The state of the weak economy is reflected in the struggling capital market, which includes the stock and bond markets. Based on this feeling of fearful uncertainty, public and private corporate firms are relying more heavily on their lines of credit as a source of funds to cover their short-term needs in the operation of their businesses. Thus, during this tumultuous recessionary phase of the millennial boom-and-bust cycle when tight lending practices are rampant, pre-existing lines of credit have become one of the few lifelines remaining to these firms. Look no further than the Ford Motor Company for an example. As a result, commercial and industrial (C & I) lending actually increased last fall, at the exact same time that corporate borrowers were struggling against tight lending practices, since so many firms were drawing so heavily on their lines of credit.
Generally, a line of credit promised by a lender is a safe hedge against decreased credit availability. However, this only holds true when the lender remains solvent. For example, when Lehman Brothers went bankrupt, Ford was suddenly unable to draw upon its full credit line since Lehman Brothers was a member of Ford’s lending syndicate. Thus, when concerns emerge about the health of the lenders who extend the lines of credit, borrowers are motivated to draw funds to the maximum extent of their lines; in effect, chipping away as much gold as possible before the mine collapses over their heads.
The financial health of the borrower also factors into the availability of credit since most credit lines contain a material adverse condition clause. This clause allows lenders to refrain from extending credit if the borrower’s credit worthiness is significantly compromised. Thus, if the performance of the borrower falters, as is frequently the case during recessions, the availability of credit will be reduced. To offset this risk, borrowers are more inclined to draw on their lines of credit before it is reduced and withdrawn completely.
first tuesday take: This article goes on to make the point that small, private firms have a more tenuous grip on their access to funds than public firms, as private firms are more affected by changes in bank lending standards. Similar to home equity lines of credit (HELOC) on residential property, credit lines extended to corporate firms are threatened by the ailing market. Even so, they remain a heavily used source of funds during times of tight lending practices.
See the “Home equity lines shrivel in tandem with decreasing values” blog article posted this week for additional commentary on the current condition of HELOCs in California.
In re: “Credit Market Conditions and the Use of Bank Lines of Credit,” from the Federal Reserve Bank of San Francisco.