Bank warns of 'credit cliff' trap

THE Bank of England has warned some major European and US companies could fall off a 'credit cliff' because of the use of credit-rating triggers in debt contracts.

With financial markets reeling after the WorldCom fraud scandal, the June edition of the bank's Financial Stability Review points out that the bankruptcy of US energy company Enron followed a credit rating downgrade that triggered early-repayment clauses in some Enron bonds, leaving the company facing a $4bn (£2.7bn) liquidity call.

The Bank says moves to link calls for additional collateral or early debt repayments to changes in ratings made by credit rating agencies 'could lead to substantial selling following a ratings downgrade and potentially to a more-brittle financial system overall'.

It quotes a report by credit rating company Standard & Poor's that identified 22 US and European industrial and utility companies that 'might be exposed to material liquidity pressures following a downgrade of one full [ratings] category or less'. The Bank also says that dependence on too much short-term borrowing has increased credit risks.

The report says such risks are focused mainly on particular sectors. 'The heavily indebted telecoms, media and technology (TMT) sector continues to raise particular concern throughout Europe and the US,' the Bank says. It points out that rating agencies have downgraded TMT companies such as Alcatel, Deutsche Telekom, Ericsson and Telefonica since the December issue of the review, with worries about the enormous debt burdens some of these companies faced now superseded by concerns about the businesses' commercial prospects.

Only a day after the WorldCom scandal again exposed the weaknesses of America's Generally Accepted Accounting Principles (GAAP), the Bank says Enron's bankruptcy raises the question of the extent to which accounting standards should be founded on detailed rules - the GAAP system - or, as in Britain and under Europe's International Accounting Standards, on broader principles. These put the onus on directors and auditors to judge whether reporting is 'true and fair'. The Bank says: 'One drawback of the US 'rules-based' approach is that management may be tempted to alter the economic appearance of a transaction while staying strictly within the rules.'

Despite its concerns about debt exposures and, especially in the US, the vulnerability of heavily-indebted companies and households to a rise in interest rates from currently unsustainably low levels, the Bank adds: 'The global financial system has proved resilient to credit deterioration stemming from the sharp slowdown in global growth in 2001, and to the biggest single corporate and sovereign bankruptcies, Enron and Argentina.'