Economics focus Banks need more capital

Alan Greenspan says banks will need much thicker capital cushions than they had before the bust

Greenspan AssociatesAlan Greenspan was the chairman of the Federal Reserve Board from 1987 to 2006. He is now president of Greenspan Associates

GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis.

For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of market perceptions of potential bank insolvency and thus of extra capital needs, rose from a long-standing ten basis points in the summer of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS spread appeared range-bound for about a year up to mid-September 2008. The Lehman default, however, drove LIBOR/OIS up markedly. It reached a riveting 364 basis points on October 10th.

The passage by Congress of the $700 billion Troubled Assets Relief Programme (TARP) on October 3rd eased, but did not erase, the post-Lehman surge in LIBOR/OIS. The spread apparently stalled in mid-November and remains worryingly high.

How much extra capital, both private and sovereign, will investors require of banks and other intermediaries to conclude that they are not at significant risk in holding financial institutions’ deposits or debt, a precondition to solving the crisis?

The insertion, last month, of $250 billion of equity into American banks through TARP (a two-percentage-point addition to capital-asset ratios) halved the post-Lehman surge of the LIBOR/OIS spread. Assuming modest further write-offs, simple linear extrapolation would suggest that another $250 billion would bring the spread back to near its pre-crisis norm. This arithmetic would imply that investors now require 14% capital rather than the 10% of mid-2006. Such linear calculations, of course, can only be very rough approximations. But recent data do suggest that, while helpful, the Treasury’s $250 billion goes only partway towards the levels required to support renewed lending.

Government credit has in effect acted as counterparty to a large segment of the financial intermediary system. But for reasons that go beyond the scope of this note, I strongly believe that the use of government credit must be temporary. What, then, will be the source of the new private capital that allows sovereign lending to be withdrawn? Eventually, the most credible source is a partial restoration of the $30 trillion of global stockmarket value wiped out this year, which would enable banks to raise the needed equity. Markets are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind). Human nature being what it is, we can count on a market reversal, hopefully, within six months to a year.

Though capital gains cannot finance physical investment, they can replenish balance-sheets. This can best be seen in the context of the consolidated balance-sheet of the world economy. All debt and derivative claims are offset in global accounting consolidation, but capital is not. This leaves the market value of the world’s real physical and intellectual assets reflected as capital. Obviously, higher global stock prices will enlarge the pool of equity that can facilitate the recapitalisation of financial institutions. Lower stock prices can impede the process. A higher level of equity, of course, makes it easier to issue debt.

Another critical price for the return of global financial stability is that of American homes. Those prices are likely to stabilise next year and with them the levels of home equity—the ultimate collateral for global holdings of American mortgage-backed securities, some toxic. Home-price stabilisation will help clarify the market value of financial institutions’ assets and therefore more closely equate the size of their book capital with the realities of market pricing. That should help stabilise their stock prices. The eventual partial recovery of global equities, as fear inevitably dissipates, should do the rest. Temporary public capital injections into banks would facilitate this process and arguably provide far more benefit per dollar than conventional fiscal stimulus.

Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter.

Corporate lending: Waiving or Drowning

Dec 4th 2008
From The Economist print edition

Even big firms are finding it tough to secure credit from the banks

Illustration by David Simonds

CONVENTIONAL wisdom says that it is better to be a large company than a small one when credit is tight. Bigger firms have more room for manoeuvre: they have access to more types of funding, they have more fat to cut, and they have greater bargaining power with lenders. Even so, life is getting ever more uncomfortable for the bigger beasts of the corporate jungle.

According to the Federal Reserve’s most recent lending survey, American banks are tightening terms more aggressively for bigger firms than for tiddlier ones (see chart). Lenders are more cautious than they have been at least since 1990. The story among European banks is similar. Lenders in emerging markets can be more suspicious of multinational firms than they are of locals. “We just don’t know what they’ve got on their balance-sheets back home,” says one bank boss in Africa.

Violent movements in exchange rates are causing additional headaches, says Andrew Balfour of Slaughter & May, a law firm. Calculations of financial ratios can be thrown out by wild currency movements, potentially triggering breaches of loan covenants. Companies with sterling-denominated credit lines may find that their facilities are not big enough as a result of the pound’s recent sharp fall, for instance.

It is not panic stations yet. Most firms can survive for a while with the credit tap turned off. Analysis by Moody’s, a rating agency, shows that the vast majority of highly rated companies in America and Europe have enough headroom, in the form of cash and undrawn bank facilities, to be able to survive for 12 months without needing new financing. European corporate-debt markets have seen a rare flurry of issues in the past few days by opportunistic, highly rated firms.

Governments are also working hard to prop up credit markets. The Fed’s programme to buy commercial paper, a form of short-term company debt, had acquired almost $300 billion by November 26th. Banks on both sides of the Atlantic are issuing lots of government-backed bonds, which should encourage lending.

For now, an uneasy truce exists between most companies and their lenders. Some banks made tentative attempts in the autumn to pull out of loan agreements because their cost of financing had spiked so high. But they quickly backed down. In turn, banks are doing what they can to persuade corporate treasurers not to draw down credit facilities unless they have to. But hard choices are looming.

As the economic news worsens and profits dive, more firms will be at risk of breaching covenants on standard measures such as the ratio of debt to earnings before interest, tax, depreciation and amortisation. Furthermore, a good deal of debt will fall due in the next few years: Reuters Loan Pricing Corporation, a data provider, estimates that more than $1 trillion of loans will need to be refinanced globally in each of the next three years, mainly in America and Europe.

Competition for capital is bound to increase in that time, given the coming torrent of government-debt issuance. Auditors also want to be reassured about refinancing prospects well before maturity dates so they can sign off on companies as going concerns. With little obvious benefit in waiting, many expect to see a concerted effort by companies to renegotiate funding facilities early in 2009, once the year-end squeeze is over (see article).

In the face of more requests for waivers and refinancings, banks will react selectively. “We will distinguish between companies that are temporarily in crisis and those that are not,” says Alessandro Profumo, the chief executive of UniCredit, an Italian bank.

The lucky ones will still pay a hefty price for access to credit. Not only will the costs of borrowing zoom, but terms will become much tighter. Old-fashioned provisions such as “clean-up” clauses, which require borrowers to pay their debts down to zero for a specified period every year, are creeping back into some discussions. The onus is also on borrowers to show that they are taking steps to cut costs before they come to lenders for more money. Banks want to know that you have exhausted all other avenues yourself, says Sheila Smith of Deloitte, a consultancy. Even then, facilities are likely to shrink as non-bank investors such as hedge funds drop out of loan syndicates and banks that had only extended money in the hope of ancillary business also draw back.

For those firms that find doors starting to shut on them, the prospects are grim. Despite some talk of a bigger role for private placements, this is not the best time to start forging relationships with new creditors if existing ones turn unfriendly. Many firms are going into this downturn with fewer unencumbered assets than in previous recessions, which makes it harder to secure new credit. Asset disposals, one obvious way of raising cash, are extremely hard to pull off at the moment. Nor does it help that many corporate loans have been securitised and divvied up among lots of investors, making it harder for firms to negotiate modifications.

Projections for defaults are rising fast. Bain, a consultancy, now expects as many as 140 American speculative-grade companies to default in 2010, sharply up from a forecast of 40-50 in April. Worse, firms that default are likelier to end up in full liquidation. In America, debtor-in-possession financing, which helps firms that have entered Chapter 11 bankruptcy protection to meet their cash needs while they reorganise, has dried up. “The gap between financial distress and financial disaster has become much smaller,” says John Grout of the Association of Corporate Treasurers, a British trade body. So too, it seems, has the difference between big companies and small ones

WB forecasts Gloom in Global Economy

Emerging economies will grow more slowly in 2009 The World Bank has forecast a significant decline in global economic growth in 2009 for both developed and emerging countries. In a report assessing economic prospects, the Bank has predicted that the world's annual economic growth will slow to 0.9%, from 2.5% this year. The rate of growth for emerging economies is expected to be around 4.5%, down from 7.9% in 2007. The Bank said a deep global recession could not be ruled out. And its forecast suggests that, on a per capita basis, world growth would be negative in 2009. "Following the insolvency of a large number of banks and financial institutions... capital flows to developing countries have dried up and huge amounts of market capitalisation have evaporated," the bank said. The World Bank has warned that some emerging economies are likely to face serious challenges, including bank failures and currency crises, even if global bail-out plans start restoring confidence in financial markets. The Bank's chief economist, Justin Lin, said the financial crisis "has eased tensions in commodity markets, but is testing banking systems and threatening job losses around the world". It also warns that capital flows to developing countries are shrinking fast, reducing the level of investment, while the slowdown in world trade is likely to cut into their export markets. Regional impacts Even the fast-growing emerging giants, India and China, are likely to suffer from the slowdown. The World Bank projects China's growth to slow from 11.9% in 2007 to 7.5% in 2009, while India's growth prospects will be cut from 9% to 5.8%. The impact of falling commodity prices has been positive for around half of developing countries. In response to the global downturn, the World Bank is increasing its support for developing countries by helping local banks recapitalise and providing aid for infrastructure projects. Despite the current crisis, the Bank says that the long-term growth prospects for developing countries remain strong, and this will lead to substantial reduction in world poverty rates by 2015, with just 15% of people living on less than $1.25 per day, compared to 25% in 2005. However, it warns that severe poverty in sub-Saharan Africa will fall less quickly, with 37% still living on $1.25 per day by 2015.