08/10/2007
SUCCESS MAGAZINE – 8th October 2007
The Cost of Credit
Whether businesses are new start ups, conserving every last penny, or mature operations, with an extensive Treasury desk involved in multi-currency loans, this summer’s turmoil in the credit markets has been a considerable shock. The full effects are still being analysed and debated, but it is clear that a structural change has taken place. Only a few months ago, economists were forecasting further increases in interest rates, not only in the UK but also Europe. Recent events were so worrying that the US Federal Reserve cut interest rates for the first time since mid 2003, while the UK has not only implicitly agreed to guarantee all bank deposits but also flushed the money markets with cash.
As calm descends, an important question for senior management is: what will the credit crunch mean for my business, especially if it has substantial borrowings? The answer depends on two factors: your time scale, and the quality of your balance sheet.
We are warning clients that a credit tsunami is sweeping across the landscape. The early effects were seen in arcane areas of the financial markets, more recently in parts of the high street. However, there are more changes to come. Too many commentators see the US housing market as the cause of this tsunami. It is not; it is a symptom. For too long, credit conditions were too easy in too many parts of the credit markets, both global and domestic. To quote Mervyn King “risk was not priced correctly”.
During a tsunami, islands and coasts are damaged one after another, depending how close they are to the original earthquake. On this occasion, we saw investment banks and hedge funds initially affected, as they could not correctly value their holdings of complex instruments. Then large parts of the commercial banking sector suffered when the wholesale money market froze, forcing Northern Rock to became front page news.
This is not the end of the process. Despite all the actions by central banks, it is important to realise that many interest rates are actually higher, not lower, both for companies and for households. UK three month interbank rates are still about 6.25%, that is 0.5% above base rates. A recent Bank of England survey showed that the average interest rate for fixed rate corporate loans was about 1% higher than in the summer. Some corporate bond deals have been well received in the market place, but this is no surprise when the offering has been 250 basis points above the normal benchmark. Looking at domestic borrowers, US jumbo mortgage rates are about 1% higher than in the early summer. This comes at a time when households in the US and the UK already face the pressure of higher mortgage payments as previously fixed deals expire, while the terms and conditions attached to new mortgages are being tightened. Is that the sound of a stable door?
The tsunami will sweep on. Balance sheets will increasingly matter – those with weak credit scores or poor collateral will find borrowing more difficult than will prime borrowers. Corporate bond spreads will come under pressure, as issuance starts up again. Volatility will pick up in currency markets, as investors react to different banks altering monetary policy at different times. Finally, the politicians will become involved. Several regulators are already under scrutiny for ‘being asleep at the wheel’. If a more generous deposit guarantee scheme is put into place in the UK, the authorities may try to ensure that any future liability to the industry or to the government is kept at a minimum, via tighter bank regulation.
In periods of structural change, previously successful business models can sometimes stop working. Businesses need to adjust to a new credit environment: quality will matter more, the quality of a balance sheet, the quality of a relationship with your bank, or the quality of your contacts with investors more generally in the capital markets.
Andrew Milligan, Head of Global Strategy at Standard Life Investments.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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All companies are authorised and regulated in the UK by the Financial Services Authority.
©2008 Standard Life Investments.
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