Carillion shows a black heart linking PFI and private/state interrelations

The weekend just passed has seen the midnight oil burnt in Westminster as increasingly desperate attempts were made to rescue the company Carillion. You may wonder why as of course it is not a bank?! But the story emerging is one that is sadly familiar in many ways but with a few credit crunch era twists. For those unaware of what it does here is how it describes itself.

Carillion is a leading integrated support services business.

Not the best of starts as we wonder what that means? Later we do get some more precise detail.

Support services –  Facilities management, facilities services, energy services, rail services, road maintenance and utility services.

Public Private Partnership (PPP) projects – Our investing activities in PPP projects range from  defence, health, education, transport, secure, energy services and other Government accommodation.

Middle East construction services – Our building and civil engineering activities in the Middle East.

Construction services (excluding the Middle East) – Our market leading consultancy, building, civil engineering and developments activities in the UK.

I recall rumblings of trouble not so long ago with the Middle East projects but the most notable issue here is what it calls PPP but what we have discussed on here as the Private Finance Initiative or PFI.

We work in partnership with the public sector to deliver important services which offer value for money and make a positive difference to the lives of people in the communities where we work.

The company embedded itself in two areas in particular that are both considered vital but also have been ridden with PFI scandals.

 Some of the country’s largest and most prestigious NHS Trusts rely on us to deliver services critical to the safe care of over three million patients each year.

In the education sector,we have designed and built 150 schools, many as Public Private Partnership projects. We provide to 875 schools, clean more than 468,000m2 of school accommodation across 245 schools and provide mechanical, electrical and fabric maintenance services in 683 schools.

 

What has happened?

They say that in war the first casualty is the truth well it is true in company collapses as well. Only on the 3rd of May the Chief Executive Richard Howson announced this.

We have made an encouraging start to the year

Yet after only a short journey to the 11th of July Reuters were reporting this.

Shares of UK construction services firm Carillion (L:CLLN) slumped again on Tuesday with a profit warning, suspension of dividends and a CEO departure now wiping out half the company’s value in two sessions.

Danger! Will Robinson Danger!

A few words at the end of the Reuters article leapt off the page at me.

one of the UK’s most heavily shorted stocks

We move in those few short words from the “Why?” of Carly Simon to the “Who Knew?” of Pink. This is because shorting a stock on such a scale indicates that more than a few people knew something was wrong here. Yet we get a sniff of possible corruption as we note that even so new contracts were awarded for example these on the 6th of November.

Carillion is today announcing two contract awards, both in respect of Network Rail’s Midland Mainline improvement programme.

Were these part of an attempt to bail the company out at the expense of the taxpayer? Even worse was this from Construction News after the July problems.

 

Carillion / Kier / Eiffage clinched the central packages, picking up the £742m C2 North Portal Chiltern Tunnels to Brackley and the £616m C3 Brackley to Long Itchington Wood Green south portal.

Yes just when you thought it could not get any worse we see that Carillion is embedded in HS2 and we got an official denial of trouble!

Transport secretary Chris Grayling has defended the choice of troubled contractor Carillion as one of the firms to build phase one of HS2.

I guess we will find out what a “secure undertaking” is.

Private Finance Initiative

This was a large strand of business and as I reported on the 1st of September last year the main sound for the companies involved was ker-ching as they counted the cash.

The capital value of the assets which have been built is £12.4bn. However, over the course of the life of the contracts, the NHS will pay in the region of £80.8bn to PFI companies for the use of these assets.

However on this road the clouds darken again as we mull how a company with contracts which gave guaranteed profits baked by the taxpayer mostly in the UK but also abroad could go broke? Either much of its other business was appalling or it spent the money profligately.

Number Crunching

There are/were some real issues here so let us start with the dividend paid last June 9th. Shareholders received some 12.65 pence each which has to be questioned as only a month later came the announcement of financial distress. Of course those who held their shares have been wiped out by the compulsory liquidation but the real issue is with the board. On what grounds did they feel able to make the payment as allowing the business to carry on as normal mostly benefited them? There is a large moral hazard here especially after they told us this.

The Board and its Committees continue to benefit from a strong balance of expertise, experience, independence and knowledge of Carillion and our business sectors.

Next comes the issue of goodwill.

I queried as to how on earth Carillion could claim this? This has led to quite a debate where the real issue is why were the numbers not downgraded as the situation worsened. We of course return to denial of the state of play and the dividend payment but it is hard to move on without mulling this from @dsquareddigest.

Force of habit means that whenever I see the word “goodwill” I read “overpayment”

Or this from @SieurdePonthieu

What evidence did the supply to their auditors to substantiate the £500m? How did the auditors test the valuation? Post auditors were supposed to be very hot on that.

Pension problems

The next piece of number crunching comes from the pension scheme. From the Financial Times.

As a result of the liquidation, the Pension Protection Fund will take over payment of pensions for the company’s 28,000 retirement scheme members, and ensure scheme members who are not yet drawing a pension receive a capped level of benefits, with their retirement income cut by around 10 per cent.

Will they end up funding the goodwill via reduced pensions? Then of course there is the Pension Protection Fund can we find the goodwill here too? From the pensions expert John Ralfe

My take on pensions. Buy out deficit = c £1.4bn. PPF deficit = c £800m.

Comment

There is a lot to consider here as we look at the collapse and liquidation of Carillion. Let us open with two pieces of good news which is firstly that the road to privatisation of profits and socialisation of losses was not open this morning as there has been no bailout. Next whilst some benefits will be reduced pensioners will get a lot of protection albeit at the cost of the PPF or other pension schemes.

But there is damage across a wide range of areas. Contractors and sub-contractors must have been dreading the news today as not only will future payments stop at least for now but due to the 120 days payment policy past payments will not be made. There should be an investigation into this as we note that there was money to pay both dividends and directors. Next we come to PFI schemes and whether such companies become mini-monopolies and how if so they can manage to fail?

Yet again we find the issue of accountancy and auditing as in spite of all the supposed checks another large public company turns out to be an emperor with no clothes. Then we find that PWC get work on the liquidation after being one of the architects of PFI as we again find ourselves mulling another monopoly of sorts. They seem to benefit whatever the outcome.

Lastly I suggest that if you find someone called Phillip Green at the top of a pension scheme you immediately get very nervous albeit it is a different one this time around.

The consequences of rising UK Gilt yields on fiscal policy,pensions and mortgages

Today I wish to cover several trends of these times as they have all come together in one market. That is the UK Gilt market which is the name for UK government bonds. This is currently being influenced by quite a few factors at once but let me open with the two main factors which brought it to extraordinarily high levels in price terms and low levels in yield terms. The first is illustrated by this from Kenneth Rogoff in the Financial Times.

The mixed results from experiments with negative interest rate policy in Europe and Japan have led many to conclude that the idea is ill begotten and should be abandoned. To do so would be a serious mistake.

As you can see given a choice between reality and the view inside his Ivory Tower he much prefers the latter. This establishment view has driven interest-rates and bond yields lower around much of the world. Added to this in the UK has come the extra £60 billion of QE (Quantitative Easing) purchases of UK Gilts announced by the Bank of England in early August. Today will see it attempt to buy some £1.17 billion of long and ultra long UK Gilts as it buys ones maturing between 2032 and 2068.

A Reversal In Yields

Back in the 12 th of September I pointed out that the benchmark UK ten-year Gilt had a yield which had risen from the 0.5% it had fallen to up to 0.88%. This week it has pushed back up above 1% (1.01%  as I type this) which meant that yesterday the Bank of England found itself buying some of our 2023 Gilt at a yield some 0.25% higher than the week before. That is a lot on a yield which was 0.38%! I will be checking later what they pay for our longest dated Gilt and how that compares to the 198 they have paid to get a scale of a program which in its recent incarnation is running at a marked to market loss.

If we look for the yield most relevant to fiscal policy the thirty-year has risen to 1.7% (low 1.19%) and for fixed-rate mortgages the five-year has risen to 0.4% from a low of 0.12%.

What has caused this?

Inflation

Markets seem to have suddenly realised that inflation is going to go higher as this from the Financial Times indicates.

As a result, market expectations of UK inflation measured by the five-year break-even swap rate have jumped to 3.6 per cent — the highest level since early 2013.

Regular readers will be aware that I was expecting a rise in UK inflation as 2016 heads to a close anyway and it would have been enough to make even the new five-year yield look silly in real terms. It would also question the ten and thirty year yields. Now if we add to this the extra 1.5% of annual inflation I expect as the impact of the lower UK Pound £ then even the new higher yields look rather crackpot. Over as far ahead as we can see then we are expecting inflation adjusted or real yields to be strongly negative. Accordingly the UK Gilt market has been singing along to the Nutty Boys.

Madness, madness, they call it madness
Madness, madness, they call it madness
I’m about to explain
A-That someone is losing their brain

Why have they done this? This is another theme of these times as they are simply front-running the Monday, Tuesday and Wednesday purchases of the Bank of England. This manipulation of the market by it means that all the old rules for pricing Gilts have been both broken and ignore or if we are less polite a false market has been created.

Fiscal Policy

The impression that the UK government will loosen fiscal policy has gained ground and this has two components. The first is that it seems likely to spend more than the previous administration in a like for like comparison and secondly there is the impact of releases like this from the UK Treasury. This has had an impact today although it is in fact the same one released several months ago.

Cabinet ministers are being warned that the Treasury could lose up to £66 billion a year in tax revenues under a “hard Brexit”, according to leaked government papers.

GDP could fall by as much as 9.5 per cent if Britain leaves the single market and has to rely on World Trade Organisation rules for trading with the continent, compared with if it stayed within the EU, the forecasts show.

So those with short memories will be made nervous by the “scoop” in the Times. I do not know if the expected 18% fall in house prices is still in it as well.

The wider picture

We are seeing a global move towards higher yields and as an example we even now have a positive yield for ten-year German bunds albeit one of a mere 0.06%. The US 10 year Treasury yield has risen to 1.76% on the back of stories like this from Bloomberg.

Pacific Investment Management Co. says the Federal Reserve may raise interest rates two or three times by the end of 2017. Treasuries tumbled after oil prices rose.

Are those the ones that have not taken place so far in 2016? Also it is hard not to have a wry smile at the statement by Pimco that UK Gilts were on a “bed of nitroglycerine” which preceded one of the strongest rallies in history.

Not everybody is upset by this

If we move to the world of pension deficits then quite a few UK companies may welcome higher Gilt yields. This has been illustrated by this news today from Pensions World.

The aggregate deficit of the 5,945 schemes in the Pension Protection Fund (PPF) 7800 Index has decreased to £419.7bn at the end of September 2016, from a deficit of £459.4bn at the end of August 2016.

So £40 billion less to find which even in these inflated times is still a tidy sum. For those of you who would like to know the total sums at play, here they are.

Total assets were £1,449.5bn and total liabilities were £1,869.3bn. There were 4,993 schemes in deficit and 952 schemes in surplus.

Comment

Let us take a dose of perspective. If I look back over my career I can recall longer Gilt yields being 15% and more so 1.7% remains extraordinarily low and we should take advantage of it if only to improve the cost of our stock of Gilts. On that basis the recent rise is small but it also shows that we should not dilly and dally forever as events move on.

However there is another case of a false market here and it is one created in inflation-linked Gilts. They should be rising as inflation forecasts rise but whilst they are not part of the QE program their price has been driven higher by it as they are closely linked to ordinary or conventional Gilts. So we face the prospect of another false market as it is possible that higher inflation could be accompanied by lower prices for index-linked Gilts. Mind you I see that the new boy at the Bank of England is getting in his excuses early. From @LiveSquawk.

BoE’s Saunders: Expects MPC To Tolerate Modest Currency-Driven Inflation Overshoot In Next 2-3 Years

I wonder what “modest” is?

BoE’s Saunders: Expects GBP Weakness To Lift Inflation ‘Quite Substantially’

Oh and we see a clear sign of one of Carney’s cronies as we see a breathtaking attempt to shift the blame for the consequences of QE.

Saunders: Government Has Many More Tools To Resolve Distributional Effects Of Monetary Policy Than BoE

 

 

 

The Bank of England goes all-in on monetary stimulus

Yesterday the Bank of England announced an extraordinary package of policy measures even for these times. So without delay let us look at the consequences and indeed damage from such moves. But let us do so to a musical theme as we did indeed find out what Chief Economist Andy Haldane meant a few short weeks ago.

I want to be your sledgehammer
Why don’t you call my name
I’m going to be-the sledgehammer
This can be my testimony
I’m your sledgehammer
Let there be no doubt about it

Sledge sledge sledgehammer

There was something of a delay as the Bank of England website collapsed which I hope is not a metaphor for its knowledge of technology. Actually having just checked it the situation is worse than I thought as it is still down as I type this.

The announcement

Here we saw pretty much the whole play book being deployed. Here it is.

This package comprises:  a 25 basis point cut in Bank Rate to 0.25%; a new Term Funding Scheme to reinforce the pass-through of the cut in Bank Rate; the purchase of up to £10 billion of UK corporate bonds; and an expansion of the asset purchase scheme for UK government bonds of £60 billion, taking the total stock of these asset purchases to £435 billion.  The last three elements will be financed by the issuance of central bank reserves.

Okay so let us work our way through this.

Firstly the Bank of England has cut Bank Rate to as low as it has ever been in its 322 year history. Next we have yet another bank subsidy which I will analyse in a moment. Then rather oddly we have what might be called a “rave from the grave” as the Bank of England repeats a past ability to buy corporate bonds. The catch is that it did not back then apart from the occasional purchase of £10 million or so  in the summer of 2013 which were usually quickly reversed. Perhaps as the ECB is undertaking such a program Governor Mark Carney saw an opportunity to live up to his description as “a dedicated follower of fashion”. Also you may note that the previous corporate bond effort was very badly timed as the UK economy was improving.

Then we got an announcement of more conventional Quantitative Easing amounting to an extra £60 billion. You might think that if £375 billion did not work then another £60 billion was unlikely to but remember Governor Carney kept telling us that such numbers had been “carefully crafted” . By who and how was left unasked! Anyway let me help out by using the Bank of England’s latest working paper on the subject.

Our focus in this paper, however, is on the second round of purchases between October 2011 and June 2012, when the Bank of England purchased £175 billion of gilts, about 11% of nominal GDP,

Okay so what impact did it have?

We find that the second round of the Bank’s QE purchases during 2011–12……..boosted GDP in the United Kingdom by around 0.5%–0.8%.

So a “carefully crafted” £60 billion will supposedly raise UK GDP by something of the order of 0.2% if the paper is correct. More of a pea shooter than a bazooka isn’t it? That is of course to ignore the side-effects like this.

(The) effect on inflation was also broadly positive reaching around 0.6 percentage points, at its peak.

If we skip over the central banker speak of higher inflation being a “positive” we see that inflation will be expected to be 0.2% higher as we already mull the side-effects that in my opinion could easily make the  additional QE a subtraction from GDP rather than a boost.

The problem that is final salary pensions

These are valued in terms of the bond yields which the Bank of England is doing its best to drive lower, specifically AA Corporate Bond yields. So as you can see the only thing worse for this than ordinary QE is the Bank of England buying Corporate Bonds. Oops! Here is some analysis of the matter from the Financial Times.

The deficit of defined benefit pensions, which pay out an income linked to an employee’s final salary, jumped £70bn as a direct consequence of the decision to reduce interest rates by 0.25 per cent, according to Hymans Robertson, the consultancy.

Ah so a one for one ratio with the planned QE increase! At this point Mark Carney and the Bank of England are wearing a collective Dunces cap. Still they have a plan.

Many companies that saw increased pension deficits were able to extend the period over which they brought them back to balance, maintaining the existing level of contributions.

So kick the can into the future and hope that the problem somehow disappears is apparently the new “carefully crafted”. Also if you mimic an ostrich and stick you head in the sand the problem disappears.

At present, however, those effects appeared to be relatively limited.

Either the Bank of England does not understand final salary schemes – after all didn’t its Chief Economist Andy Haldane state that only recently? – or it is being rather economical with the truth here.

Yet another subsidy for the banks

The announcement of the Term Funding Scheme came like this.

the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate.

At this point you may be thinking is this the Funding for (Mortgage) Lending Scheme or FLS in disguise? That will only be reinforced by this bit.

the TFS provides participants with a cost-effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.

So a £100 billion of subsidy sorry funding to the banks. At that point please indulge me a little as I cut to this morning’s announcement from Royal Bank of Scotland (RBS) .From the BBC

Royal Bank of Scotland reports £2bn loss for the first six months of the year, blaming “legacy issues”

That is the same RBS which was fixed last year and the year before that and the year before that and the year before that…….

Oh by the way how is the culture of subsiding our banks going?

Of course the official version of the TFS is this.

This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions.

No doubt “should help” will be appearing in future versions of my financial lexicon for these times.

The impact of the fall in the UK Pound £

The trade-weighted index fell by around 1% or to put it another way equivalent to another 0.25% fall in Bank Rate to add to the 2% post Brexit fall that I discussed on Wednesday.

The Bank of England cuts its own income

The last three elements will be financed by the issuance of central bank reserves.

A little known fact is that the Bank of England charges Bank Rate on such issuance such that it got 0.5% until yesterday in what might be called “a nice little earner” by Arthur Daley. In a way it is analogous to seigniorage although there are differences. Now it will be 0.25% and presumably less later in 2016. Mind you that 0.25% will of course be levied on more,more,more.

Open Mouth Operations

The actual moves were added to by a lot of rhetoric about more in fact so much more that they should have been playing MARRS.

pump up the volume
pump up the volume

brothers and sisters
pump up the volume
we’re gonna need you

brothers and sisters
pump up the volume
pump that baby

We were left in no doubt that if necessary the volume will be turned up to 11.

Comment

On Wednesday I wrote that I would have voted for no further stimulus on two main grounds. Firstly the fall in the UK Pound £ at that point was broadly equivalent to a 2% reduction in Bank Rate. Secondly I feel that moves which are badged as stimulus have such side effects that the can easily turn out to be both deflationary for demand and inflationary for prices for the economy. That operates through businesses via pension schemes as I have looked at above and for the ordinary person in falls in real wages just like what happened when the Bank of England looked through an inflationary episode in 2010/11.

What we are in effect seeing are put options for the banking sector, house prices and the equity market.

Also if we move to the Bank of England press conference there was one glaring bit as Bank of England Deputy Governor Broadbent told us that they were looking at sentiment measures and downgraded “hard data” such as GDP. This was a complete U-Turn on past policy which has often been to wait for GDP data. Please do not think I am a sort of fan boy for GDP statistics, regular readers will have seen my critiques. But my point is that the Bank of England is now “cherry-picking ” the data to confirm its pre-existing view.

Actually Ben Broadbent seems to be in a state of distress. Here is the BBC’s view of what he said on Radio 4 Today earlier.

Deputy governor Ben Broadbent asked if the ‘s action will have an effect soon, he replies “absolutely, yes”

I have asked them if he has abandoned the long-standing view that interest-rate changes take 18/24 months to have full effect? If I get a reply I will let you know.

Never believe anything until it is officially denied.

Bank of England deputy governor Ben Broadbent says interest rate cut does not send out message of panic (The Independent).

Share Radio

I will be on Share Radio today between 1.10 pm and 1.40 pm covering these matters and the US Employment Report in the latter part. For those not in the UK it is online as well.