Goodbye, easy credit as 'risk hunger' turns to financial indigestion

With banks caught out by their extravagant lending, private equity firms, hedge funds and consumers will find backing harder to come by. Tim Webb reports
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The Independent Online

It is often said that economists can never agree. So perhaps it is a sobering sign of the scale of the turmoil in the money and credit markets that, for once, economists are united on two key points. First, the good times of (virtually) free and easy credit are over for the foreseeable future. And second, no one knows whether we are witnessing a brief correction in price and risk or something altogether more serious.

John Mackie is a rare voice of optimism. As a director of Parallel Private Equity and former chief executive of trade body the British Venture Capital Association, you might expect him to be. "We could just be seeing a spot of midsummer madness," he reckons. "We'll know next month when everyone is back at their desks."

More typical is the air of gloom that Merrill Lynch lends to the analysis. Last week, a research note from the investment bank cheerfully noted: "Our strategists point out that no asset bubble has ever corrected in an orderly manner."

Analysts estimate that US and European banks have underwritten $300bn (£150bn) of debt for leveraged buyouts they have yet to place in the capital markets. In September, banks will start reporting results, which will provide a clearer picture of who holds the liabilities from the murky world of repackaged sub-prime mortgage debt and other forms of collaterised debt obligations (CDOs). Once investors know where they stand, banks will find out how much of this $300bn debt they can repackage and syndicate, and how much they must keep on their own balance sheets. Then the banks can start lending again.

But even if Mr Mackie is right and stock markets recover and credit starts flowing again, experts agree that the banks will not resume lending with the abandon of recent months.

Robert Talbut, chief investment officer of Royal London Asset Management, says: "We are not going to see a return to the degree of the risk hunger of three months ago any time in the foreseeable future. Access to credit will be more difficult and it will become more expensive in the future."

In fact, he says central banks and other policy makers will be glad that an increasingly irrationally exuberant market is correcting itself, painful though this process may be for some. "I believe this will be welcomed by the financial authorities, who are quite clearly trying to engineer a situation whereby stability is restored, but at the same time do not wish to provide a wholesale bailout for what they see as some foolish and inappropriate pricing of risk."

Mr Talbut adds: "Some people have blindly accepted levels of risk without contemplating that the incredibly benign conditions were not likely to continue indefinitely."

It is not immediately clear what the consequences of less lending and a more cautious approach will be. It will at the very least force the deal-prolific private equity industry to pause for breath as banks no longer seem prepared to lend to them at such high multiples to their takeover targets' earnings. Certainly, many of the deals which have recently been agreed now look shaky and may be ditched.

Delta Two, the investment fund backed by the Qatari royal family, which has made a £10.4bn bid for supermarket Sainsbury's, was relying on being able to raise £6.4bn of debt from the banks. But in the current climate, it looks increasingly likely that banks will pull out for fear of not being able to syndicate the debt to other investors, so deals will founder.

Fewer deals mean smaller pay-outs for excessively paid private equity bosses, who attracted opprobrium from unions and politicians on both sides of the Atlantic this spring. Banks also earn fees for making loans, so their income will fall accordingly.

It would be wrong to suggest deals will dry up altogether. Mr Mackie says the fall in share prices could result in more takeover opportunities for private equity firms. "If prices come down significantly, that is a cracking time to invest," he says.

But private equity firms – which had recently appeared increasingly indiscriminate in selecting companies to buy – will have to be choosier in the future. There will be fewer investors prepared to provide the debt, and the cost of borrowing will be higher.

It is harder to calculate the extent to which the turmoil in the money and credit markets might spill over into the wider econ-omy. Certainly, the American economy looks vulnerable. Mr Mackie admits: "Given what has happened in the sub-prime market, it would not take a lot to knock the US off course."

Merrill Lynch estimates that cumulative losses from defaulting US sub-prime mortgages stand at $120bn to $170bn, out of a total market size of $1.3 trillion. In the context of the global economy, these relatively small losses have caused disproportionate damage to their size. But we're not out of the woods yet: US homeowners' defaults are set to rise further over the coming months as thousands of mortgages move on to higher borrowing rates. There are also concerns that $1 trillion of prime- grade mortgages in the US could also be vulnerable to default.

But even if the US slips into recession – and few economists are predicting it will – the impact on the global economy would not be as severe as it was a decade ago.

Goldman Sachs says: "Our economists remain confident about the 'de-coupling story' as the US becomes less important in driving growth." The bank notes, for example, that in the first quarter, China's 11.1 per cent GDP growth rate meant that for the first time in modern history, it contributed more than the US to global growth.

But as banks restrict lending, this will affect consumer spending and the housing market in the UK too, says Stephen King, HSBC's chief economist. "There is already evidence that banks have become more cautious in their lending. There is no doubt that pressure will increase on them to become even more cautious. The issue now is what sort of collateral lenders will accept. Mortages of 100 per cent won't be so easily available." On Friday, UK lender Northern Rock increased the borrowing rate for sub-prime mortgages by up to 1.25 per cent.

Mr Talbut from Royal London adds: "In the UK, there will be ripple effects from the CDO and sub-prime turmoil via the repricing of risk into the real economy."

So economists and strategists agree: the tidal wave of cheap credit which fuelled the M&A boom and helped prop surging stock markets has run its course. What no one knows is what happens next. But one thing's for sure: it won't just be the private equity outfits and hedge funds that suffer if the credit dries up.