Who’s afraid of corporate defaults? “Not me,” say the banks. “Not me,” say the borrowers. So why is it business as usual in the corporate loan sector, even though banks are reeling from collapsing telecoms companies, not to mention NTL’s biggest-in-history £7.4bn bond default?
“What is unusual is that, notwithstanding the huge losses they’ve taken in the cable and telecoms sector, the banks are still relatively well capitalised,” says Neil Thomas, a director of KPMG Corporate Finance.
“There are few signs of a credit squeeze, much less a credit crunch. At the moment there are no systemic problems.”
In the mid-1980s, the Latin American debt crisis cost UK banks a sum of the order of £5bn in bad-debt provisions. Then, in the early 1990s, the hit came on commercial property. However, this time, the odds are in favour of the banks. The biggest concern is that a lot of asset quality is derived from low interest rates, and that companies are highly-geared.
Although rates are at an all time low and could spike up, in the worst case scenario they are forecast to cap at 6%. This means companies find it less burdensome to service their debt.
Also, the economic cycle, especially in Europe, is less volatile than in previous downturns. Given the global nature of the capital markets, all banks are picking up debt because of the way loans are syndicated.
But they are in a position to cushion those losses. Moreover, the process of consolidation over the past few years, creating monsters such as Citigroup and JP Morgan Chase, has left fewer players, with more negotiating power.
“We have not taken an aggressive rating action as the banks seem to be doing a better job,” says Ian Linnell, analyst at rating agency Fitch.
“This is not to say they won’t get hit, and I do worry about the cumulative effect of events such as the crisis in Argentina, exposure to airline debt and TMT failures. A sharp rise in interest rates could cause a shock that would push ratings down, although if rates peak at 6% the banks could handle this. Meanwhile, the banks are trying to expand their lending in safe areas such as utilities and food.”
Currently, the banks are resting on a huge capital base, as they have been incredibly profitable over the past few years. Taking the case of Marconi, the banks have been lending on average £250m to £300m each, and they can probably afford to lose half of that without taking a hit on their Tier 1 ratio.
But there is a nervous undercurrent because, historically, the banks always seem to lend to the worst problem sectors. The slightest concern over capital ratios tends to send the rating agencies’ antennae flying round, as was the case recently with Abbey National. Its exposure to the junk bond market prompted Standard & Poor’s to downgrade it from AA to AA-.
Banks have reacted to the deterioration in corporate credit by tightening pricing. But, as Thomas points out, when considering the impact of corporate defaults on the cost of borrowing, it is important to look, not only at the all-in material cost with regard to price, but also the terms of debt, such as the covenants and ratings triggers.
“There has been a shift in the terms of trade,” he says. “The situation regarding Enron and the impact of structured transactions have made people more nervous about lending to companies that have significant elements of structured finance, or lending to companies like Marconi where there were no financial covenants.”
Thomas believes everybody is conscious of the risk of rating downgrades.
“Compass, Rexam and Imperial Tobacco are in different sectors, but have all had to take account of changes in market conditions,” he says. “They have issued sterling bonds in the last few months with an automatic 125bp coupon step-up in the event of a downgrade to non-investment grade.”
The real crunch, of course, came in TMT, where banks funded licence purchases that have failed to deliver the expected returns. There has been a radical shift in the terms of trade for borrowers in that sector, but it should be noted that even here this applies only to weak players.
Vodafone has managed to renew its bank facilities more or less on the same terms as last year.
So the loan market is by no means shut, especially for solid mid-cap corporates. Lots of companies are issuing long-term debt and re-financing on reasonable terms. But if more cable and telecoms companies fail, and other sectors start to creak, there will still be problems.