Since August 2007, the Fed has cut its Fed funds rate from 5.25% to 0.25%. So shouldn't the cost of borrowing be down 5% as well? At first glance you might think that the cost of corporate borrowing would be down right along with the Fed funds rate. But rather than dropping 95%, the cost of borrowing for even the most credit worthy companies has nearly doubled. That matters because companies are likely to try to borrow $700 billion in 2009. And therein lies the reason that the Fed has no power to fix what ails us.
Here are two examples:
- Southwest Airlines (NYSE: LUV) , the only investment grade rated airline, raised $400 million in bonds in December 2008 to cover its losses from betting that fuel costs would stay high. Rather than paying the roughly 6% it had paid in 2004 to raise $350 million when the Fed funds rate ranged between 1.25% and 2.25%, Southwest had to put up 17 of its Boeing (NYSE: BA) jets as collateral and pay interest of 10.5% percent, nearly double the rate it had paid in 2004.
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Nabors Industries (NYSE: NBR), an oil services company, issued $1.1 billion in 10-year bonds in early January 2009, agreeing to a 9.25% -- in January 2008 when oil prices were rising, Nabors paid a mere 6.15% to borrow $975 million.
Why are companies paying more to borrow even though the Fed has slashed its short-term rate to near zero?
There could be two reasons:
- Insolvent banks. Many banks would be insolvent were it not for the likelihood that the government will keep shoveling more capital onto their balance sheets. As a result, banks feel that they lack the capital they need to undertake the risk of making a loan that might not get paid back.
- Business risk. As the cases of Southwest and Nabors illustrate, both companies face significant business risks that could increase the odds that loans might not get paid back. In Southwest's case, it is hard to know whether the economic crisis will crimp demand and lead to losses -- which is why lenders demanded aircraft as collateral which could presumably be sold to pay off the loan. And in the case of Nabors, the price of oil has fallen fast -- from $147 in July 2008 to $35.59 today.
There are three possible solutions to the problem:
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Let the government lend directly. If the government is so determined to keep companies from going bankrupt, then it should stop trying to give money to banks and hoping they'll lend it. Instead, the government should simply lend the money directly to companies and individuals.
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Create new banks. As I have posted, existing banks have too many problems to feel comfortable lending. But if the government and private investors got together to create new banks that were free of those problems, then they would view lending as a very profitable business and they would make loans.
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Let the free market work. A third alternative is to let the free market work. Under this approach, companies that could afford to refinance at higher rates -- which could top 20% for companies with poorer credit ratings and weak prospects -- would get loans. Those that chose not to refinance their debt could sell assets to pay back the loans or file for bankruptcy.
I like the second option best. The reason is that I think just letting lots of companies file for bankruptcy could be extremely costly and that funding new banks would help mitigate that damage. What do you think?
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College. Portfolio recently published his eighth book, You Can't Order Change: Lessons From Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.
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Reader Comments (Page 1 of 1)
1-19-2009 @ 1:00PM
Coco Kengen said...
If we created new banks, doesn't the same risk still exist; the companies failing and not be able to pay back the loan to the new banks? Why not let the government give out the loans rather than giving it to the banks, without having much control of it?