Why we’re all between a Rock and a hard place now

Jul 24 2008 Agenda

Charles Cattaneo, partner at Grant Thornton in Birmingham, says that trading conditions are going to be demanding for those involved in the financial markets.

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2007’s run on Northern Rock brought the consequences of the behaviour of lenders and borrowers crashing into everyone’s lives, causing a collapse in confidence.

To stand a chance of predicting the future and working out how we should respond, we need to understand what happened.

For more than the last decade, we have had very low inflation, relatively speaking.

In their search for above average returns investors have sought out more risky opportunities.

Essentially, people have been happier to take bigger risks for smaller rewards and as long as the rewards ultimately covered the risks this was okay.

A good example is the US mortgage market. Lenders increasingly lent to those borrowers whose exposure was far beyond their resources.

After all, house prices were always going to rise, weren’t they?

So lenders saw little real risk in lending more to those with a poor or no credit rating – so called ‘sub-prime’ lending.

To get a quicker return, the lenders packaged these sub-prime mortgages with better quality mortgages, cut them into units and sold them on to other financial institutions that either were unable to tell what they were buying or spent little time checking what they had bought.

This might seem incredible to you and me – when was the last time you bought something in a brown paper bag and didn’t bother to look inside?

Why was everyone in the chain taking these extraordinary risks – borrowing more than they could afford, lending to those without the necessary resources and buying the unknown? 

A mistaken belief that house prices would continue to rise was certainly a factor, together with relentless pressure for ever greater returns on investments.

Low inflation meant the only way to achieve returns was to take greater risks that might deliver a higher upside.

The property market has been a perfect investment vehicle.

Low inflation rates have meant that individuals have borrowed far more than previously but with similar monthly repayments.

It’s no surprise house prices have soared and investing in property has been seen as being ‘safe as houses’.

The outcome, particularly in the US, is that people have bought homes with loans they can never hope to pay off.

The financial institutions who had bought the units of mortgage debt suddenly found the underlying value of the units was falling and had to recognise the resulting accounting losses.

The only option was a debt write off, which in turn has left a massive hole in the balance sheets of these financial institutions. But why does their balance sheet bother us?

Every bank has to maintain a number of pre-set solvency/capital ratios.

This protection ensures it has sufficient funds to guarantee it can repay depositors as and when they want to withdraw their money.

Traditionally financial institutions simply borrow and lend to each other to maintain the ratio as depositors move their cash around the system.

“I take money out of my bank to pay you and you then pay it into your bank account”.

This is pretty much a zero sum game as the funds remain in the financial system but have moved from one bank to another.

However, when a bank writes off debt it effectively reduces its capital base, meaning it will stop lending ‘surplus’ funds to other banks and may need to borrow more funds to maintain its capital/solvency ratios.

But, those with holes in their balance sheet have found the interbank market for credit has dried up.

Banks did not want use the Bank of England standing facility for funds since this very public act would immediately be seen as a sign of weakness, possibly sparking another Northern Rock.

Some have looked to shareholders to ease their position and we have seen record-breaking share issues that have been the talk of the City, some for the wrong reasons.

Mervyn King, Governor of the Bank of England also took steps to increase liquidity in the market in April.

He has now said he will introduce a permanent facility for troubled banks, enabling them to avoid using the Bank of England’s standing facility.

The Governor has, however, made it clear that lenders should not view this as a ‘get out of jail free’ card.

Lessons must be learnt.

So what next?

Everyone who shops or watches the news will know commodity prices are soaring.  While this is largely driven by booming emerging economies like India and China, and speculators betting on the oil price, it is introducing inflationary pressure, reducing profits, driving the UK ever closer towards a recession.

The US, where the sub-prime problem arose, will almost certainly go into recession and, since they are one of our biggest trading partners we will be affected.

But, our economic links with the strongly growing Eastern European economies that have recently joined the EU may give us just enough buoyancy to keep our head above water.

However, there will be significant job losses in the financial services sector and this will knock on into manufacturing and more traditional businesses.

Figures published in June have shown the number of hours worked has declined, a likely pre-cursor to redundancies.

So what do we do?

Companies that don’t have the right strategy or systems in place will be exposed.

Management teams need to act now to make sure they have good business disciplines in place and the right financial structure to weather the storm.

They must fastidiously conserve and control cash.

Bearing in mind that creditors are likely to pay less quickly it makes sense to identify short-term cash requirements and forecast longer-term cash flows based on credible and realistic financial information. With banks reticent to lend, running out of cash could be fatal.

Cost control is obviously essential, but it’s equally important to sustain things that are important to long term success.

Investment should not dry up now, but plans should be sanity-checked and prices negotiated ruthlessly.

Mergers & acquisitions (M&A) activity is not going to evaporate.

Business valuations may be lower compared to this time last year, but we are definitely seeing that if the company is strong and the strategy right there is funding available.

We are also seeing an increase in investment from the relatively cash-rich emerging economies.

UK companies continue to attract the attention of acquisitive Chinese, Indian and American companies, but we will also continue to see the strong interest in our companies from the oil and energy rich Gulf States and also from Russia.

We are not in a recession; the economy is still growing although the leading indicators are going the wrong way.

We currently have a ‘bear market’, with many investors looking to sell.

However, the opportunists are starting to come back into the stock market.

There is still an appetite to fund good quality companies in their corporate aspirations whether it be flotation, merger, acquisition or investment for growth.

It is just that conditions are more demanding, the terms will be tighter, negotiations tougher and the financial institutions will be making sure they really have worked out their risk and reward ratios.

Institutions are looking very closely at what is in the “sub-prime” brown paper bag.