黑洞社区

In his description of the euro crisis last week, Bank of England governor Mervyn King said: 鈥淚n the last three years, we have seen extraordinary events. Who knows what鈥檚 going to happen tomorrow, let alone next month?鈥� Amid reports that the Treasury is contingency planning for another credit crunch, it seems the market agrees.

As the euro crisis deepens, there is growing evidence that construction finance is not in a happy place. Lenders are leaving the market, the cost of borrowing money is rising quickly, and the availability of funding is diminishing fast. Obtaining the loans vital to get projects off the ground is like wading through treacle. So from this industry鈥檚 perspective at least, time at the Treasury preparing for another credit crunch looks to be well spent. James Stewart, chair of global infrastructure at KPMG, and former head of the government鈥檚 infrastructure unit, sums up the mood: 鈥淚f the governor of the Bank of England doesn鈥檛 know what鈥檚 going to happen, then what鈥檚 the chance for us mere mortals?鈥�

Nevertheless, this is the background against which chancellor George Osborne will next week lay out his 拢50bn growth plan. For the government, itself unlikely to find new money to pump in to the economy, the key will be attracting other sources of funding - pension funds, insurance funds and sovereign wealth funds - to fill the gap. The question is that persuasion will work, and what the government will have to promise the institutions in order to persuade them to ride to the rescue.

The fear factor

Bank funding for construction projects - both long-term infrastructure schemes, and shorter term construction work - has not been straightforward since the 2008 credit crunch. Chris Brown, chief executive of regeneration developer Igloo, has long experience of funding residential schemes. He says: 鈥淚n 2008 the number of banks in the market willing to fund projects reduced massively. Since then some have started to come back, and things have started to ease. But now we鈥檙e seeing another wave of retrenchment, and it鈥檚 uncertainty in the euro that鈥檚 increasing the cost of money.鈥�

Long-term infrastructure schemes - both social infrastructure such as hospitals and schools, and economic infrastructure such as transport and waste projects - are suffering from the same problem. Financiers measure the cost of debt financing by the interest rate premium funders add to the Bank of England base rate before agreeing a deal. Before 2008, PFI schemes were being funded for as little as 40 basis points (0.4%) above base rate. The credit crunch pushed this up to over 300 basis points (3%), but it has been falling since then. Until recently.

KPMG鈥檚 Stewart says: 鈥淲e鈥檙e not quite in 2008 territory yet, but rates have jumped up. We were heading down towards 200 basis points. Now we look like we鈥檙e heading back up to 300.鈥� Likewise Brown says the price of debt funding has spiked in recent weeks - with the required interest rate moving up a 鈥渂allpark figure鈥� of 50 basis points, or 0.5%, to more than 250 points, making developments harder to get off the ground.

The reason the crisis in the euro has such a dramatic impact is that the threat of sovereign default on huge loan books increases the risks banks perceive in lending to each other. This means it costs them more to raise money. The best measure of this is in the price of Credit Default Swaps (CDS), financial instruments used to insure against loans defaulting. These are not traded on a publicly viewable index, but data compiled by the Royal Bank of Scotland and seen by 黑洞社区 suggests that the price of CDSs for major UK banks is now a good deal higher than it was when Lehman Brothers went bust, at more than 400 basis points for the most at risk.

In other words, fear is back. But it doesn鈥檛 just affect the price of funding projects, crucially it also affects the availability and conditions applied to get that funding. Lenders are leaving the market again, and many are demanding longer periods for the banks to recoup funds at the end of projects in case of any problems - called a 鈥渓onger tail鈥�. Stewart says 鈥淭here are signs that the number of people playing in the market is reducing again, and the syndication market is looking weak. Terms are tightening, with banks requiring more equity.鈥�

Rising costs, tougher deals

Trevor Butcher, partner at law firm DLA Piper, is involved in bringing big infrastructure deals together. He says: 鈥淪o far we鈥檙e not seeing deals falling apart. But the supply of finance is getting smaller, we鈥檙e seeing a return to the pressure for shorter term debt and the terms are hardening . Now project sponsors are having to go to a wider pool of banks, because many banks want a smaller ticket, and some could well withdraw before the deal is signed.鈥� All this means, inevitably, it鈥檚 taking longer for deals to be signed.

In the residential sector it also means that for some projects or firms, once again it鈥檚 simply impossible to get any funding at all. Igloo鈥檚 Brown says: 鈥淚f you鈥檙e doing small scale speculative resi developments in central London there鈥檚 money available, and if you鈥檙e doing commercial developments underwritten by a tenant with a blue chip covenant then the banks will come in. But otherwise it鈥檚 very difficult.鈥� For Jeffrey Adams, chief executive of residential developer United House, it鈥檚 the relationship with a bank that is key. 鈥淸For us] each deal takes an enormous amount of time to get through the credit committees. But if you鈥檙e a new guy on the block you don鈥檛 have a cat in hell鈥檚 chance.鈥�

Infrastructure and PFI deals have, in addition, a specific problem: banks are increasingly refusing to offer long-term finance for the life of an infrastructure concession or 25-year PFI term. This can be either through simply saying no, or changing the terms of the loan after a certain point, making it vastly expensive without a refinancing - a deal dubbed a 鈥渕ini perm.鈥� The Royal Bank of Scotland, for example, is rumoured to have recently pulled all new funding for terms longer than seven years; Others stopped this funding in 2008 and have never come back into the market. This means that these long-term projects have to bear the risk of refinancing the deals half-way through - which either the private sponsor or the public sector has to agree to underwrite. Richard Threlfall, head of infrastructure at KPMG, says: 鈥淚f someone says that in year seven there鈥檚 a chance you might be on the hook for 拢200m, then that鈥檚 quite a big risk. Sponsors are just saying it鈥檚 鈥榦ver their dead bodies鈥� they鈥檒l take that on. The question is whether the government should step in.鈥�

Attracting pension funds

The government review of PFI, announced last week, looks set to take this on board, but there is no clarity over when it will report. For infrastructure schemes the potential solutions is for institutions to step in once the more risky construction phase is complete. All the signs are that the government is acutely aware of this need, and there is no doubt that there is interest from potential investors. 鈥淭he key is getting pension funds locked in, and they鈥檙e up for it, because in the current environment they鈥檙e not getting the right returns from their traditional investments,鈥� says Steve Beechey, group investment director at contractor Wates. Infrastructure as a class gives healthy returns, with very little history of defaults. The problem, however, is that pension funds still perceive it as too risky: they are used to investing in 鈥淎鈥�-rated assets; typically infrastructure projects are 鈥淏BB鈥�.

Therefore, something has to be done to package infrastructure projects in a way that reduces their risk. Stewart says: 鈥淭he key is finding a route to market for pension funds, some kind of wrap that allows them to reduce risk.鈥� Residential investment has similar problems, but also additional concerns that rental returns are relatively low compared with commercial property, despite the changes to stamp duty rules confirmed in this week鈥檚 housing strategy, and that investors will balk at the complexity of having hundreds of demanding individual tenants to satisfy. 鈥淚 think they tend to have the view that life鈥檚 too short for them to deal with the complexity of residential renting. It takes a totally different approach to life - why would they go from having one tenant to having 600, with all the nightmares that brings?鈥� says United House鈥檚 Adams.

Interest in the sector is demonstrated by the fact a number of funds have been launched, such as the Hadrian鈥檚 Wall venture backed by insurer Aviva, and the joint venture between developer Grainger and contractor Bouygues to create a residential fund to build up to 1,500 homes. But so far none of these has borne fruit. DLA Piper鈥檚 Butcher is sceptical about anything happening immediately. 鈥淣o one is currently there with a product the market is grabbing with open arms. A lot of people are trying it but they鈥檙e not ready. There are a lot of good ideas, but they鈥檙e just ideas right now.鈥�

Government back-up

The obvious answer is for the government to step in, and for many this is where next week鈥檚 Autumn Statement could prove pivotal. Wates鈥� Beechey says: 鈥淲e want the public sector to share some of the risk. If, for example, the government can underwrite projects for the risky construction phase, then we can develop a clear package, then at a certain point the institutions can step in. Osborne needs to come off the fence.鈥�

Igloo鈥檚 Brown says there is already institutional money chasing investment opportunities backed by government covenants, demonstrating how quickly a market could be formed with the right intervention. But he is gloomy about the likelihood of getting it together: 鈥淭he Treasury is comfortable with spending cash, but it is really uncomfortable with risk. Unless there is real leadership from the chancellor not much will happen.鈥�

Without that leadership, Beechey has a dismal forecast for the impact upon PFI schemes, activity on which he says has already fallen 30-40% in the last few years. Without a quick decision on the future of PFI and action on institutional investment, this could worsen dramatically. 鈥淏y 2013 it could be 20% of what it was four years ago,鈥� he says. For Osborne, desperately attempting to provoke economic growth, that kind of fall-off in activity simply isn鈥檛 on.