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The big squeeze

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Banks are getting tough with lending, but public/private deals are still a relatively safe investment.

According to the International Monetary Fund, the global credit crunch will cost the world’s economy a cool $1,000bn. So it is no surprise that local government will feel the pinch. Exactly how hard and in what ways is unclear, but if things go badly wrong in coming months, major capital projects could be at risk.

“You have to test the appetite of the City almost day by day,” says Piers Williamson, chief executive of the Housing Finance Corporation. “The Treasury’s financial stability report is saying that the worst is over, yet we have just had the Royal Bank of Scotland making the largest rights issue in history. Banks are in rebuilding and financial strengthening mode.

“The key measure of performance is the return on equity. [To achieve that] you have to either exponentially increase your returns, or strip out costs. My guess is that this will last six to 12 months a short, sharp, shock.”

'Crunch, not crisis'

Iain Hasdell, UK head of local government at KPMG, says: “The credit crunch and it is a credit crunch, rather than a crisis is definitely going to impact on local government finances, including on private finance initiatives. The difficulty is knowing
whether this is long or short term, which is the same for the whole of the economy. Nobody knows what the impact is going to be.”

He suggests there will be just a limited impact on the smaller public finance initiative and public private partnership (PPP) deals already taking place, such as for back office outsourcing, Building Schools for the Future (BSF) and roads.

The real impact will be on schemes currently being developed, says Mr Hasdell. “Any PFI deal that is relatively larger risk, or is big, is going to have significantly more difficulty in getting underway than a year ago. Local government has been relying on these bigger PPP deals to achieve efficiencies. So a whole load of internal operational stuff where PPPs are a big part of improvement agendas will be affected.”

But while some schemes are now less likely to come to market, those that obtain finance are not costing more. “In times of trouble, the one safe sector for the banks is funding of government-backed schemes,” explains Coralie Foster, a partner in financial/business adviser Grant Thornton’s government and infrastructural advisory team. Low-risk local government projects are now even more attractive to banks, Ms Foster adds.

'Overall cost is down'

Paul Davies, a partner at PricewaterhouseCoopers (PwC), explains: “In general, public sector schemes with low risk have done better out of the credit crunch. Banks’ margins have gone up, but interest rates have fallen over the period. They are over a percentage point lower than last July. So the overall cost is down. A feature of local government and infrastructure projects is that they are long-dated and index-linked, so they are still attractive to lenders.”

John Reed, project director at 4ps, says the turmoil in the financial market is not affecting projects that are already advanced. “Lots of schemes have been completed and the forecasts are that they will continue to do so without serious problems,” says Mr Reed. “But banks are getting more risk-averse generally in respect of all borrowing.

“We are seeing more scrutinising and due diligence across the board. And the cost of debt is increasing. But this is only returning the margins to where they were two or three years ago.”

Mr Reed points out that the cost of finance for PFI and PPP schemes is strongly influenced by long-term interest rates, which have fallen. The reduction in these costs has more than offset the higher margins imposed by banks. Where there is a mature market as in waste management, transport schemes and social care schemes are being processed without any significant impact from the financial markets turmoil, according to Mr Reed. But he also reports banks are wary about supporting higher-risk activities, such as property-based joint ventures involving local government.

PwC’s Mr Davies also observes a greater reluctance by lenders to take risks, particularly where the value of the underlying assets is uncertain. This puts particular pressure on regeneration schemes and lending against poor-condition housing estates, both of which currently face difficulty in getting financial backing.

While Grant Thornton’s Ms Foster says that “it is business as usual” for most PPP schemes, she accepts that banks are nervous about higher-risk and less-transparent projects. For instance, banks are not interested in local government schemes that offer what Ms Foster terms “asset-backed, less-tested structures”.

She says banks are keen to lend for BSF schemes. As for waste management projects, banks are willing to lend, but are unconvinced by some of the technology and because “some of the schemes are pretty large for PFI”. These deals might, in the past, have used bond financing (see bonds and PPP box), but are now unable to do so. Ms Foster reports specific difficulties in raising finance for projects that are inflexible and require more than£150m. The picture on housing schemes is also mixed, she says (see housing box).

But there is, at least as yet, no reason to panic. Despite expectations of declining tax revenues, the government has not reduced the£10.8bn PFI credits allocated in last year’s Budget. And the picture on the ground is that programmed schemes have gone ahead as planned. 4ps has just completed tendering for an£800m procurement programme for councils’ street lighting across the country that will be delivered on a phased basis.

Such reports of schemes obtaining finance will provide some reassurance. But it is likely to be several months before councils can have real confidence again about their plans for raising capital or even certainty about private funding.

The impact on housing

“I have heard banks are more wary about lending on housing schemes, but I haven’t seen any evidence of that,” says Coralie Foster, a partner in Grant Thornton’s government and infrastructural advisory team. “Activity is picking up and we are not seeing any resistance at all from banks going for housing private finance initiative schemes,” she says, adding that the main issue vis-à-vis PFI is not obtaining finance but councils’ reluctance to opt for such projects.

Piers Williamson, chief executive of the Housing Finance Corporation, suggests the credit crunch could potentially stall large scale voluntary transfers (LSVTs) of housing estates. “The big players in the LSVT market, the banks and the building societies, are all impacted by the liquidity crunch,” says Mr Williamson. Interest rates available three or six months ago on LSVTs are unlikely to be replicated in the near future.

“I am sure we can get through this, but at the moment banks are looking very, very carefully at liquidity and margins and looking at the moment at self-preservation.

“That is an issue for the next LSVTs on the blocks. And they are already getting more difficult as they go. All the shire counties have been done and now we have got to inner city crumbling estates.”

Bonds and PPP

The structure of PPP deals is changing with less use of bonds to raise finance on PPP projects as a result of difficulties in the credit market.

The reason for this is that ‘monolines’ bond insurers traditionally underwrote municipal bond issues in the US, but expanded their activities to guarantee PPPs, including in the UK, and US sub-prime mortgages. As increasing numbers of mortgages went sour, so monolines became threatened with large losses.

Monolines no longer have the high credit ratings to provide guarantees on PPP bond issues, at least until they have completed raising new equity capital.

Although local government PPPs have not used bonds and monolines extensively, they would have wanted the option for the largest schemes. In place of bond financing on large projects, banks are lending to PPPs using senior debt - loans that have first call on the underlying assets in the event of anything going wrong.

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