Matthew Prest knows he is about to get busy. As head of Close Brothers’
European restructuring business, he gets going when companies find
themselves in trouble. After reading the accounts posted last week by HBOS
and Lloyds TSB, two of Britain’s biggest banks, Prest is preparing for a
bonanza.
The banks last week revealed that bad debts jumped by more than 30% in the
first six months of the year, resulting in a collapse in profits.
On Friday, Alliance & Leicester also revealed increasing problems in parts
of its business, saying its profits had been all but wiped out by the credit
crisis. This week, similar trends of rising bad debts, particularly in
corporate loans, are expected to emerge from HSBC, Barclays and Royal Bank
of Scotland.
One year on from the onset of the global credit crunch, the deeper
consequences of the crisis are beginning to emerge. What started as a
problem in the financial system, sparked by American sub-prime mortgages, is
now hitting business squarely on the chin.
Within the next few weeks a fresh wave of corporate insolvencies is likely to
swamp the British economy. While that spells good news for Prest and his
peers in the insolvency business, it also means that Britain’s banks have a
long and difficult road ahead of them.
“This is just the tip of the iceberg,” said Prest. “There’s a lot more to
come. The problems in the corporate economy are only just beginning to
appear.”
CORPORATE Britain owes its banks a shade over £545 billion, according to
figures from the Bank of England. This figure is within a hair’s breadth of
the total annual spending of the British government, across all departments.
While the threat of crisis in the mortgage market has been looming for some
months, corporate Britain had until recently been considered more resilient.
Now, as soaring energy costs add further pressures to an economy weighed
down by the credit crisis, bad loans to UK plc look set to create the second
wave of the problem.
“Companies went into this downturn looking very strong,” said Peter Spencer,
chief economic adviser to the Ernst & Young Item Club. “Profitability,
even in manufacturing, was high. In the service sector it was remarkable —
an all-time high. Cash flows were very strong.
“Companies had been rebuilding their balance sheets rather than spending on
investment, much to the prime minister’s chagrin. I thought that was quite a
strong platform. Having said that, when you look at some of the latest Bank
of England data, there are some real weak spots. Companies are now in
exactly the same kind of jam that consumers are in.”
HBOS last week wrote off close to £1 billion to cover losses from its
corporate loan book. The charge is almost twice the size of the provision
the bank took against its £237 billion mortgage book, which had been thought
by many commentators to be a bigger concern.
The size of the debt charge is comparatively small, amounting to less than 2%
of its total corporate lending. Given the boom in the value of loans,
however, the percentage figure does not need to be very high to run into
many billions of pounds.
This matches historical trends. Across the British banking industry, the
default rate on corporate loans was about 0.6% last year. Even at the height
of the recession in the early 1990s, only about 2% of corporate loans ended
up defaulting, causing considerable problems for the banking sector.
HBOS chief executive Andy Hornby did little to boost confidence, warning of
“upward pressure on impairment losses”. He added that “in corporate, we are
not currently seeing material signs of tenant default, but the deteriorating
economic climate is likely to put some further pressure on impairments”.
Lloyds TSB, meanwhile, revealed that bad debts had almost doubled in its
commercial banking business, which deals with smaller businesses. Again the
percentage figure was low, but across the banking sector as a whole it is
corporate loans that are now worrying analysts more than anything else.
“Lloyds has been the bank that has been telling everyone that nothing is as
bad as it seems,” said one analyst. “When they came out with their results,
it became a little more difficult for them to argue that. As the reporting
season goes on we are going to see more bad debts, more problems.”
Alliance & Leicester’s business bank was performing better than most, with
arrears actually falling in its small, specialised corporate lending book,
though this does not reflect the broader story.
Barclays and Royal Bank of Scotland will inevitably come under the same close
scrutiny over their corporate bad-debt charges later this week, along with
HSBC. The City is unanimous in its belief that the figures will show further
signs of weakness.
“We believe that corporate-lending credit-loss charges will once again prove
the biggest variable in bank profits in an economic downturn,” said Robert
Law, an analyst at Lehman Brothers.
One of Britain’s biggest banks conducts regular surveys of its corporate
customers. At the start of the year, 70% of business leaders polled said
they expected their order books to increase this year.
“When we repeated the exercise a month ago the figures were completely
reversed,” said a senior executive at the bank. “There are now 70% of
businesses telling us they expect their order books to decrease this year.”
That drop in corporate confidence is expected to be reflected later this week
in closely watched reports due to be published by the CBI and the Purchasing
Managers’ Index.
THE fragility of consumer confidence was hammered home last week when the key
GfK consumer confidence index slipped further than expected to a 34-year
low.
The latest report from Nationwide, meanwhile, revealed that UK house prices
have dropped more than 8% in the past year, after a ninth consecutive month
of declines.
The rating agency Standard & Poor’s then predicted a further 17% fall
between now and next April, which would knock another £30,000 or so from the
value of the average British home. The projection is in line with estimates
produced by HBOS and Lloyds TSB, and would leave some 1.7m British
households in negative equity, Standard & Poor’s said.
Senior executives at some of Britain’s biggest banks say they are starting to
monitor consumer spending patterns through transactions on credit cards and
current accounts.
“Our customers are pulling back somewhat,” said one banker. “People are not
going to pubs but buying beer and staying at home. They are denying
themselves luxuries and spending more on necessities.”
This behaviour is probably good news for the banking sector’s retail-lending
operations, but could spell further disaster for parts of corporate Britain.
Floors 2 Go, a wooden flooring retailer, went into administration two weeks
ago. The General Trading Company, a Chelsea-based emporium that provided the
wedding list for the Prince of Wales and the Duchess of Cornwall’s 2005
wedding, has also collapsed recently. Wrapit, an online wedding-list firm,
is teetering on the brink of administration and Sister Ray, an independent
record store in London’s Berwick Street, went into administration late last
week.
Dozens of other retailers have already gone under this year as a result of
heavy borrowing costs and falling consumer spending.
Insolvency experts are now waiting for September 25, the next “quarter day”
for retailers, when store rents are due to be paid. Expectations are
mounting that these rent payments could sound the death knell for a number
of struggling outfits. This would in turn spell trouble for the banks that
are owed money.
“We have had a primarily consumer-led economy in Britain for the past 10
years,” said Close’s Prest. “Every indicator tells you that consumers are
feeling the pinch. Things are very bad out there.”
IN response to their troubles, banks have begun looking at their books far
more thoroughly in recent months. At the headquarters of the City of London
police, officers are dealing with a flood of fraud allegations that have
been raised recently by Britain’s big banks against their customers.
“This time last year we had no mortgage frauds on our books, said Detective
Chief Superintendent Steve Wilmot, head of the economic crime unit. “Now we
have four very large ones at various stages of investigation.”
Over the coming weeks and months there will be a slew of further bad news for
banks. Their only option seems to be to tough it out.
In spite of the headwinds facing the economy, the Bank of England’s monetary
policy committee is expected to leave interest rates on hold at its monthly
meeting this week. Inflation fears are still real, as evidenced by the 35%
rise in gas prices by Centrica last week.
Share prices can only fall so much further, however. Over the past 12 months,
HBOS shares have plunged 70%, while Barclays’ have dropped 50% and Royal
Bank of Scotland’s more than 60%. Analyst forecasts are already factoring in
Armageddon across mortgages, corporate loans and then, later in the cycle,
credit cards.
Profit forecasts for 2009 and 2010 have been steadily lowered in recent weeks
as economic conditions have deteriorated. Earlier this month, James Eden,
banking analyst at Exane BNP Paribas, lopped more than 60% off his forecast
for Royal Bank of Scotland’s pre-tax profits in this financial year. The
City is already braced for disaster.
“We know that house prices are going to keep falling and we know that house
transactions are going to keep falling,” said Alastair Ryan, banks analyst
at UBS. “Unemployment is likely to rise, and corporate debts are going to
keep deteriorating. In the financial markets, we have already anticipated
most of this. What’s happening now is just beginning to catch up with our
numbers.”
Trying to fix the mortgage market
SIR JAMES CROSBY’s long-awaited report into the mortgage market warned last
week that there are no easy ways for the government to encourage banks to
lend more money to British consumers.
Treasury officials, however, seem undeterred in their efforts to find a way to
kickstart the mortgage market. Plans are being drafted in Whitehall to
expand the Bank of England’s £50 billion special liquidity scheme, according
to senior bankers.
The move would see the range of collateral that can be posted with the Bank
widened to include mortgages given out this year. Industry sources have
argued that this would help building societies to take advantage of the
emergency lending facilities and potentially introduce a greater element of
competition into the mortgage market.
The proposal was one of the remedies discussed in Crosby’s report, which the
former HBOS chief executive said would “expose” the authorities to
“significant legal and fiscal risks”. Crosby also said the Bank of England
might be straying beyond its remit were it to offer its balance sheet in
this way.
Nonetheless, banking sources say that feedback from government suggests this
is under active consideration in Whitehall.
Crosby’s final recommendations may be for the government to avoid intervention
altogether and allow the market to solve its own problems.
Other potential solutions include rejuvenating the mortgage-backed securities
market — bonds sold to financial investors and used to finance mortgage
lending.
The proposals included a new “gold standard” system for mortgage-backed
securities, to restore trust in the quality of the bonds, and urging
international co-operation to create a more efficient world market.
Crosby’s report cautioned against the creation of a government-backed mortgage
agency, in the style of Fannie Mae or Freddie Mac in America.
