Wednesday, July 16, 2008

Eurozone credit crunch or squeeze?

The current credit crisis should be both a squeeze and a crunch, but it seems to have been neither in the euro area. This column explains why credit may become costlier or scarcer under current conditions and explores how European financial entities seem to be defying the negative news. (Guillermo de la Dehesa @ Vox)

There are two channels through which the present credit crisis can affect economic activity. The first is prices, making credit more costly, and the second is quantities, making it scarcer. Dearer credit is called a “credit squeeze” and while scarcer credit is called “credit crunch”. The euro area seems to be suffering neither of the two, at least for the time being.
Credit may be getting dearer for at least for four reasons.

  • Today’s banks tend to face higher spreads when issuing debt compared to non-banks, even of the same rating, thus their lending to non-banks is less profitable or unprofitable unless they get other fees from these corporations or charge higher rates to other borrowers with lower ratings.
  • Average inter-bank one- and three-month euribor rates have gone up from 10bp a year ago to 80bp today over the OIS (overnight index swap) or EONIA, which is a proxy for future central bank rates.
  • Banks are re-pricing their credit because they finally have found out – after experiencing an increase in non-performing loans – that they were lending at too cheap rates for the risk that they were taking.
  • Banks’ credit default swap or the market price for insuring their risk of default has gone up more than that of non-banks.
    Credit may be becoming more restricted for two reasons.
  • Banks have been forced to do large write-downs of many of their assets that have depreciated using IFRS mark-to-market valuation.

As of today, total write-downs by large banks in developed countries have reached around $400 billion, but they have been able to raise capital by around $300 billion to be able to continue lending. According to the ECB, banks in the euro area only made €21 billion in write downs from August 2007 to the end of February 2008 (9.5 % of their total asset level of €22 trillion), and they have been able to raise capital enough to deleverage 8 percentage points and compensate most of them.

  • Some euro area banks have created, with the approval or consent of their supervisors, off-balance sheet vehicles that proved to be riskier than their rating, so both asset-backed securities commercial paper markets have been drying up since August 2007, falling by more than $450 billion.

These off-balance sheet vehicles (SIV and other conduits), which were created with minimum capital, were borrowing short in the asset-backed securities commercial paper market both in the United States and Europe and investing long in asset-backed securities and other instruments; the purchased assets were used as collateral.

For example, although the ABX HE index is not a very reliable source of valuations given that transactions are small and few, the fall in their values is remarkable. After an improvement in the indexes during April and May, today, triple A asset-backed securities has fallen from 100 in January 2007 to less than 50, double A has fallen to less than 10, single A to less than 7 and triple B to 5. That trend means that banks write-downs may continue for some time, because subprime credits are increasingly defaulting as every year there is a new reset of their interest rates upwards (teaser rates), and in 2008 it will affect $280 billion of them.

  • As banks are unable to refinance these investing vehicles in the capital markets, they may be forced to put them back into their balance sheets.

It is estimated that if all these vehicles were to be reincorporated into the euro area banks balance sheets, their regulatory capital would fall by more than 1 percentage point, from 8% to 7% of total eligible assets and therefore, if no capital were raised –highly improbable – credit would have to be reduced by 12%.

Neither a crunch nor a squeeze

Nevertheless, for the time being, seasonally adjusted annual credit growth in the euro area keeps slowing down rather slowly.

According to the June ECB report on bank lending, the annual growth rate of total credit to the private sector fell from 12.2 % in March to 12.0% in April and to 11.9% in May. Lending annual growth rate to private sector companies fell from 10.8% in March to 10.6% in April and to 10.4% in May. Annual growth rate of loans to non-financial corporations decreased to 14.2% in May from 14.9% in April. Annual growth rate of loans to households fell from 5.4% in March to 5.2% in April and to 4.9% in May. Loans growth rate for house purchase declined 5.5% in May from 5.9% in April and loans growth rate for consumer credit fell to 4.8% in May from 5.2% in April.

Moreover, credit is not getting dearer.

According to the ECB, interest rates on loans to the private sector have not changed on average. On loans to non-financial corporations, they have fallen slightly: Banks’ overdraft interest rates have gone down, from 6.62% in December 2007 to 6.54% in April 2008. On loans up to €1 million, floating rate and over-five-years initial rate fixation have gone down from 5.30% in December to 5.22% in April and on loans over €1 million, up to five years rates have gone down from 5.48% to 5.39%. In the case of interest rates on loans to households, banks’ overdrafts have gone slightly up from 10.46% in December 2007 to 10.55% in April 2008, as well as in the case of loans for consumption floating rate and over-five-years initial rate fixation, which have increased slightly from 8.17% to 8.45%. Interest rates for house purchase have come down slightly. For loans floating rate and over 10 years initial fixation rate, they have gone down from 5.18% to 5.11% in the same period.

Defiant behaviour

It is really difficult to understand why the increase in banks’ borrowing costs, their continuous increase in write-downs, the incorporation of vehicles into their balance sheets, their re-pricing of risk, and the increase in their non-performing loans ratios are not having a more negative impact on the flow and the price of their loans to the private sector in the euro area.

Some reasons include:

  • In the case of corporations, is that banks have maximum loan and price commitments to their main clients that contractually are still in force and have not been disposed yet by borrowers.
  • In the case of private equity funds and hedge funds, (which actually have increased their annual growth rate from 22.2% in April to 25.7% in May) might be that banks seem to be at ease with their average collateral ratio of 90% of loans and because most of them have met their banks’ margin calls on time by de-leveraging.
  • Unlike in the US, many euro area large banks did not create special vehicles off-balance sheet or they were very small.
  • The average small and medium size company in the euro area is not much indebted and that most households have taken loans to invest in houses and not for consumption and that they have seldom used equity withdrawals.
  • Many large European corporations still have sound financials and good ratings.

Will this soft loan and interest rate trend persist longer or is it going to change if the credit crisis continues biting the euro area banks balance sheets? Time will tell.

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