Insolvency: The butterfly effect
14 July 2008
On ;30 ;October ;1974, Muhammad Ali took on the heavyweight champion of the world George Foreman in Kinshasa, Zaire. Foreman was at the height of his powers. No one gave Ali a chance. Dubbed the ‘Rumble in the Jungle’, the fight has gone down in boxing folklore. It is remembered for Ali’s staying power, his ability to absorb blow after blow and to remain standing when he should have been on the canvas, his counter-attacking and eventually, against all expectations, knocking Foreman out.
Parallels between this epic battle and the UK’s economy can be drawn. Over the past 10-15 years the UK economy has generally had a fine run. Unprecedented amounts of investment capital have been available at historically low rates of interest. An entire generation has borrowed, bought properties and businesses, consumed and become prosperous without the interference of recession or inflation. And then came the turning point last summer.
Since then, like Ali, the UK economy has endured a remarkable series of blows. It started, of course, with the impact of non-performing subprime assets in the US and quickly led to an unwillingness by financial institutions to lend money in consideration for commercial paper of one kind or another, or to roll over existing commercial paper for a further term.
This reflected a rapid and acute crisis of confidence in the real value of the assets underlying the commercial paper and other asset-backed investments available for trade in the market. People started to question the reliability of the credit ratings of assets. Normative expectations were undermined, credibility was lost and lending dried up.
Due largely to its reliance on short-term borrowing and access to the capital markets to maintain adequate levels of working capital, Northern Rock was an early casualty. The acute shortage of liquidity in the capital markets from August 2007 on was also the cause of the effective demise of structured investment vehicles (SIVs).
SIVs required a highly liquid financial market to survive and prosper. They were structured in order to make a profit on the difference between interest paid to lenders and investments made. Lenders acquired short-term debt issued by a special purchase vehicle (SPV), which lay at the heart of the SIV structure.
Billions of dollars were borrowed and the SPVs used the capital to acquire assets. Subprime assets notwithstanding, these were generally of a high quality, but when liquidity dried up so did an SPV’s ability to service its debts. Many are now in receivership. The various institutions that had lent to these SIVs, or had sponsored them, such as Citibank, suffered paper losses running into billions of dollars. It remains to be seen whether we have witnessed the full impact of these losses. Then there was Bear Stearns’ collapse, of which it is said that catastrophe in the financial markets was only avoided by the prompt action of the Federal Reserve.
The economy under assault
In the ‘real’ economy there is reduced demand for housing as borrowing becomes harder and more expensive. We have started to witness house price deflation. The Council of Mortgage Lenders predicts that UK house prices will fall by 7 per cent by the end of this year. Mortgage approvals fell by almost 40 per cent year-on-year and the Royal Institute of Chartered Surveyors says property sales could fall by as much as 40 per cent in 2008.
As the value of our most precious assets falls, inflation – particularly that affecting food and fuel prices – is on the rise. The cost of the wars in Iraq and Afghanistan constrain the Government’s ability to take fiscal measures, while there has also been a sharp drop in consumer confidence. The most recent R3 debt index records that 18 per cent of people say their debt is out of control and is causing them great difficulties.
Companies in a wide variety of sectors are under stress. In the past six months we have dealt with problems in the property services, retail, travel, financial services and technology sectors. Construction, leisure and other sectors are also likely to come under increased pressure. Some of these will inevitably become distressed and require restructuring, or succumb to a formal insolvency process.
On the ropes, but fighting on
The UK economy may be on the ropes, but it is not on the canvas. Not yet, at least. Confidence may be low, but the picture is not all black. Whereas financial institutions have had a hard time, large corporations remain profitable.
The economy is still expected to grow this year. Private equity houses, hedge funds and sovereign wealth funds have money to invest should the right opportunities present themselves. SIVs are likely to be refinanced, deals are still being done and unemployment remains low.
Tough times may lie ahead for the foreseeable future, but the UK’s economy has demonstrated remarkable resilience in the past 12 months. The conditions we now face may be no more than a reminder that, like markets, economic fortunes can go down as well as up.
James Levy is a partner and Rachel Mulligan an associate at Ashurst. Both are members of insolvency trade body R3