babcocks web of risk

Babcock's web of risk

The Spectators

The prudential regulator's unusual approach to the enforcement of rules designed to restrict lending to groups of related borrowers should benefit Babcock & Brown and its listed satellites, but it may not necessarily be in the interests of depositors of the Big Four banks.

The approach taken by the Australian Prudential Regulatory Authority in relation to the Babcock & Brown group raises the question of whether Australia's prudential rules need to be updated to capture what has become known as the 'Macquarie model'.

Under the large exposures prudential rule, banks must treat entities as “a group of related counterparties” where there is a linkage by cross-guarantees; common ownership or management; ability to control; financial interdependency; or other connections which, in the ADI's assessment, would lead it to regard facilities it has provided to the various entities as representing a common risk.

The rule, which is designed to limit concentration of risk on bank balance sheets, grew out of notorious large scale financial collapses and was first introduced when the Reserve Bank started a supervisory division more than 20 years ago.

Babcock & Brown and its satellites appear to be captured by at least two and possibly three of criteria under the large exposures rule.

APRA refuses to say whether the Babcock & Brown Group fits the large exposures criteria.

But one of the Big Four banks told Business Spectator that the Australian banks are not forced by APRA to aggregate all their loan exposures to entities in the Babcock & Brown Group. It's also important to remember that although it's regarded as an investment bank it is not regulated by APRA.

One banker said that if the Big Four were forced to aggregate their exposures to all the entities in the Babcock & Brown empire, which has $46 billion in total debt, they may be severely restrained in their ability to continue to lend to it.

The concern is that the banks would be “full up” with lending to one group and therefore restricted in their ability to take part in further financings by Babcock & Brown and its satellites.

By taking a hands-off approach to the interpretation of the large exposures rule, APRA is effectively providing Babcock & Brown and its satellites with some breathing space while it navigates its way through the credit crunch.

APRA's primary responsibility is to the beneficiaries of deposit-taking institutions and it is not clear that this obligation is well served by the apparent concessionary treatment for one of the country's biggest borrowers.

Equity markets are taking a less optimistic view of the future facing several Babcock & Brown entities.

Babcock & Brown says the $46 billion in total debt owed by the headstock and various satellites is more than adequately covered by assets of more than $70 billion. However, equity markets are currently valuing those assets at about $7 billion.

This huge disconnect between published asset values and equity valuations reflects the growing concern that while the bankers may be okay in the event of trouble, equity holders will suffer losses.

The two entities causing the most concern are Babcock & Brown Infrastructure with about $9 billion in debt and Babcock & Brown Power with about $4 billion in net debt.

A fire sale of assets by either or both of these funds would probably result in the assets being worth as much as the debt. At worst banks would get 95 cents in the dollar and shareholders would probably not get a lot.

Babcock & Brown rejects the idea that the combination of the headstock – Babcock & Brown Ltd – and the various satellites constitutes a group of related parties.

It says that from a financing perspective each entity is separately funded and that there are no cross guarantees. Therefore, there is no common default risk.

Common default risk is the key criteria used by banks to determine whether entities are related for concentration of risk purposes.

A common default risk can occur when borrowers are too heavily exposed to a particular industry. For example a taxi company that is 85 per cent reliant on airport traffic could be classified as having a common default risk with an airline.

Babcock & Brown's heavy exposure to the infrastructure sector and its heavy gearing means that it is heavily exposed to upward movements in interest rates.

The problems besetting Babcock & Brown Power and Babcock & Brown Infrastructure can be traced back to the purchase last year of Alinta at crazy valuations. The Alinta business was able to deliver a good return and reasonable distributions at interest rates of 6 per cent, but is struggling at current levels.

Babcock & Brown argues that because there are no loan covenants forcing it to lend to its satellites there is no common financial risk. While there are examples of the headstock stepping in to lend money to cash strapped satellites, this has occurred by choice and the loans have usually been for a short term before being paid back.

The headstock recently agreed to lend $190 million to Babcock & Brown Power. However, there is confusion among analysts as to what that money is for.

Babcock & Brown maintains that because all the listed funds managed by the group have independent boards with majorities of independent directors, the different entities should not be lumped into one entity.

It also maintains that the obvious common management control evident from the headstock or one of its subsidiaries being managers of the listed funds is not a reason to warrant treatment as related counterparties.

Babcock & Brown is well aware that the Big Four banks have lent money to various different projects across the satellites but it sees this as an advantage.

Banks that have done due diligence on different parts of the group as part of lending decisions are said to be better informed about the group's drivers, risks and opportunities.

The only Babcock & Brown banking syndicate to be publicly raked over is the $2.8 billion facility to the headstock. That facility grew from $2.5 billion to $2.8 billion in March and an additional six lenders were added to the syndicate. The Big Four are said to be owed about $600 million in roughly equal proportions.

It is not known whether lending by the Big Four to other Babcock & Brown satellites is disclosed to APRA in the regular quarterly updates on the 10 biggest loan exposures.

Babcock & Brown and its satellites are not comparable to the 1980s groups that went bust leaving banks holding loans that were cross guaranteed over the same assets.

But its pyramid structure with headstock at the top drawing fees from the satellites spinning below does not mean the group and its lenders are immune from the impact of a turn for the worse in credit conditions and or asset values being found wanting.

APRA's primary duty is to protect the beneficiaries of deposit taking institutions and that includes restricting concentrations of risk in the financial system, not just in individual financial institutions.

Having followed the unusual path of not forcing the Big Four to aggregate their exposures to the Babcock & Brown group, APRA should use its discretion under the law to determine that, in this case, a closely related group exists.