Credit crunch bites public sector: Public Eye

Posted on June 6, 2008 · Posted in Public Eye

 

The public sector crunch

 

by Paul Gosling

 

It has been like a perverse game of pass the parcel. Only when the music stops does it become clear which banks have been left holding billions of pounds of losses. But the impacts of the credit crunch go beyond the banking industry and it is now clear that some public bodies have lost heavily.

 

As the public sector losses have crystalised, so the recriminations have begun. Brokers and bankers have been accused in a number of legal claims of not properly advising public sector clients of the risk character of investments that turned out to have been underpinned by sub-prime loans in the United States.

 

Losers have included states and counties in the US. About 20 states put money into Structured Investment Vehicles believing, apparently, that these were low risk opportunities to earn above market returns, enabling them to cover budget deficits.

 

But the ripples of the credit crunch have flowed to public bodies on the furthest corners of the globe. Wingecarribee Shire Council in Australia’s New South Wales is seeking recovery through the courts of over a million pounds in losses, after it emerged that it had invested in collateralised debt obligations that turned bad in the sub-prime market collapse. In all, about 35 Australian councils lost about £12m, as the CDOs lost 85% of their value.

 

It is a similar story in the town of Narvik, on the far nothern tip of Europe. It was part of a group of four Norwegian towns that put nearly £50m into high risk bonds, which the municipalities claim they did not understand. The councils say that unless they are successful in their attempts in legal recovery they will be forced to dispose of assets to cover their losses. What has been particularly galling to Norwegian taxpayers is that they had no idea their municipal leaders had put public money into risky investments.

 

Meanwhile, Germany has had its own catastrophe. Underlining the realities of the globalised financial markets, it has emerged that the country’s banks – particularly some of the public sector banks – were heavily exposed to US sub-prime debt. As a result, the Sachsen Landesbank – owned by the regional state – had to be rescued through amalgamation with the larger Landesbank Baden-Wurttemburg.

 

By contrast, most UK public bodies can feel relieved that strict controls mean they are not permitted to make high risk investments. For example, health trusts – other than foundation trusts – must deposit balances over £50,000 with the Department of Health. Local authorities must not over-invest in any one institution and are only allowed to invest in highly rated bodies.

 

Yet some British local authorities nearly came very badly adrift when Northern Rock – which was highly rated – almost collapsed. Had Chancellor Alistair Darling not stepped in with government guarantees, several councils could have lost heavily in any fall-out. Public bodies holding deposits with the Newcastle bank included the Metropolitan Police Authority – which had £39m on deposit with it, some 12% of its total investments – and the Greater London Authority – which placed £5m with Northern Rock, two days before the bank’s plight emerged.

 

Andy Wynne, ACCA’s head of public sector technical issues, says that despite the fact that UK public bodies have, so far, avoided large losses from the sub-prime related financial crisis, they must recognise that they do face serious risks. “Modern public sector reforms have led to the fragmentation of the public sector and the creation of a multitude of ‘mini-businesses’,” explains Wynne. “As a result, although, central government debt is now approaching Gordon Brown’s self-imposed limit of 40% of GDP, many public sector organisations and their pension funds are simultaneously investing billions of pounds on the financial markets.”

 

Wynne adds: “Codes of practice for treasury management by restricting investments to those entities with a good credit rating and spreading investments across a range of organisations can reduce the risk, but investing in the market can still be very risky as the recent events around Northern Rock – and the previous fallout from the collapse of Barings Bank – have shown. The public sector has to ensure that it does not unnecessarily increase this risk by some organisations holding significant public debt, while simultaneously other organisations are investing in financial markets.”

 

But any potential losses from the investment of balances in institutions such as Northern Rock are dwarfed by the actual increase in liabilities suffered by public sector pension funds as the credit crunch damages the financial markets. According to fund consultants Aon, the collapse in share price valuations in January added £40bn to FTSE100 scheme liabilities in just one week.

 

It was a similar story in public sector pension funds, says John Wright, a partner in Hymans Robertson, which advises many local government schemes. Between March and December last year, on the back of a strong stock market performance, the value of local government funds rose by 6% – and then they fell by a similar level in the first four weeks of 2008. In addition, because long term interest rates have fallen, scheme liabilities have increased. The total impact of increased liabilities and lower returns from shares and commercial property investments is that the funding level has fallen by 10% since March last year.

 

But, says Wright, “there’s definitely no cause for alarm”. “Funding pension schemes should not be a roller coaster ride,” he explains. Employers must always take a long-term view on funding schemes, argues Wright.

 

It is in the funding of major capital projects where there is an immediate challenge for the UK public sector, with jitters across the market for infrastructure funding. Bond insurers that underwrote much of the sub-prime mortgage market have now lost their top notch credit ratings. As these bond insurers have also participated in the UK PFI market as bond guarantors, some large PFI schemes may now have to borrow at higher rates on the market, rather than raising finance through bonds. The result is higher borrowing costs on PFI and, ultimately, higher costs for public sector clients.

 

But Bank of Scotland, one of the largest lenders in the PFI and infrastructural assets market, plays down the suggestion that the UK PFI market is seriously affected by the credit crunch. It argues that deals take so long to fulfil that short term market volatility has little or no impact on lending. Spokesman Mark Elliott says: “We are doing deals and we are open for business and we have not changed our approach to lending.” Elliott stresses that the percentage of PFI and infrastructural asset lending as part of its total loans portfolio has not changed in the recent period, though he is unable to disclose total recent lending figures. Despite market conditions, the sector is regarded as a solid one to lend into, said Elliott. “As an asset class it behaves like fixed income, or government bonds.”

 

Perhaps, though, we just have to admit that we do not yet know the full impact of the sub-prime crisis. Asked about the effects of the French revolution, Chairman Mao replied that it was too soon to say. So there is no dishonour in admitting that we will also have to wait a while before we can assess the true impact of the credit crunch on the UK public sector.