

The benefits of this change in the financial underpinning of the economy were evident during the recession. As banks tightened lending standards, alternative lenders and capital markets took up the slack. Automakers jump-started car sales by extending zero-percent financing through their lending arms. When investors turned cold on airlines after Sept. 11, Boeing Capital lent UAL Corp.’s United Airlines more than $700 million to pay for jets. Before the recession and throughout it, Fannie Mae and Freddie Mac made the housing boom possible. Their mortgage holdings have risen 21% and 35%, respectively, since the end of 2000. Those of banks are up just 8%.

But all of this also has a downside. These companies’ hunger for growth helped increase borrowing, aggravating excess capacity in some industries and fueling bubble-like conditions in others. More worrisome, many of these nontraditional lenders don’t get as much regulatory oversight as traditional banks and brokerage houses, even though the failure of a big alternative lender would be no less troublesome to the economy than a big bank’s collapse.

Federal Reserve Chairman Alan Greenspan and other top financial regulators point out regularly that the nation’s banking system is stronger — and, thus, better able to keep credit flowing — than it was during and immediately after the recession of the early 1990s. But risks to the economy may reside elsewhere — in the financial operations of businesses other than banks. Such financial operations don’t include just lending but also trading and venture investing.

“Banks are not the place to be looking for the next blowup,” says Steve Galbraith, a Morgan Stanley investment strategist. If there is trouble, he says, “because of the greater importance of these nonbank financial companies, odds are you’ll get a hiccup in this area.”

Because of limited disclosure and sometimes murky accounting, outsiders often simply don’t know how much risk nontraditional lenders are taking on. “Information about . . . what they do, about the volume of business they engage in, about their counterparties is very sketchy, if not nonexistent,” says Hung Tran, a senior official of the International Monetary Fund. “We only learn about these things when something happens, like in the case of Enron.”

The recession and financial turmoil of the past few years haven’t claimed any major banks. But they have seen bankruptcy filings by Finova Group Inc., a commercial finance company that lent heavily to resort developers; by Comdisco Inc., a technology-leasing company done in by ill-fated venture investments in tech and telecom; and of course by Enron Corp. Enron had became deeply involved in trading commodities and derivatives but without the oversight that conventional banks and brokers get. Now, Conseco Inc. is struggling under bad debts resulting from the purchase of a finance company specializing in mobile-home loans.

Nonbank lending is certainly not new. GE Capital got its start in 1933, helping families buy appliances. Sears, Roebuck & Co. issued its first credit card in 1953. And banks are still critical to the economy. But advances in technology, risk management and capital markets have spurred new players to enter the market and allowed others to grow rapidly and diversify — even as regulators, anxious to prevent a repeat of past banking and thrift crises, have been watching banks for excess risk-taking.

Almost 40% of the earnings of the companies in the Standard & Poor’s 500-stock index in 2000 came from lending, trading, venture investments and other financial activity, Mr. Galbraith estimates. Of those earnings, a third were at nonfinancial companies such as Enron and GE. “Corporate America is rapidly becoming Bank America,” he says.

Some of these companies are drawn to finance because it offers more growth potential than slow-growing, increasingly competitive core businesses. Others want to boost sales by giving customers easier access to credit. Fifteen retailers, including Circuit City Stores Inc. and Pier 1 Imports Inc., now issue credit cards through banks they own, according to The Nilson Report newsletter. Fewer than half a dozen did in the 1980s. “Old economy” manufacturers such as Deere & Co., which have long financed customers’ purchases, were joined in the 1990s by technology suppliers including Lucent Technologies Inc.

But some customers that benefited from Lucent’s generous vendor financing went under, and the Securities and Exchange Commission is probing whether Lucent was too aggressive in how it recorded some of its sales. Its vendor-financing commitments have been cut back from a peak of $8.1 billion but still total $2.2 billion.

Regulatory oversight of alternative lenders varies. Most are subject to consumer-protection rules. Some have subsidiaries that are regulated as banks or insurance companies. But in general few are subject to the on-site examinations, constant monitoring and risk of government-ordered closure that are standard for banks. For the most part, the government lets bond markets and credit-rating agencies discipline these competitors to banks.

A major justification for close government supervision of banks is deposit insurance, which became widespread in the early 1930s. This gives government an interest in preventing reckless lending because taxpayer money is at risk. But another reason is to shield the economy from the disruption and panic that bank failures can cause.

Few companies illustrate the rewards and risks of these trends as well as GE Capital. Its assets are more than six times as high as in 1990. Its operations span insurance, credit cards and truck rentals. One of its fastest-growing lines is making business loans of between $50,000 and $50 million, usually secured by equipment.

The manufacturing recession was a boon to GE Capital. Ned Reynolds, senior vice president for marketing in its commercial-finance group, says banks prefer to lend based on firms’ cash flow, which was weak during the recession. But GE Capital commonly lends against the value of a customer’s assets. It sometimes has more experience valuing such assets than banks do. Mr. Reynolds says banks are less inclined than GE Capital to be patient with a borrower facing difficulty.

The printing industry has been plagued by excess capacity and a steep slump in advertising and financial-related printing. Prices are falling, bankruptcies rising and resale values of printing equipment plummeting. All that has driven banks away. Peake Printers might have been forced to sell its assets and dismiss its workers if GE Capital hadn’t come through, says Mr. Moran, Peake’s CFO.

GE Capital bought booths at trade shows and cold-called prospects such as Linemark Printing Inc. in Largo, Md. Linemark borrowed $2.75 million from GE instead of its bank. The bank was “offended,” says Linemark’s president, Steve Bearden, but GE offered better terms and faster service.

GE Capital has had some problems with its printing loans. It contributed to a $60 million lending facility to Master Graphics Inc., Cordova, Tenn., which filed for bankruptcy protection in 2000 and emerged last year. It is also a creditor to Printing Arts America Inc., a Darien, Conn., company that filed for bankruptcy protection last fall. GE Capital “made it too easy for some to borrow,” says Joseph Becker, a Lanham, Md., consultant to printing companies. That led to excess capacity, he says.

GE disagrees. It hasn’t recognized a loss on its lending to either firm and is involved in the restructuring of both, says a spokesman. He says GE Capital’s loan losses are well below those recorded by comparable bank loans, adding that its operations are highly diverse and its average loan relatively small.

Credit-rating agencies give GE Capital and its parent the highest rating, triple-A. But amid spreading concerns about corporate accounting, some investors worry they don’t know enough about how GE and GE Capital make money. Bill Gross of Pacific Investment Management Co., or Pimco, caused a stir earlier this year when he criticized GE Capital’s reliance on the short-term IOUs called commercial paper — a cheap source of funds that can disappear if investors get nervous. GE has been providing more-detailed disclosures, a conference call and Web-casts with analysts and a vow to reduce its dependence on commercial paper.

Fannie Mae and Freddie Mac, meanwhile, are exempt from SEC disclosure and other requirements that all other public companies face. Their regulator, the Office of Federal Housing Enterprise Oversight, monitors them and makes site visits, but it doesn’t have as much power as bank regulators, nor does it require them to hold as much capital as banks and thrifts.

Fannie and Freddie had equity of a bit more than 3% of assets at the end of 2000, according to Larry Wall and Scott Frame of the Federal Reserve Bank of Atlanta. Thrifts had 8.45%. Some critics worry that so much leverage exposes Fannie and Freddie to adverse moves in interest rates.

Spokesmen for the companies argue that they are just as well capitalized as banks, given how much safer residential mortgage loans are than a typical bank’s loans. They add that their voluntary disclosure equals or exceeds that of most public companies. Freddie Mac says its regulator will soon require it to show that its capital is adequate to withstand scenarios of extreme economic stress. Fannie Mae says it uses specially structured bonds and derivatives more than the average bank or thrift to hedge its interest-rate risk.

The likelihood of a wave of homeowner defaults serious enough to significantly hurt Fannie and Freddie’s creditworthiness appears remote. The comfort level isn’t quite so great for some of the companies getting into lending in a big way.

Boeing Capital’s lending portfolio has tripled since 1999 to more than $10 billion. James Palmer, its president, says loan and lease decisions are independent of the parent’s sales operation. He also notes that collateral is usually airplanes, which hold their value even if an airline goes under. Yet investors such as Shannon Bass, a Pimco bond manager, fret that if an airline such as United Airlines, which owes Boeing Capital $1.2 billion, ever became unable to pay its debts, Boeing’s creditworthiness would suffer.

Even when loans are sound, financing activity makes a company far more sensitive to a loss of confidence among its investors and lenders. Tyco International Ltd. bought the equipment-finance company CIT Group a year ago for $9.5 billion, hoping to use it to finance buyers of Tyco’s industrial products. But when Tyco’s credit rating fell this year amid concerns about its debt and accounting, CIT was downgraded, too. That cost CIT access to the commercial-paper market and forced it to turn to costlier bank borrowing, constraining its ability to make new loans.

“Our acquisition of CIT made us a lot more vulnerable to the debt markets than we’d ever been,” says J. Brad McGee, a Tyco spokesman. He says the downgrade didn’t hurt CIT’s growth. But Tyco still plans to spin CIT off to reduce the parent’s huge debt load. That task isn’t getting any easier. One potential buyer, Lehman Brothers Holdings Inc., backed away from an offer for CIT last month after it leaked.

The risk from all the nonbank finance is that profligate lending could ultimately cripple some lenders, making it harder for them to make new loans and hurting the broader economy, as occurred with thrifts in the late 1980s and early 1990s. The odds of this may be low, but it can happen. Consider the mobile-home industry. Finance companies have traditionally been major lenders to mobile-home buyers, especially those with weak credit. The lending exploded in the 1990s as Wall Street enabled the companies to repackage these loans as asset-backed securities and sell them.

“The business that was done in the late ’90s and early 2000 was not priced to make money, it was to maintain market share,” says Mark Lubbers, a Conseco spokesman. Industry standards slipped so far that an applicant who had never repaid a loan could qualify for a 25-year credit with a 5% downpayment.

“Anyone who filled out a loan application got a loan,” says Colleen Bauman of Champion Enterprises Inc., a mobile-home maker in Auburn Hills, Mich. She says that to spur business, some lenders even gave dealers 5% of the loan amount for making a sale. Shipments of mobile homes soared.

By the late 1990s, loan delinquencies were climbing. The rise soured investors on securities backed by the loans, making it hard to issue new ones. Many lenders, such as CIT, quit. Conseco suffered huge losses, hurting both its stock price and its credit rating.

New management has tightened lending standards and sharply raised the interest Conseco demands on a typical mobile-home loan to almost 13% from 9% in 1999. It expects to make less than $2 billion of such loans this year, down by more than two-thirds from 1999.

Meanwhile, Conseco has 17,000 repossessed units. Champion, the manufacturer of new ones, has closed 21 of its 68 factories.

Bill Poynter is a retailer of mobile homes in Kentucky. “One Saturday, we wrote nine deals,” he says, “and got none of them approved” for loans. With his business losing money for the past year and a half, he says he prays every night that it pulls through.

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Written by gregip

June 10, 2002 at 10:57 pm

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