Bad Debts Mounting By Dan Green 12/07/00 12:00 PM ET

Mega-lender Bank of America surprised the markets yesterday by announcing that earnings would fall far short of expectations, in part due to problems with bad debts. Bank of America, like nearly every other lender, extended credit too easily as the economy boomed, and it is now preparing to pay the price.

Years of accelerating profit growth and strong equity markets allowed many firms with somewhat questionable financial prospects to get loans. This year, as a result, credit agencies like Moody's are downgrading corporate debt at the fastest pace in a decade.

The junk bond market has collapsed in recent months, as lenders have belatedly become more cautious while numerous borrowers are defaulting on their debts. November was the second-worst month this year for junk bond defaults. Trading has nearly halted in many poorly rated firms' debt, as investors seek safer returns in higher-rated corporate bonds or Treasurys.

Commercial and industrial loans are also performing poorly. While bank loan quality has not yet suffered too badly, many commercial and industrial loans, especially large loans made by several cooperating banks, are not being paid off on time.

There are clear similarities between events in the high-yield debt markets and the IPO market. In both cases, companies were able to acquire capital too quickly in the same way that investors and lenders became reckless in the pursuit of extraordinary returns.

Unfortunately these same relationships work just as well in reverse. Just as the IPO market is now effectively closed, so too are the credit markets tightening very quickly, and perhaps excessively, in reaction to mounting piles of bad debt. The closure of the IPO market is unfortunate for investment bankers and high-tech entrepreneurs, but has yet to measurably impact the economy or the pace of innovation. Credit markets are another story, however. Bank loans in particular are essential to economic growth. This is why Fed Chairman Alan Greenspan's speech Tuesday repeatedly urged bankers to continue to extend credit even as bad debts mount.

The slowdown in debt and equity market deals, coupled with the deterioration of credit quality on outstanding loans, are hammering Bank of America and are likely to hit the firm's competitors. The natural response is to batten down the hatches, contain costs, and curtail lending.

Lenders surely needed to be chastened for making too many bad loans, just as stock investors were pummeled for throwing money at money-losing companies as the Nasdaq rose to 5,000. The stock market's decline is bad news for large swaths of the economy, but pales behind the destructive potential of too sharp a slowdown in bank lending.

When banks become too cautious, firms are less able to hire new employees or make productive investments. Credit squeezes, often inspired by the Fed, worked hand in glove with rising oil prices to spark the last three major recessions. You can bet that Alan Greenspan is not eager to let the economy slip into recession, especially as oil prices seem to be under control and the economy's worst excesses are already fading. That is why the Fed will lower interest rates sooner rather than later.

http://www.dismal.com/todays_econ/te_120700_2.asp

-- Martin Thompson (mthom1927@aol.com), December 09, 2000