Europe's excess liquidity is passed into risky hands

"We live in a cyclical world and we have been here before......We have not seen any accidents recently.....but potentially somewhat inevitable." - Julian van Kan, head of loan syndication at BNP Paribas

......Why are banks, hedge funds and other financial players in Europe awash with funds and what are the consequences of this state of affairs? The pattern is global but it is arguably made starker in Europe because, unlike the US Federal Reserve, the European Central Bank is not raising interest rates (and the Bank of England has just cut them). Europe's sluggish economy is meanwhile creating little mainstream demand for loans, forcing banks and other financial players to seek other outlets for surplus cash that can produce reasonable returns.

"They keep making more and more money and they don't know what to do with it," says Louis Elson of Palamon Capital Partners, a private equity group, who estimates that European banks will make some $90bn in profits this year. Of this, $20bn would be set aside to strengthen their core capital and a further slice to pay dividends. But, after adding in surpluses made in previous years, the banks' debt financing capacity could be as high as $100bn. "Some of it is moving into esoteric financial areas," Mr Elson adds.

This makes some policymakers uneasy. The ECB, for example, has repeatedly warned that excess liquidity could hold longer-term dangers for the region"™s economy, by creating a de­stabilising boom in inflation and asset prices "“ and a subsequent bust.

However, there is still little evidence of bubbles forming "“ at least not in areas of the economy usually associated with financial excess. House price growth is modest across the eurozone as a whole. European equity markets are not exhibiting euphoric behaviour. More notable still, not many mainstream companies are responding to the lure of cheap cash by embarking on spending sprees. On the contrary, ECB surveys suggest that companies are very reluctant to borrow, except to refinance their existing loans at a cheaper rate "“ even though banks are loosening lending conditions (see charts) and the price of a loan for a high-quality company is at an eight-year low.

......because US buy-out groups have seen Europe as ripe for corporate change. However, the factor that has recently given the sector the greatest boost is the ease of raising finance.......

Another "“ arguably just as important "“ factor is the changing structure of European debt markets. A decade ago, the European leveraged loan sector barely existed, but it has sharply expanded in recent years, largely centred around private equity, as both banks and hedge funds have become eager investors "“ adding more liquidity to the pot. This has made it possible for buy-out groups to chase ever-larger deals......

"œThere has been a marked deterioration in the quality of deals in institutional portfolios," says Paul Watters, head of loan analysis at Standard & Poor"™s......

Most bankers insist, in public anyway, that the picture can last. The default rate for companies is very low and there is little expectation that liquidity is about to dry up. The money markets are not projecting an imminent ECB rate rise and developments in Asia could push even more finance into Europe soon. "œIf Asian central banks diversify out of the dollar, that will mean that some of the liquidity now flowing from Asia into the US will come to Europe instead," says Mark Watts, head of fixed income at Morley Fund Management.

Also, if investors might normally be getting nervous the explosive recent growth in the structured credit markets appear to be pacifying them. Products such as credit default swaps allow bankers or hedge funds to protect themselves against the risk of a company going into default. That seems to be making investors more willing to fund risky deals, even though the longer-term resilience of this safety net remains untested.

Nevertheless, as the levels of leverage become more extreme, some industry players are becoming uneasy. "œOperating risk must be tied closely to the financial risk. But the two are divorcing," warns Mr O"™Grady of 3i. "œSome [investors] will get caught with egg on their face."......

However, history suggests that when credit bubbles emerge, these rarely deflate smoothly "“ or without creating unexpected casualties. "œWe live in a cyclical world "“ we have been here before," says Julian van Kan, head of loan syndication at BNP Paribas. "œWe have not seen any accidents recently....but [these are] potentially somewhat inevitable."......

http://news.ft.com/cms/s/d487ab4e-0dbb-11da-aa67-00000e2511c8.html