Corporate financing

By Marcel Côté

In the fall of 2008, capital markets collapsed in the wake of an unprecedented loss of confidence in the workings of the market economy. The headlines focused on the interbank lending market crisis, sparked by the bankruptcy of Lehman Brothers, which led to banks paying a premium of up to 5% on one-day interbank loans. This market is slowly recovering. However, there was far less talk about the problems of the corporate debt securities market, whether it was commercial papers to finance working capital or corporate bonds and debentures to fund business development.

This market hasn’t yet picked up and its collapse has a major impact on the economy. There are a number of reasons for its failure: uncertainty about the scale of the recession, volatile interest rates, disregard for traditional business rules (which allowed many organizations to renege on their obligations) and so on. Investor confidence has been dealt a serious blow. In addition, the stock market decline forced institutional investors to rebalance their portfolios and reduce the weighting of corporate debt securities.

When the crisis hit in 2007, corporate balance sheets were fairly healthy. In fact, many companies used their liquidities to redeem their shares. Even today, balance sheets are still healthy in most industries. Nonetheless, most companies have very little access to new capital. De-pressed equity markets also make equity financing un-attractive to a majority of firms. Banks want to rebuild their balance sheets, which have been decimated by their losses on the mortgage and derivative markets, and have become risk averse, tightening lending. In short, businesses have very few external financing options left.

The impact has been devastating in such sectors as real estate, resources and growth industries in general, which rely heavily on development projects. With no external financing available, businesses have to substantially trim their operations. The resulting sharp decline in private investment will exacerbate the recession.

It is also unrealistic to hope that banks can pick up the capital market slack. Fifty years ago, they held more than 80% of the corporate financing market. That percentage has gradually fallen to less than 20%, as a result of savings disintermediation. It is fairly unlikely that we will see a “reintermediation” since the banks are ill-equipped to re-capture this market.

Imagine a company that needs $400 million for a new plant. Up until last year, it would have obtained this financing on the market through a few debt issues and perhaps a share issue. As a result, its financing would have been divided among thousands of holders, a very effective way to manage risk. Now that the market has evaporated, could the company borrow the $400 million from a bank syndicate? It does not seem likely. For a loan of this size, the risk incurred by each participating bank would be much higher than the risk incurred by individual debt holders if the company had floated a debt issue. That’s why there’s been a trend toward disintermediation over the past 50 years: the risk in bank financing is more concentrated and, as a result, bank financing is harder to obtain than market financing. If we multiply this example by thousands, imagine the challenge for the Canadian economy.

The way for the government to revitalize the economy is not through infrastructure spending but by kick-starting private investment. But as long as the corporate financing market hasn’t recovered, there will be problems injecting funds into the economy.

It isn’t easy to revive a market. The US government introduced a number of initiatives in this respect and Ottawa should follow its lead. A laissez-faire attitude isn’t acceptable because the market will take too long to correct itself on its own. It’s essential to restore investor confidence and breathe new life into the capital markets.

Marcel Côté is founding partner at SECOR Consulting in Montreal