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Europe also faces a financial bubble

by Jerome a Paris Wed Aug 17th, 2005 at 05:50:23 AM EST

I write a lot about the bubbles that threaten the US economy, and some have accused me of unseemly catastrophism or schadenfreude... Today, I won't correct the first impression, may will try to do something about the second...

For the second day in a row, the Financial Times publishes a worrying article about the bubbly nature of European finance and the possible fallout for banks. Banking crises are the worst of all, as they cost horrendous amounts of money to clean up and they always present the risk that they will spread to other sectors or , worse, create panics. Banking regulation and banks' internal risk assessment procedures have imporved in recent years, but when market conditions are as aggressive as today, you start wondering again...

Yesterday's article (Europe’s excess liquidity is passed into risky hands) is a very long one about the increased risks taken by players in the structured finance markets. The second one, today (Beware the bubble of irrational lending, by the chief executive of KPMG Corporate Finance, a big advisor in the same markets) concludes as follows:

There is little doubt that the round of irrational lending we have seen of late has inflated a market bubble. A bubble, it seems, that is highly likely to burst with some potentially dire consequences for borrowers.

More details below, as well as a discussion of the anglo-saxon vs continental financing models.

The first article provides some striking graphs:

The first one above show the growth in the volume of leveraged transactions, i.e. transactions that use a high proportion of debt, as opposed to equity, to be completed (I can't say what the cutoff point is in terms of debt to equity ratio, maybe 1 or higher).

The striking thing is how the volumes quickly overtook the "bubbly" levels of 1999. Some of it is linked to the emergence of the euro as a single currency for debt emission, with a vast internal market to tap into, but such rapid growth can only be attributed to an otherwise enthusiastic market for these aggressive transactions.

from the "excess liquidity" article"

Why are banks, hedge funds and other financial players in Europe awash with funds and what are the consequences of this state of affairs? The pattern is global but it is arguably made starker in Europe because – unlike the US Federal Reserve – the European Central Bank is not raising interest rates (and the Bank of England has just cut them). Europe’s sluggish economy is meanwhile creating little mainstream demand for loans – forcing banks and other financial players to seek other outlets for surplus cash that can produce reasonable returns.

“They keep making more and more money and they don’t know what to do with it,” says Louis Elson of Palamon Capital Partners, a private equity group, who estimates that European banks will make some €90bn in profits this year. Of this, €20bn would be set aside to strengthen their core capital and a further slice to pay dividends. But, after adding in surpluses made in previous years, the banks’ debt financing capacity could be as high as €100bn. “Some of it is moving into esoteric financial areas,” Mr Elson adds.

By esoteric, read - riskier. Banks and other players are awash in money, and don't know what to do with it or how to get a return for it. The article notes that the housing market, for the eurozone as a whole is very calm (even if there are small bubbly markets like Ireland or Spain), corporate customers are very prudent in their borrowing, and consumers are not splurging on debt like in the US.

So what's left - the locusts:

from the "excess liquidity" article"

Nevertheless, if policymakers want to find somewhere susceptible to a bubble, the opaque world of leveraged finance seems a good place to look. Whereas investment-grade companies are exhibiting debt restraint, riskier borrowers – particularly in the private equity world – are more than compensating for this by taking on higher and higher levels of debt. Though this has recently fuelled a boom in buy-out activity in Europe, it also risks sowing the seeds for future problems – particularly if financing costs head upward.

Data currently emanating from that sector are startling. In recent years, US buy-out specialists such as Blackstone, Carlyle, Kohlberg Kravis Roberts and Texas Pacific have crossed the Atlantic on a striking scale: whereas total private equity activity in Europe was just $32bn in 1998, deals announced so far this year have totalled $123bn, according to Dealogic, the research group. As a result, the value of European private equity deals has come to dwarf activity in the US, which rose from $42bn in 1998 to $97bn for the year to date.

American funds are finding opportunities for restructuring in Europe, and they are finding the cheap and aggressive funding they need to carry it out:

Thus this rush into (increasingly) leveraged transactions.

That second graph shows how much debt is piled on a given stream of revenue: ebitda (earnings before interest, tax, depreciation and amortisation) is a measure of operational cash-flow, i.e. of how much money the underlying business makes, before it has to repay those that have financed it. It's a rough measure of how much value the company creates, befor the financial stakeholders (including the fisc) fight it out to know who gets what chunk of that value.

Typically, a debt to ebitda ratio of 3 was considered the limit - i.e. the company would need 3 full years of revenues to pay back its debt. Spread out over a longer period, this is easily borne and thus seen as reasonable. As the graph above shows, that ratio has shot to the roof recently.

What this means is that the financiers will expect - worse, they will need stellar financial performance from these companies for a very long time to have a chance to be repaid, which means that the pressure will be relentless (the silver lining, possibly, is that, in theory, they won't be interested in short term fixes, as they need income over the long run - so they cannot behave as vultures - but we'll see more about that below)

from the "excess liquidity" article"

as the levels of leverage become more extreme, some industry players are becoming uneasy. “Operating risk must be tied closely to the financial risk. But the two are divorcing,” warns Mr O’Grady of 3i. “Some [investors] will get caught with egg on their face.”

David Blitzer, a senior Blackstone executive, agrees that debt markets are frothy and the peak cannot be far away in terms of leverage multiples and supply of capital. “That said, a lot of these companies that are being financed on high multiples are very good companies. I don’t think the risk profile of the debt holders is off the wall,” he adds.

Yet the higher leverage clearly makes indebted companies more vulnerable to any future rise in funding costs. “The pressure is rising – [higher leverage] means that these deals are becoming less and less able to withstand future exogenous shocks,” warns Mr Watters of S&P.

There is no sign yet of such a funding shock occurring. And some policymakers argue that, even if it did hit the sector, its impact on the broader economy would be limited, hurting just a few private equity and hedge fund players. Banks, with their strong profit streams, seem well funded enough to ride out any storm.

However, history suggests that when credit bubbles emerge, these rarely deflate smoothly – or without creating unexpected casualties. “We live in a cyclical world – we have been here before,” says Julian van Kan, head of loan syndication at BNP Paribas. “We have not seen any accidents recently?.?.?. but [these are] potentially somewhat inevitable.”

That's the thing. Most of the players in these markets have no memory of crisis and it sometimes seems that thay are behaving as if good times will go on for ever. Those that know that they don't (go on for ever) are getting worried, and saying, as usual, that consequences are unpredictable, but that we are tempting fate with such aggressive structures.

The other article points out that the way these deals are structured presents some dangers:

from the "bubble" article

Lending used to be regarded as aggressive if debt exceeded a multiple of three times the borrower’s earnings (ebitda). Lately, banks and other lenders have been falling over themselves to rewrite the rules. Anecdotally, “five is the new three”, and multiples of ebitda of seven, eight and more have been seen in debt packages supporting private equity acquisitions. With these debt packages come some onerous default provisions if the borrower’s financial performance is not maintained.

So a substantial proportion of the UK economy, including many household names, is beginning to face up to increasingly nervous and difficult trading conditions with alarmingly little financial flexibility.

This is a problem we've seen elsewhere: banks put tough conditions on these loans, and if the financial condition of the company goes bad, these conditions get tougher (typically, the conditions are linked either to the operational cash-flows of the company or its credit rating, and they trigger limits on the level of indebtedeness of the company, or the interest rates on loans. This can easily turn into a vicious circle, as companies are asked to repay their debt or to pay more interest precisely at the time they are having financial difficulties - i.e. these structures tend to accelerate the fall when it has started (and amplify the cycle). This is exactly what happened in the power sector in both the US and the UK following the overinvestment of the boom years in the late 90s and the Enron meltdown - a number of players with agressive borrowing patterns went bankrupt or had to seriously restructure.

But there is something new (at least for Europe):

from the "bubble" article

In addition to the speed and extent to which trading difficulties may, in this cycle, turn quickly into default, there has been a fundamental change in the way these default situations are dealt with. The working assumption that lenders and borrowers share the same economic interest and will sit around the table to work out the way forward is no longer valid. In the current immensely liquid market, debt is now regarded much more as an asset to be traded than as a long-term relationship commitment. A variety of techniques have emerged to enable investors to hedge or sell their debt exposure, meaning that many companies struggle to identify who their lenders are, making negotiations fragmented and complicated.

In addition, hedge funds and specialist “value” investors are increasingly buying up the debt of companies that they believe may face distress. These investors are rational and creative; there are many arguments supporting the nature of this type of investor and behaviour in a competitive, transparent economy. But they often acquire the debt at a significant discount, and they have no loyalty, duty or relationship with the borrower. Their single purpose is to maximise the return they receive on the debt they have bought.

This means, in fact, that the initial investors will NOT, in fact, stick in for the long term. If they decide that the new financial perspectives of the company cannot justify the current level of debt, they will sell that debt to another player for whatever value they can get instead of helping the company go through the difficult period. The new owner of the debt will only need to get a return on a smaller amount and can decide that squeezing the company in the short run can make more sense - and more profit from them, coming from their very narrow perspective of getting a return on distressed debt. If there is a mix of different kind of investors, following various transfers of debt or equity, then the negotiations to refinance a distressed business can get very complex, and the likelihood of bankruptcy as lenders cannot agree to a plan, higher.

This goes to the core of one of the most important ideological debates between anglo-saxon finance and continental European banking: European banks have traditionally built long term links with their clients, and they support them in bad times instead of letting them down, and they get some rewards in good times. You have a privileged relationship between client and banker which is not determined only by the short term profitability or cost of a given transaction. This is the opposite of the market driven financings (typically the bond market) where each transaction must stand on its own and there is much less loyalty between borrowers and sellers. Lenders can simply step out, by selling their asset at whatever price the market will bear.

With the emergence of very liquid bond markets in the eurozone, that second approach has been given a boost, especially at times like now where money is plentiful and lenders are fighting it out for the clients. The downside of that will be visible in the next downturn (coming soon!) when the companies that have borrowed on these markers will feel the pressure to deliver with no leeway from their new lenders. This trend is accelerated by changes in banking regulations (fought hard by European banks, but it is a losing battle) to bring "fair value" concepts to loan portfolios, just like on the financial markets. In essence, regulators want bank loans to be assessed at their immediate market value, and not at their face value. This would have the effect of making the long term relationship between a client and its bank much less important, as the bank would not care anymore about being repaid in the end, but about having a good portfolio at all times, thus leading to speculative trading of their client's debts.

(This debate has been fuelled by a few high profile company failures in Europe, where banks were accused of supporting them for too long instead of letting them go bankrupt, and in some cases to commit fraud to hide the ongoing difficulties)

This debate is not over (it's part of the whole "Basle 2" process which I won't go into further here), but it may get fresh input from the real world if, for the first time since these discussions started, corporations have to face a real downturn and live with the new behavior of their financial market lenders. We'll see if they still find that attractive then.

But take note, while the "locusts" are American, they are using money from mostly European lenders, and thus the pain will remain in Europe, and so will the political fallout...

My head is swimming. Are you saying that American investors are (potentially) causing European financial problems?

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia
by whataboutbob on Wed Aug 17th, 2005 at 06:19:20 AM EST
In a way, yes, but they should not be blamed. It is European banks that are providing the aggressive funding and agreeing to/actively putting in place  the financial terms that may lead to the future vicious circles.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Aug 17th, 2005 at 07:00:13 AM EST
[ Parent ]
I just skimmed the article, so will read in more depth later...but unless you discuss this in depth there...I have this question: why, now, are the banks opening themselves up to this risk?

(Has everybody gone crazy? Bankers wre always the one group you count on being conservative...in a good way: protecting our money. Why would they start risky behavior now?)

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia

by whataboutbob on Wed Aug 17th, 2005 at 07:07:33 AM EST
[ Parent ]
Bankers who don't lend money don't get bonuses.
by Colman (colman at eurotrib.com) on Wed Aug 17th, 2005 at 07:15:53 AM EST
[ Parent ]
and the bankers that make the loans are usually not those that will deal with the eventual crisis aftetmath whn there is one...

I actually spent my first 2 years as a banker preparing somehigh profile Russian loans, and the next 2 managing their survival through the 1998 crisis. It has given me some interesting perspective on these things... (and yes, we got all our money back)

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Aug 17th, 2005 at 08:25:18 AM EST
[ Parent ]
And they don't run banks for very long, either. Banks MUST lend their assets in order to have a business; that's how banking works.
by asdf on Wed Aug 17th, 2005 at 04:24:38 PM EST
[ Parent ]
They already jumped on the new economy ship.

I remember well a Spiegel cover in, was it late 1999 or early 2000, showing bank highrises in a caricature of a famous "Tower of Babel" painting. The ocassion was a fusion of two large German banks, but the article more broadly wrote about runaway senselessness in the German financial community - correctly predicting the crash shortly after. (Yeah, they were proud of that feat.)

*Lunatic*, n.
One whose delusions are out of fashion.

by DoDo on Thu Aug 18th, 2005 at 06:38:58 AM EST
[ Parent ]
I found it, issue 11/2000:

*Lunatic*, n.
One whose delusions are out of fashion.

by DoDo on Thu Aug 18th, 2005 at 06:42:19 AM EST
[ Parent ]
I understand that debt is becoming a commodity to be bought and sold, instead of a long-term commitment on the part of the lender, and that this makes it difficult or impossible for borrowers to renegotiate terms in the event of problems.

But if and when the bubble bursts, wouldn't this at least be self-correcting, i.e. wouldn't the market then be awash in heavily discounted debt, and wouldn't this be an incentive for lenders to come to an agreement with borrowers?

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman

by dvx (dvx.clt ät gmail dotcom) on Wed Aug 17th, 2005 at 10:44:21 AM EST
From Reuters:

Lured by booming oil prices and friendly Kremlin ties, Western banks want to extend Russia the largest loans in its history, brushing aside fears of bad debts, the ghosts of fallen YUKOS and high levels of borrowing.

The biggest loans include $7 billion to fund Russia's purchase of a 10.7 percent stake in gas monopoly Gazprom, $2 billion for state oil firm Rosneft and up to $10 billion for Gazprom to buy oil firm Sibneft.

(Also posted in European Breakfast 18 August.)

by afew (afew(a in a circle)eurotrib_dot_com) on Thu Aug 18th, 2005 at 09:04:57 AM EST

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