Waiting for the ‘Receiver Special’
Bill Jamieson says patterns of bank lending and business investment indicate that considerably worse news is still to come in the current economic downturn
After the worst of the 1980-81 recession was over, I came across a phenomenon which gave an unsettling insight into the nature of the business cycle. I remember making early-morning rail journeys out of London to South Wales and the north-east of England. The carriages became unusually full of accountancy types in shirtsleeves toiling over notebooks, spread sheets and calculators.
After one particularly crowded Monday-morning train journey to Cardiff I remarked to a prominent business figure there that this surely was an encouraging pointer to a business upturn. ‘Oh no,’ he corrected me. ‘You came down on the Receiver Special.’
I was right about the accountancy types dispatched from London head office, but innocent of their baleful purpose. It was a memorable introduction to a grim truth of the business cycle. The peak period for business failures is neither in the initial downswing, nor in the trough, but a year or so into the recovery, when firms need to tool up and replenish working capital as business picks up. At this point of the ‘hockey stick’ upturn, cash is keenly needed, but most difficult to obtain from a chastened banking system reluctant to lend against a background of mounting bad-debt provisions – and particularly reluctant to lend to companies whose previous year’s accounts were deeply bathed in red.
Six weeks ago the wisdom eagerly grasped was that we were past the worst of the credit crisis in the financial sector. Are we? For UK banks with share prices buckling under the weight of massive rights-issue calls and worrisome property lending exposures, that judgment has come to look premature. And for an apprehensive business sector there is a sense of foreboding that the worst is most definitely still to come.
A trickle of early failures is starting to flow: small retailers whose survival till now rather than failure has been the surprise; estate agencies and businesses particularly dependent on growth to survive. But for the UK corporate sector as a whole, default rates remain, for now, at near-record low levels.
According to the Bank of England’s latest Financial Stability Report, the majority of the UK corporate sector has moderate leverage and healthy buffers of liquidity. UK companies took advantage of the abundant credit availability of recent years to extend the maturity of their debt and to secure committed credit lines.
However, since the final quarter of 2007, the Bank’s credit Conditions Survey has shown a tightening of lending to business and higher default losses on medium and large corporate lending. Highly leveraged companies are particularly exposed to the changes in credit conditions. ‘Borrowing costs for a hypothetical but representative leveraged buy-out deal,’ it points out, ‘have almost doubled since mid-2007.’
Spreads on lower-risk corporate debt instruments have also risen sharply since last October, despite the business sector having remained reasonably robust. Investment grade corporate bond spreads are at their highest level since the early 1980s – the era of those Receiver Specials – despite a record-low insolvency rate. The UK banks’ annual write-off rates on lending to the non-financial business sector have remained low. But, the Financial Stability Report warned, lenders now expect losses to increase over the next few months. As a result, banks have tightened the availability of credit to companies through wider spreads, higher fees and tougher non-price items such as loan covenants and maximum credit lines.
Up until the stark warnings in the Inflation Report in mid-May about the strength of the inflation threat, business on the whole was still reasonably upbeat about prospects. Despite almost nine months of unremittingly dire headlines, conditions in the real economy outside housing were better than many had cause to fear. There was a sense of a ‘hide and seek’ recession – darkening problems in the financial sector, but retail holding up relatively well and export-orientated companies quite upbeat. The prospect of a series of interest-rate cuts taking the bank rate down to 4 per cent by the year-end gave hope that the MPC cavalry would ride to the rescue in the nick of time.
But the sharp upturn in inflation has put the cavalry on hold. This has dealt a particularly heavy blow to the housebuilding and property sectors. Reports of a near 70 per cent collapse in new house reservations confirm the worst fears of a housebuilding slump that will hit much wider than the construction sector. With a slowdown now spreading into other areas of the economy and set to persist into 2009 and beyond, business borrowers have real cause to be concerned about the ability of their banks to see them through by loan roll-over and term extension, particularly when fuel and raw material costs have been rising at an explosive rate.
Property companies, along with housebuilders, have special reason to be apprehensive. Commercial property lending now accounts for £135 billion, or 38 per cent, of major banks’ lending to the corporate sector (now around £358 billion) compared with 19 per cent in 1998 (see chart). This does not include off- balance sheet exposure, reckoned at some £40 billion. Royal Bank of Scotland and HBOS are among the biggest lenders to the market. Total corporate lending by HBOS to construction and property clients stood at £40.4 billion at end 2007, or 37 per cent of its total corporate loan book.
Concerns about commercial property valuations were evident even before the onset of the credit crunch, in part because the initial rental yield on property fell in 2006 below the cost of finance. But the speed and magnitude of the recent fall in values (20-25 per cent) has still surprised many. Falling commercial property values increase the riskiness of loans and erode the equity buffer by which borrowers can withstand financial shocks. Lower collateral values could also result in commercial property companies finding it increasingly difficult to refinance existing loans, adding to the probability of default. According to industry surveys, average loan-to-value ratios for almost all sectors are the lowest recorded, conditions for borrowers are not improving and breaches of loan value covenants are on the rise.
Meanwhile, access to equity capital does not look encouraging. In the first four months of this year, UK companies raised just £439 million on the London Stock Exchange, against £2.7 billion in the same period of 2007. The number of companies floating on AIM has nearly halved and the total raised is down from £1 billion to just £374.5 million.
An early casualty of weakening business confidence and constraints on access to capital is business investment. This fell 1.4 per cent quarter on quarter in the first three months of the year. The weakness is widespread, with marked quarter-on-quarter falls in manufacturing investment (down 4.9 per cent) and construction (10.1 per cent). Private sector investment in new building work has plunged 35 per cent on the previous quarter (see graph). Another worrying pointer noted by the Bank of England agents’ survey is a sharp slowdown in the growth of bank deposits held by non-financial companies, a sign of worsening corporate liquidity as well as a marked deterioration in firms’ investment intentions in April – this on top of a big decrease over the past six months.
Failing demand; falling business confidence; retreating hopes of interest rate cuts and markedly tighter lending conditions: faced with these, UK business has every reason to suspect that, far from the worst being over, it is still to come.
Bill Jamieson is executive editor of The Scotsman