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Old Banks, New Lending Tricks

Lenders haven't sworn off risky financial products. They've come up with a slew of new ones

Wednesday, August 5, 2009 - 00:00
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That didn't take long. The economy hasn't yet recovered from the implosion of risky investments that led to the worst recession in decades—and already some of the world's biggest banks are peddling a new generation of dicey products to corporations, consumers, and investors.

In recent months such big banks as Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) have rolled out newfangled corporate credit lines tied to complicated and volatile derivatives. Others, including Wells Fargo (WFC) and Fifth Third (FITB), are offering payday-loan programs aimed at cash-strapped consumers. Still others are marketing new, potentially risky "structured notes" to small investors.

There's no indication that the loans and instruments are doomed to fail. If the economy keeps moving toward recovery, as many measures suggest, then the new products might well work out for buyers and sellers alike.

But it's another scenario that worries regulators, lawmakers, and consumer advocates: that banks once again are making dangerous loans to borrowers who can't repay them and selling toxic investments to investors who don't understand the risks—all of which could cause blowups in the banking sector and weigh on the economy.

CDS-Linked Corporate Credit Lines

Some of Wall Street's latest innovations give reason for pause. Consider a trend in business loans. Lenders typically tie corporate credit lines to short-term interest rates. But now Citi, JPMorgan Chase, and BofA, among others, are linking credit lines both to short-term rates and credit default swaps (CDSs), the volatile and complicated derivatives that are supposed to act as "insurance" by paying off the owners if a company defaults on its debt. JPMorgan, BofA, and Citi declined to comment.

In these new arrangements, when the price of the CDS rises—generally a sign the market thinks the company's health is deteriorating—the cost of the loan increases, too. The result: The weaker the company, the higher the interest rates it must pay, which hurts the company further.

The lenders stress that the new products give them extra protection against default. But for companies, the opposite may be true. Managers now must deal with two layers of volatility—both short-term interest rates and credit default swaps, whose prices can spike for reasons outside their control.

Making matters more difficult for corporate borrowers: high fees. Banks are raising their rates for credit lines across the board—but the new CDS-based credit lines cost far more than the old lines. FedEx (FDX) could end up paying $1.9Â million to $3.6Â million a month if it decides to tap a new line from JPMorgan and Bank of America. On its previous line with JPMorgan, FedEx would have paid about $540,000.

Yet many companies have little alternative. With corporate credit remaining tight, banks increasingly are steering borrowers to the CDS-linked loans. All told, lenders have handed out nearly $40Â billion worth this year—roughly 70% of the total in credit lines extended to borrowers in fairly good standing. That's up from around 14% in 2008. FedEx, United Parcel Service (UPS), Hewlett-Packard (HPQ), and Toyota Motor Credit have all taken the plunge. "It wasn't our idea," says a UPS spokesman. "The banks pulled back from offering set rates."

Big Banks Offering Payday Loans

At the other end of the borrower spectrum, big banks are entering another controversial arena: payday loans, whose interest rates can run as high as 400%. Historically the market has been dominated by small nonbank lenders, which mainly operate in poor urban centers and offer customers an advance on their paychecks. But big lenders Fifth Third and U.S. Bancorp (USB) started offering the loans, while Wells Fargo continues to boost its payday-loan program, which it began in 1994.

More big banks are getting into the market just as a recent flurry of usury laws has crippled smaller players. In the past two years lawmakers in 15 states have capped interest rates on short-term loans or kicked out payday lenders altogether. The state of Ohio, for example, has imposed a 28% interest rate limit. But thanks to interstate commerce rules, nationally chartered banks don't have to follow local rules. After Ohio limited rates, Cincinnati-based Fifth Third, which has 400 branches in the state but also operates in 11 others, introduced its Early Access Loan, with an annual interest rate of 120%. "These banks are skirting state laws," says Kathleen Day of advocacy group Center for Responsible Lending. Says a spokeswoman for Fifth Third: "Our Early Access product fully complies with federal regulations and applicable state regulations."

Lenders argue they offer a valuable service for those who need emergency cash. Wells Fargo says it warns customers using its Direct Deposit Advance that the loan is expensive and tries to offer alternatives. "We have policies in place to prevent long-term usage of the services," says a spokeswoman. U.S. Bancorp didn't return calls.

National regulators are taking notice, however. The Office of Thrift Supervision says it is "looking into" two institutions that are offering the high-interest loans. "We need to make sure there's no predatory lending and also ensure that there are no risks to the institutions," says an OTS spokesman.

Derivatives for Small Investors

On the investing front, too, Wall Street firms are embracing more risk. Big brokerage houses, including Morgan Stanley Smith Barney (MS) and UBS (UBS), are selling new forms of "structured notes," a type of debt instrument. Wall Street sold $15Â billion of the products in the second quarter, up from $13Â billion in the first, according to Some of the new notes have a minimum investment of only $1,000.

Structured notes are essentially derivatives for small investors—and they make sense for some. Basic structured notes let buyers benefit from the growth in stock, bond, or currency prices while offering some degree of loss protection. But many of the latest iterations are highly complex and may not compensate for all the risk. Buyers "have to have the [financial] experience to be able to evaluate the risk," says Gary L. Goldsholle, general counsel at the Financial Industry Regulatory Authority, the securities industry's self-governing organization.

The new debt investments offer attractive rates, sometimes guaranteeing double-digit returns for the first couple of years. But when those teaser rates disappear, investors face huge potential losses over the life of the instrument, up to 15 years. A Morgan Stanley spokeswoman says the firm "services a broad range of products for retail and ultrahigh-net-worth clients," including structured products, and "offers training to financial advisers to assist them in making suitability determinations." UBS declined to comment.

The risks to investors can be tough to tease out of the prospectus. A July offering from Morgan Stanley promises 10% interest for the first two years. After that, it pays 10% when short-term interest rates and the Standard & Poor's 500-stock index both stay within certain ranges. If they don't, the investment pays nothing.

The prospectus says the latter scenario would have been a rare event over the past 15 years. But as the recent market turmoil has shown, historical patterns aren't always reliable. Investors in similar notes got burned last year when Lehman Brothers failed. Says Bob Williams, a broker at Delta Trust Investments in Little Rock who's often pitched on such investments: "I'm not convinced half the brokers in this country, much less their clients, understand these products."