We’ve seen a run in them in recent weeks: the potential for a cascade of corporate defaults to impact sectors like insurance and banking.
UBS picked up on the idea on Friday, expounding the danger of a sharp increase in company default rates in its latest European Credit Tracker:
In every quarter since Q3 ’07, the sector has reported a more severe tightening of credit criteria in its corporate lending than for any other loan-book. In the ECB’s Q4 Euro-area lending survey, 65% of respondent banks in the Euro-area reported a net tightening of corporate credit conditions q/q, vs 41% for mortgage lending and 42% for consumer credit.
Corporate credit growth stood at 10% y/y in December ’08, vs mortgage and consumer credit growth rates both at 2% y/y. We would attribute this strikingly robust corporate credit growth to the drawing down of pre-arranged credit lines by corporates, a trend which we would argue will result in a delay to, not the prevention of, corporate defaults.
The corporate default rate has, historically, trended closely with the stringency of corporate credit conditions. We would argue that the current de-coupling of this relationship is a result of this drawdown of credit-lines, suggesting significant upside to the current default rate. As consumers continue to choose to save, not spend, we believe the strain of the corporate sector will come to the fore in ’09.
This synchs well with previous research from Dresdner, which suggested that the worst of the recessionary increase in corporate defaults had yet to come, and the thrust of recent research pieces on specific companies like Barclays and Legal & General.
You can see the decoupling effect, between the default rate and corporate credit conditions as mentioned above, below:
The suggestion here is that when those credit lines arranged pre-Credit Crunch start running out, the corporate default rate will spike very quickly as companies are unable to source alternative lines amid a deteriorating macro-economic environment. In short: boomtime for corporate defaults and a sudden and dramatic impairment for companies with large exposure to them.
HBOS, with its somewhat enthusiastic corporate lending practices, is a prime example of the potential pace and severity of the default effect. The bank announced a £7bn hit on its corporate loan book on Feb 13. Corporate impairments had previously stood at £0.5bn at in the first-half of 2008, £1.7bn at Q3 and £3.3bn for the eleven months to November. That’s a very sudden deterioration. Note also that at HBOS, the corporate book generated three times the impairment losses of the retail division, despite being less than half the size.
Hence, this paragraph from UBS. Its bank-specific but we think you can extend it to any company with significant corporate exposure:Consequently, we would highlight the sector’s corporate loanbook as the ‘elephant in the room’ as we progress in 2009. With banks more stringent than ever with the supply of new credit, and with consumers saving not spending, we view the existence of pre-arranged credit lines as a temporary camouflage to the inevitable, and impending, uptick in corporate impairments. From a top-down view, the banking sectors which operate in economies with the highest ratio of corporate credit to GDP are Ireland (96%), Spain (88%), Portugal (72%) and Denmark (65%). This reinforces our cautious stance on the banks that operate in each of these respective economies.
In summary, it’s not an elephant, it’s a whole pachydermic herd — messy, enormously destructive and increasingly difficult to ignore.
Related links:
(Tastefully) Bankrupt with pessimism porn – FT Alphaville
Barclays’ monoline risk - FT Alphaville
SELL: Insurers – FT Alphaville