With one investment bank gone and the sword of Damocles hovering just out of sight above others, even the most insulated syndicated loan banker knows something is happening out there, and not much of it is very nice, notes Loan Radar’s Tom Freke in a post (Back to banks) that asks why banks keep lending to emerging market corporates.
Loan bankers keep churning out the deals – and many of them are not what you’d call “small”, says Freke, citing the multi-billion dollar monster deals for companies such as Rusal, Evraz, Lukoil, TMK and the rest.
So how can the loan market be so busy when all the other credit markets have ground to a halt?, he asks.
There are two answers, one pointing to a trend just beginning – and the other to a trend just ending.
The latter trend is the process of disintermediation — where lenders and borrowers bypass traditional banking options and capital flows through alternative systems and structures. Bonds are a “simple example of a disintermediated capital product”, says Freke.
This decade’s credit boom has largely been the product of massive disintermediation of capital. A wealth of abbreviations has entered our vocabulary, most of which relate to non-bank investors or structures designed to pick up or support their leveraged funds. ABS, CLOs, CDOs, CDS, LCDS, LBOs and SBOs — these have all boomed on the back of non-bank support.
Banks were heavily involved in this process, of course, because they had the skills and expertise to create and profit from clever financial engineering. And many banks believed they had to jump onto the bandwagon for fear of being disintermediated out of existence.
And it is no coincidence that some of the main beneficiaries of this process were credit rating agencies, says Freke. “In a bank-focused credit environment, it is banks that retain and apply financial information, but in a disintermediated credit world, someone had to step in and fill the gap”.
The credit crunch, however, shows that even with risks, assets and information broadly spread across a disintermediated system, there is no effective mechanism to discipline over-exuberance, leading to over-expansion and then – sudden collapse.
Collapse leads to the next trend, in Freke’s view: the process of reintermediation, whereby banks have had to take many of the risks and assets of the financial system back onto their own books.
First it was sub-prime, then SIVs and now, it’s hedge funds.
At each step banks have had to act largely because others could not or would not. Non-bank investors and lenders remain paralysed by the crunch, frozen by uncertainty and unforeseen losses amidst dramatically changed market conditions.
(There have various suggestions that non-bank players, such as SWFs or private equity companies, will start operating as bank-type lenders. However, such plans appear to have gone nowhere. See here, here and here.)
To borrowers, this means there is little or no capacity amidst non-bank lenders. The bond market has been shut or near-shut for nine months, with each tentative sign of recovery squashed by abysmal credit market news. And without the funds, unsold leveraged loans loom large over the buyout market, depressing valuations and keeping new deals out.
And so borrowers — like everyone else — have turned to the banks for support. But with all the other claims on their finances, the banks are being careful.
Such caution, however, has not closed the loan market, says Freke.
The banks might be feeling the pain but they remain willing and able after a decade of cheap liquidity and growing profits. And anyway, defaults remain at historic lows. Afterall, money can still be made from lending.
In the emerging markets, many banks have grown rapidly on the back of cheap external funds. But such policies don’t have an infinite lifespan. As a result, emerging market banks are being challenged to demonstrate a more sustainable growth strategy, as well as to pay a more realistic rate of return, and pricing on such loans appears to be rising each week.
Emerging market corporates, on the other hand, are in much greater demand, notes Freke.
Banks still want exposure to strong growth stories, and the majority of these can be found in a string of countries running from Brazil across North Africa, through Turkey and the Middle East into Russia, Kazakhstan, China, India and the big south-east Asian countries. Once known as the ‘second world’, these states are now at the forefront of many banks’ growth plans, notes Freke.
Many are commodity-rich, at a time when economic growth and the rise of China has driven the cost of such products to all-time highs. This commodity wealth has played a part in helping to retain local talent and capital, which is now used to reinforce domestic growth rather than going abroad to developed countries.
So, concludes Freke, it’s hardly surprising that western banks find calls from big companies in Russia, Kazakhstan and Turkey “too tempting to ignore”, especially at a time when the first world is not offering so many opportunities.
And when such companies ask for record-breaking sums for big consolidation deals – as Brazil’s Vale and Kazakhstan’s ENRC have done – the banks have stood up to be counted, looking at the value of the long-term relationships that might be on offer.
It is difficult at this point in time to see how far the tide of reintermediation will go before it starts to move back out again, says Freke. The events at Bear Stearns demonstrate that for US investment banks, the process still has some way to run. And until it does come to an end, credit markets that depend on investor confidence amidst non-bank investors are likely to continue to struggle.
So the burden – and rewards – of funding voracious second-world corporates are likely to fall entirely on the banks, at least, for the first half of 2008. Then we will have to see.
But what will happen first?, asks Freke: Will the banks run out of money or will the other capital markets return to life? That is likely to be the story for the second half of 2008.