The Bank Credit Line Danger is Brewing

General Motor's announcement to draw down $3.5 billion from its credit line at J.P. Morgan and Citigroup is a sign of a liquidity concern at this distressed auto company. It might also be its concern about the lack of liquidity in the banking system. About a year ago, Sprint drew down its mega billion credit line as it wanted to have enough cash to avert a potential bankruptcy. At that time, I raised a concern with my friends and colleague that this event is just the beginning of a major new problem for all banks.

Most companies have undrawn credit lines from their banks as a means to maintain a source of liquidity in difficult times or to use during periods of increased working capital needs. From a banks perspective, these lines of credit are an insurance policy to all their customers. The banks earn fees for undrawn lines and don't expect most of them to ever use the bulk of the funds. This insurance principle allows banks in aggregate to lend trillions of these lines of credit in a fashion similar to using an actuarial table.

In strong economic times, this system works well, In fact, in weak economic times, banks also profit from these credit lines. However, in a period where leverage has escalated, the economy is very weak, and the financial system is on the brink of collapse, credit lines might be the skeleton in the closet. What do I mean by all this? Corporate America is assessing its ability to borry money in the capital markets. Bank lines of credit are generally the last source of cash a company wants to borrow as it is used for a rainy day. Well, as CFO's look outside they are starting to see the clouds looming, the thunder bellowing, and lightning striking. If the credit markets are closed to most companies, then the source of needed funding must come from somewhere else. The most likely source is the undrawn lines of credit from banks.

Many banks have started to realize how this phenomenon could drain their own liquidity. Let's look at the extreme possibility. Banks have lines of credit in aggregate which equal mulitiples of their equity capital bases. If every company gets scared that they won't have enough cash to meet their working capital needs, they will draw down all the lines of credit. Now we have a problem. From where wiill the cash come? As I stated above, banks freely give lines of credit using an actuarial type of calculation with the assumption that only a small fraction will ever be drawn upon. In the event all lines are drawn at once, there will be a run on the banking system.

Most banks have been trying to protect against this possibility by refusing to renew lines of credit as they come due or substantially making the terms of the loans more onerous to corporate America. While this effort has positive results toward mitigating the unforeseen run on the bank, will it prevent the potential disaster. It is a race between the banks reducing their exposure to sick companies and the hopeful economic expansion to strengthen both the banking system and corporate America.