The Lending Squeeze.

BANKS TAKING EVASIVE ACTION AS COMMERCIAL LOAN DEFAULTS INCREASE

BANKERS don't have to wait for official word on an economic slowdown. They see the sobering news every day in their commercial loan portfolios.

An increasing number of large commercial borrowers are defaulting on their loans, pushing banks' non-performing loan ratios to their highest level in almost five years.

Banks, in turn, are tightening loan standards, staffing up their workout departments, and aggressively pursuing new lines of business, such as investment-related services.

"We are clearly at a state in the business cycle where there is the potential for an economic downturn, and if that comes, banks will turn out to have made loans they're going to regret," said Nancy Sidhu, senior economist at the L.A. Economic Development Corp.

The level of "regrettable" loans already is rising.

The ratio of noncurrent loans (those at least 90 days past due) in California rose to 1.07 percent of total loans as of March 31, the highest level since year-end 1996, according to the Federal Deposit Insurance Corp.

The level of "regrettable" loans already is rising.

The ratio of noncurrent loans (those at least 90 days past due) in California rose to 1.07 percent of total loans as of March 31, the highest level since year-end 1996, according to the Federal Deposit Insurance Corp.

The degree of trouble is nowhere near as bad as it was during the depth of the last recession, in June 1991, when the noncurrent loan ratio nationwide peaked at 3.98 percent. Nonetheless, lenders aren't about to let the condition of their portfolios deteriorate to anywhere near those levels. Instead, they are charging off bad loans faster.

Yet despite such housecleaning, the level of sour loans keeps growing.

"Even though (lenders) have been bailing at a progressively faster rate, they're still lower in the water," said Ross Waldrop, chief of the FDIC's banking statistics section in Washington.

To date, the problems have been concentrated at the large banks, and with large commercial borrowers. Those problems already are showing up in local bankruptcy filings. Year to date, through June 12, there have been eight L.A.-area bankruptcy filings with $50 million or more in debts, up from just two such mega-filings in L.A. during the like year-ago period.

"There has been a huge expansion in the bankruptcy business locally, with a lot more substantial companies filing for Chapter 11," said Richard L. Wynne, name partner at Wynne Spiegel Itkin, an L.A. bankruptcy law firm that this month merged with Kirkland & Ellis.

Among those filing this year: Bugle Boy Industries Inc., Maxicare, Stan Lee Media Inc. and California Power Exchange Corp.

Unlike last year, when financial troubles were largely concentrated in the technology arena, several other industries are causing headaches for L.A. lenders: apparel, telecommunications, health care, entertainment and retailing. In addition, companies that serviced the dot-com industry - such as cable firms and equipment resellers - are suffering trickledown pain.

Many of those industries were cited as sources of problem loans during Federal Reserve Chairman Alan Greenspan's testimony before the Senate Banking Committee last week.

"Bank asset quality is deteriorating," Greenspan told the committee. "Some of the credits that were made in periods of earlier optimism, especially in syndicated loans, are now under pressure and scrutiny."

As for Los Angeles, the slowing regional economy is heightening concerns over bank loan performance. The seasonally adjusted, annualized job growth rate for the five-county greater Los Angeles area was still running at 2.8 percent for the 12 months through April. But that rate dwindled to 2.4 percent for the first four months this year. And for the latest three months, it stalled at -2.0 percent (February), 1.2 percent (March) and 0.9 percent (April).

"There's going to be very strong increases in bankruptcy activity for the next three to five years," Wynne predicted.

That's supported by the growing number of loans going into "covenant default." This can occur when borrowers are still current on their actual loan payments, but their companies' financial condition has deteriorated below the minimum standards specified in the loan agreement.

Those minimum standards can include net worth, asset value, average age of receivables, or some other credit-quality indicator. To help borrowers correct covenant defaults before they become actual payment defaults, or to correct payment defaults before they become bankruptcies, Bank of America, Union Bank of California, Wells Fargo & Co. and other big lenders are staffing up their workout departments, according to industry sources.

Bank officials are reluctant to talk about their problem loans, or how they are dealing with them.

When asked if any Union Bank officials would comment on the condition of the institution's loan portfolio - and steps being taken to alleviate deterioration - bank spokeswoman Sharon Woodson-Bryant checked with senior executives and responded: "It's not going to be possible."

At Wells Fargo, Greg Seibly, an executive vice president in the L.A. commercial banking operation, conceded that the bank "has done some staffing up in the workout side."

George Smith, chairman of L.A.-based George Smith Partners Inc., a real estate financing firm, said a developer would be required today to put up a 50 percent cash down payment for a loan to build a spec L.A. office project. Two years ago such a loan could be had for only 20 percent down.

For borrowers able to meet the more-stringent requirements, lenders are offering increasingly flexible terms to win their business. "Lenders are rolling out all kinds of bells and whisfles," Smith said.

For example, Fannie Mae, insurance companies and other lenders are offering floatingrate loans that can be converted to a fixed rate at a later date, with the ability to get an increased loan amount on a second mortgage if the property's cash flow increases.

"Before, all they offered was plain-vanilla, fixed," Smith said.

Actually, the deterioration in loan portfolios has not yet trickled through to real estate, which tends to be a lagging sector.

Most of the problems are occurring in the "commercial and industrial loan" sector, essentially business loans. As of March 31, the noncurrent ratio (at least 90 days past due) for such loans held by California banks was 2.0 percent, the highest level since March 1994, according to the FDIC.

Loan problems tend to first surface with businesses. Then, as commercial tenants default, the problems spread to commercial developers, and then to landlords of existing commercial properties. Residential loans tend to be among the last to sour.

Even if the economy slumps into a fullblown recession, don't expect to see banks fail in any significant numbers, unlike that of Southern California thrifts in the late 1980s and early 1990s. Today's financial institutions are better capitalized and more diversified - geographically and in the types of businesses they lend money to.

For now, the problems are confined primarily to big banks and big commercial borrowers.

Consumer Debt Levels Increase as Business Loads Drop

As the local economy slows, the level of debt being carried by L.A.-area consumers and businesses becomes a topic of increasing importance - and intrigue.

Anecdotal evidence suggests that debt levels are alarmingly high, and rising. But because virtually all debt is tracked by the headquarters location of the lenders rather than by the location of borrowers -- and the lion's share of Angelenos' debt is owed to lenders elsewhere -- definitive numbers on local debt are not available. Several indicators, however, suggest L.A.-area business debt loads are falling, while consumer debt continues to rise.

On the consumer front, Angelenos are taking on slightly more mortgage debt. Lenders issued $5 billion in mortgages for the purchase of L.A-area residential properties during the first quarter ended March 31, up 2.9 percent from the year-earlier period, according to Data Quick Information Services.

Residential refinance loan volume in L.A. County skyrocketed 64.3 percent in the first quarter, but almost all that borrowing was used to retire pre-existing mortgage debt. So the net effect on consumer debt is minimal.

As for Angelenos' credit card debt, it is believed to closely parallel the national level, which stood at $553 billion as of May 31, up 8.3 percent from a year ago, according to the Federal Reserve Bank. (Visa and MasterCard have the ability to break out regional credit card debt levels, but they both declined to do so.)

Gary Zimmerman, an economist with the Federal Reserve Bank in San Francisco, believes L.A. consumers are taking on more credit card debt, despite the slowing economy, because of the "wealth effect" created by home price appreciation. A similar but more dramatic wealth effect was observed in the Bay Area during the late 1990s, driven by capital gains in tech investments. (That effect has begun to reverse itself in recent months.)

As for the debt levels of L.A.-area businesses, they are likely declining for a number of reasons. For one, banks are increasingly reluctant to extend new credit to local businesses because of the rising volume of non-performing loans in the area, and nationwide. Also, L.A. businesses are reluctant to increase their debt loads due to concerns about slowing earnings and job growth. In short, both lenders and borrowers are more interested in cleaning up their balance sheets and reducing their exposure in the slowing economy.

Businesses intent on taking on more debt increasingly are opting for altemative sources of financing with less-restrictive terms than bank loans.

Junk-bond underwriters and subordinated lenders "have stepped up to fill the gap that the banks have abandoned," said Gregory Range, managing director in the L.A. office of investment bankers Duff & Phelps LLC.

Subordinated loans generally carry higher interest rates (11 to 14 percent, vs. 7 to 9 percent for bank loans), and longer terms (five to seven years). They typically only require borrowers to pay interest over the term, with a balloon payment for the entire principal amount due at maturity. However, the borrower also typically has to provide the subordinated lender with warrants -- the right to purchase an equity stake at a predetermined, discounted price.

Whopper Bankruptcies Rising

L.A.-area bankruptcy filings with debts of $50 million or more through first half of 2000, 2001.

2000

Hollywood Rental Co. LLC, Burbank Core Business: Provider of equipment and services to entertainment production companies Filing Date: April 6, 2000 Type: Chapter 11 Debts: $50 million to $100 million

Superior National Insurance, Oak Park Core Business: Workers' compensation insurer Filing Date: April 26, 2000 Type: Chapter 11 Debts: $400 million

2001

Bugle Boy Industries Inc., Simi Valley Core Business: Apparel manufacturing Filing Date: Feb. 1,2001 Type: Chapter 11 Debts: Over $100 million

Calif. Power Exchange, Pasadena Core Business: Energy trading market Filing Date: March 9, 2001 Type: Chapter 11 Debts: Over $100 million

Custom Food Products Inc., Montebello Core Business: Wholesale supplier of meat products Filing Date: Feb. 1,2001 Type: Chapter 11 Debts: $157.1 million

Destination Film Dist., Santa Monica Core Business: Film production and distribution Filing Date: Feb. 27, 2001 Type: Chapter 7 Debts: $50 million E4L Inc., Encino Core Business: Direct-response TV Filing Date: March 5, 2001 Type: Chapter 11 Debts: $67.9 million

Maxicare, Los Angeles Core Business: HMO Filing Date: May 25, 2001 Type: Chapter 11 Debts: $50 million to $100 million

OAN Services Inc., Northridge Core Business: Billing services for telecommunications industry Filing Date: May 25, 2001 Type: Chapter 11 Debts: Over $100 million

Outsource Int'l, Inc., City of Industry Core Business: Employment staffing Filing Date: June 11, 2001 Type: Chapter 11 Debts: $60.7 million

Source: Timely Info of Los Angeles

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