PwC podcast on the effects of the credit crunch on the UK economy transcript

Philip Wright: Welcome to this PwC podcast, I’m Philip Wright, chairman to the firm’s non-executive director programme, and with me today are Bill Knight, chairman of the financial reporting review panel, John Hawksworth, head of our economics unit, Tony Lomas, a senior partner in our business recovery services and John Hitchins, a senior partner in our Banking and Capital Markets division. We are going to be discussing today the causes of the credit crunch and its impact on the various aspects of the economy.

Starting of with you John Hawksworth. What do we mean by the term credit crunch and how is it affecting the UK economy?

John Hawksworth: Well, I think you have to go back quite a few years. If you think back to the dot.com crash to actually head that off, the Federals cut interest rates a lot in the US, and created a lot of cheap money. There was also a lot of cheap money coming in from China and Asia. So all this money is sloshing about the global economy, and it had to go somewhere, and what you found was that a lot of it was lent out, some of it very sensibly, some of in retrospect, less sensibly, particularly may be in the US housing market where you’ve got a lot of this subprime lending. Now, when that subprime lending was kind of actually came unstuck and many people couldn’t repay their loans that obviously hit the US housing market, but it also hit the rest of the financial system, because those subprime loans had been packaged up into things like collateral or debt obligations and other types of fancy financial derivatives and spread around the global system so that actually what should have been mainly a US problem, turned into a global problem. Banks became very nervous, they couldn’t value their assets, they were nervous about lending to each other; there was a liquidity crunch and that in turn has led into a credit crunch, and so that has really been an affect that started in the US and has kind of infected the global financial system. The big question that no-one is sure about is how far that will affect the real economy,in places like the UK, as opposed to just the city.

Philip Wright: And just to stay on that point, given that this is a bit of uncertain territority and the law of unintended consequences is on the loose, what do you feel the effect of the normal instruments will be on this? And if I can bring Tony in as well. When the bank cuts interest rates, do you think it will be effective in avoiding a recession?

John Hawksworth: I guess traditional economic models and the kind of thing I use, would say that that might put the risk of really serious downturn at more like 1 in 3 or less, so not the most likely outcome. The most likely outcome is that the bank will save the day with interest rate cuts, but other people may have different persective on how effective that will be.

Philip Wright: Tony, you’ve been saying that you think that the quantity of money rather than the interest rates at which they borrowed might be a problem?

Tony Lomas: Yes, well I think both those factors will be a problem, quantity and interest rates. Just staying with interest rates at the moment, I think one of the problems that that I can see from some of the situations I’m looking at at the moment, is that there has been a bit of a disconnect between the bank base rate and the inter-bank rates, making it very expensive for institutions to borrow from each other. Which means in turn for those institiutions to pass on credit to the consumers they are imposing relatively penal high rates on those consumers. So I don’t necessarily see that there will be an immediate loosening up in the consumer arena if base rates drop down. I think consumer credit will remain quite expensive.

John Hitchins: I think, if I can just add there, I think there is a general perception among the banks that credit has been priced too cheaply and now is an opportunity to re-think it and reprice it.

John Hawksworth: I would agree with that, although I think that you know, you have had other price credits, as I said earlier, a lot of cheap money sloshing around, the real issue is how far - if base rates come down, that will actually help to kind of allow a financial system to if you like self right itself. Now, traditional economic models do tend to be relatively optimistic about that, particularly in a situation where in quite a lot of the rest of the real economy, outside the city, the numbers are still looking pretty good. I mean just today we had manufacturing data showing that actually manufacturers had a better November than they had October in the UK. Then we’ve got China, India and economies like that booming and taking over from the US as the driver of level of growth, once you get outside the city and the banking sector, you begin to feel that other parts of the economy are still healthy. I guess the quesiton is whether, if the bank were to cut off the oxygen, if you like, that that health will be choked away come the new year.

Philip Wright: So John, what industry sectors are most vulnerable, if that were to happen?

John Hawksworth: Well I think things like construction and commercial property companies always tend to be quite vulnerable to any restriction in bank lending. Retailers could be very vulnerable to any kind of loss of confidence in the consumer sector and obvioulsy people producing goods to sell in the shops as well as areas like travel and leisure tend to be discretionary spending. You know people’s budgets are a bit tight and so they cut back a bit on the fancy holidays and so on, so most of the sectors always tend to be pretty cyclical.

Philip Wright: And Tony, presumably, you’d agree with that from your experience practically out in the field?

Tony Lomas: Oh, I would, but my area of the firm has been relatively benign, if you like, for the last 3 years or so.With a mixture of cases coming in from all sorts of sectors, often with management problems rather than structural industry problems. But I have to say that over the last quarter there has been something of an uptake, but not a significant one, but something of an uptake and its in particular, areas like retail, consumer services and some commercial property, particularly large commercial property situations when lenders are getting quite nervous. So there are signs there but of course we are in the Christmas season, whilst consumer spending might slow, I don’t think it will disappear altogether. It will be much more interesting to look at this in the first quarter of next year, and see what happens then.

Philip Wright: And finally John, what about the housing market, which is the thing most individuals worry about. Are we likely to go the way of the US?

John Hawksworth: Well, I mean, there is always a risk, I referred earlier to some modelling work, which was suggesting that 1 in 3 housing prices would be lower in real terms in 3 years than they are now. I think the mitigating factors is that firstly there is still a supply shortage. We are rather a small, congested island. And secondly, I think there is still reasonable strength in the labour market. When people are employed, they can usually repay their mortgages. So, I would say there are some mitigating factors, but certainly, if banks really do cut off the oxygen on the mortgages, it could turn out to be nastier than we currently hope or expect.

Tony Lomas: One of the differences I can see between what we are experiencing now and recession, what truly was a recession in the early 90s is the job security issue. I mean, John has just mentioned it there. I mean back in the 90s people were worried stiff that they were going to lose their jobs, which may have been a misconception. They may have been in safe jobs but that in turn caused considerable slow down in their spending. There was good reason to worry about job losses, because there were wholesale job losses in that period. Whereas now I feel there is a certain amount more job security there. People wont draw their horns in necessarily because they are concerned they will loose their jobs, its more around concern that they will have to lock into more expensive credit. Particularly on this fixed rate mortgage point. When they renew their fixes, or they go on to variable and they have to pay these penal rates, because there is clear evidence out there that mortgages providers are reluctant to provide mortgages in the same volume at the same price as they did before, and I cant see that ever coming back.

Philip Wright: Right, just moving on, Tony, to the credit crunch and its effect on the output of the financial sector, what are the practical effects likely to be for financial institutions. What are you seeing happening?

Tony Lomas: Obviously, we deal with banks all the time, because they are coming to us to help advise them on their distressed credit. Now, as we’ve seen something of an uptake, their workout units, as they call them, have also seen something of an uptake, so they are resourcing up to deal with an increased flow of cases into them. Because they have more expensive costs of funds themselves, they are being a bit more careful about some of the credits that they are advancing. They are stuck with a number of highly leverage transactions, some of them that they have not been able to syndicate out. They are having to give away more of the fee that they took on the original transaction in order to encourage others to come in, so there is an awful lot more caution out there now on lending into corporate UK. Particularly around the deals, the private equity led highly leverage deals. And I think what we could find going forward into Q1,2 and 3 next year, is that reflecting in more stringent lending terms as facilities roll over, possibly a bit more caution around expansion funding that corporates seek.

Philip Wright: The other John, Hitchins, are there any practical steps that the structured finance sector and the finance sector can take to help this situation?

John Hitchins: Well, the core problem is all about confidence. People are still not sure they know where all the losses are. The best thing that anybody can do, is to have no more shocks until all the year end financial reporting period is out of the way, but I think there are still some lessons for the industry, around the structured products. They need to be much more transparent about how these things work, to be able to put more effort into educating their investors as to what the risks are and how they react to it over time. And also to perhaps look around the governance of some of them. Because most of these things go through structured vehicles, so they are in separate limited companies, often referred to as SPEs. Those companies do have boards of directors, they are non-executive but they have traditionally been fairly passive, and I think its time to think about whether the model that we have the corporate world of much more active non-executive directors should start to apply to the SPE workd.

Philip Wright: We all seem very comfortable that there wont be any more shocks,but people must be worried “Is there another Northern Rock out there?” I suppose, put it like that. Is that something people do worry about in the financial sector?

John Hitchins: Well, we’ve already seen one major buy-to-let lender announce a couple of weeks ago (that’s paragon) that it was having significant difficulties re-funding itself. Any financial institution that is wholly dependant on wholesale funding is going to find the next 6 – 9 months, possibly year, very difficult to get through.

John Hawksworth: I think we certainly cant rule out more shocks, because this issue of cheap money was a global one,so it wasn’t just subprime lending to the US housing market. Everything from emerging market debt to general corporate low level, junk bond debt, to private equity debt… all of this stuff was basically being pushed by very cheap global money.
I mean there is always the possibility of domino effects of that time. It would be very surprising if there weren’t any more shocks.

Philip Wright: Just returning to the financial sector, and this climate of uncertainly and lack of confidence, And so the question of fair value of some of these…

John Hitchins: Well, fair values are going to be the biggest issue for both the preparers of bank accounts and us as auditors. I mean the whole concept of fair value accounting is predicated on the idea that in a market you’ve got a willing buyer and a willing seller, and if you look at a number of transactions at the moment, although the buyer is clearly quite willing, the seller is distressed and would rather not sell if he didn’t have to.

Philip Wright: Bill, moving on finally to what it all means for non-exec directors. What should they be thinking about in the boardrooms over the next few months?

Bill Knight: Well, the Financial Reporting Review panel, we are obviously interested in accounts and the way people account for their businesses. We select accounts for review for a number of reasons, but one of the reasons we select is sectors of the economy which we think are under strain, and we’ve announced that next year we will be looking at banking, retail, travel and leisure, commercial property and house builders. And we will also be focusing on the smaller end of the holistic market. But even outside those sectors you may hear from us. We view accounts right across the range of our agreement, and I think for non-executive directors the specific requirement that I would draw to your attention is the requirement in the companies act that the director’s report should describe the principle risks and uncertainties facing the business. There, what the panel is looking for is a description of the principle risks and uncertainties, not just a shopping list of things that might go wrong for any business, but really we’d like to know what the directors think inside the boardroom. We’d like to see that reflected in the report per se.

Philip Wright: The FRRP occasionally writes a letter to boards, what should a board do if it’s in receipt of such a letter?

Bill Knight: Take it seriously, but don’t panic. Consult your audit committee, talk to your auditors and give a full and considered response. Most of our cases are about things that we simply don’t understand in important accounts, and if we get a really good reply that tends to deal with a lot of them. There is guidance on our website of what to do if you hear from us and we hope that you look that up.

Philip Wright: Thank you very much Bill, and thank you everybody for your insights and for taking part in this podcast. My own view from what you’ve said and from reading around the subject, is that there are definitely risks of a recession, rather than a slow down and one can have a view on how likely that is. There are definitely difference between this cycle and previous cycles: the interest rates, the amounts of debt in the corporate sector, and as Tony said, the worry about losing jobs, which doesn’t at the moment seem to be there. But there are still downside risks as well, particularly given the rise in global commodity prices and the possibility of shocks else where in the system. So companies in those potentially vulnerable sectors, and there appears to have been a bit of a conversation before this podcast, about what those sectors are. There is a commonality about them, would be well advised to stress-test their businesses to make certain that they are more than a going concern in this reporting season.

You can find more information about the credit crunch and its implications for non-executive directors on our website: nedagenda.co.uk.

Thankyou for listening!