Are Oil Loans the New Subprime Mortgages

Remember when banks got too greedy with subprime mortgages?

Remember when banks (and their executives) just couldn’t say no to the massive earnings (and by extension massive bonuses) that came from building bigger and riskier portfolios of subprime loans?

Well, get ready for oil loans.

Oil Loans and Bank Risk

If you think Wall Street and the big banks learned their lesson from the subprime loan driven banking crisis, you really don’t understand how compensation works in the financial industry. You see, bonuses are paid based on big gains. This encourages risk taking. However, there is no downside for being wrong on those big risks, not even losing some of the bonus you earned earlier in the year. As a result, risk is the name of the game at Wall Street’s big banks.

This time, banks rushed to lend money to companies in the oil industry when prices where high. In addition, they extended very generous lines of credit to those same companies on pretty sweet terms. Just like with the subprime mortgage crisis, as long as oil prices didn’t fall too far, too fast, everything would be fine.

Deja vu.

With oil prices at low levels, and any oil price recovery looking very shallow, banks are now worrying about those loans that might not get repaid. Just as scary are lines of credit that they have already extended to oil industry related companies. Those companies can come tap those lines at any time, even if their prospects look much worse than they did when the lines were approved. These lines of credit are contractual and while banks are hurrying to adjust terms, that may not be enough action. According to the Wall Street Journal, the biggest group of both funded, and unfunded loans to energy companies belong to, Citigroup, followed by Bank of America, J.P. Morgan, and Wells Fargo.

oil drilling rig

Of course, this all comes down to who the strong are, and how they survive.

Consider, Tidewater, Inc. an oil-industry company that suspended its dividend and stock repurchase program in January as a way to conserve cash. In March, it took the full $600 million from its Bank of America credit line. On the one hand, this is exactly what a credit line is for. On the other hand, for a company already looking for ways to save cash, loading up on $600 million of it from a credit line is something to be watched.

Tidewater, is actually a fairly strong company. The real danger might lie in much smaller companies with much smaller lines of credit. As these companies draw on their credit lines, no one action will be significant, but will banks notice quickly enough to spot a growing trend, before it becomes a big issue? And, if oil prices don’t rebound, it is those smaller companies that are likely to fall on the bankruptcy sword first. The really tricky part is that many of these loans are considered secured, but they are secured by oil reserves that may not be valuable enough in a slumping market to cover the bank’s claims.

As always, the key is risk management. Banks that took on too much risk, based on too rosy of projections will be the ones hit hardest. Those that maintained the discipline necessary to say no to loans that may have impaired the bank’s overall diversification and exposure will be the most able to absorb any ill effects.

It seems more than ever, any investment in a big bank is a bet that the bank is properly managing its risk without taking too big of bets to cash in on the latest craze. If this oil loan issue does blow up, it will expose which banks are doing risk management correctly, and which are just gambling with investor’s money. Don’t expect the fallout from any of this to affect the top management or Boards even at the banks that get hammered. Instead, you’ll need to watch carefully and move your financial sector investments to the banks that do manage their risk correctly.

 

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