Financial Times - February 22, 2000
US risky debt threat to banks
By Daniel Bögler and Gary Silverman in New York
US companies and consumers have built up record levels of risky debt that could threaten banks' financial health if the economy slows, warns McKinsey, the management consultancy.
Wolfgang Hammes, a senior manager in McKinsey's banking practice, said: "There is a substantial amount of hidden credit risk at US financial institutions that could potentially lead to serious loan losses. Most banks' risk management systems are not sufficient to identify and quantify these risks."
Mr Hammes, who has been studying debt levels intensively in recent months, points out that despite a nine-year economic boom, US consumers and companies are more indebted than ever. The borrowings of the average US household now exceed a year's disposable income, according to Federal Reserve figures.
Meanwhile, the debt to equity ratio of S&P 500 companies has shot up to 116 per cent, compared with 84 per cent in 1990 at the end of the 1980s junk bond boom.
The consultancy is even more concerned at the rapid growth of riskier types of credit on bank balance sheets.
Volumes of subprime lending have grown by 80 per cent a year to more than $100bn (E102bn) since 1995, while margin debt, about which Fed chairman Alan Greenspan has voiced concerns, now exceeds $200bn.
McKinsey also points to the growth of corporate high-yield borrowing as well as a trend among individuals to take out new home equity loans to pay off credit card debts.
One problem, says Mr Hammes, is that bank managements are rewarded on the basis of earnings growth and return on equity, rather than on the basis of risk-adjusted capital.
"It is possible to generate very high short-term returns on equity but only if you take on very high levels of risk", he says. Much of this pressure comes from investors. McKinsey analysed 200 Wall Street analysts' reports over the past year and found that only 5 per cent addressed credit risk issues.
Many banks, for example, are freeing up regulatory capital by packaging low-yielding loans and selling them in the bond markets. But to persuade investors to buy these loans, they generally retain the riskiest tranche. On top of that, they then use the spare capital to make higher-yielding, riskier loans.
Another danger is that the inter-relatedness of domestic and international credit markets has increased significantly over the past several years, as the crisis in autumn 1998 showed. Combined with the current debt leverage of banks, warns McKinsey, this could lead to a much faster and intense swing of the credit cycle, leaving many market participants with sudden, massive credit losses.
The trouble, according to Mark Shapiro, a McKinsey partner, is that it is often impossible for insiders, let alone external observers, like investors, to judge which banks have their risks under control and which do not.