Outlook: Barclays shows banking cycle is not dead, only resting

Orange minority; Colt Telecom

Matt Barrett may never have said it outright, but his predecessor as chief executive of Barclays, Martin Taylor, certainly did. With better risk management it ought to be possible to abolish the banking cycle. Mr Barrett has scarcely been more cautious in his remarks. Throughout the business downturn, he's remained entirely sanguine about the likelihood of significant bad debt experience.

Well, perhaps inevitably, bad debts are climbing again. For Barclays they were sharply higher at the half-way stage, ensuring a fall in overall profits, and yesterday Barclays confirmed that they were still climbing even as growth in revenues from retail banking was grinding to a halt. As a result, full-year profits will be at the bottom end of expectations.

Black mark for Mr Barrett, his first significant one since taking up the post in 1999. However, one of the most surprising things about the economic slowdown is quite how subdued bad debt experience has been so far among the big banks. Certainly it has been climbing, and share prices have fallen to match, but compared with past recessions, when bad debt would routinely reduce the clearers to loss, it scarcely seems worth mentioning.

Up to a point Mr Taylor has been proved right. Improvements in banking supervision, capital requirements and risk management have succeeded in greatly reducing the pain to the banking system of economic slowdown. The growth in markets for securitised assets and the emergence of a wealth of different derivative instruments has also allowed banks to disperse credit risk in a way which in the past was next to impossible.

But let's not speak too soon. So far, there hasn't been an outright recession. Consumer, mortgage and small business loans haven't seen the sharp increase in bad debt experience that the bubble industries of the New Economy have. This in turn is explained by historically low interest rates and the absence of a credit crunch. If this situation changes, then all bets are off. The banking cycle may seem less severe than it used to be, but perhaps that's because things haven't yet bottomed out.

Orange minority

Watch out if you are part of the minority in Orange, the mobile phones company. The fly in the ointment for the Orange IPO was always that France Telecom would remain the dominant majority shareholder. The more troubled the French parent gets, the more real the danger becomes that Orange will end up being run for the particular benefit of France Telecom, rather than as it should be for Orange and its shareholders.

The evidence that this is already occurring grows by the day. France Telecom is labouring under a €70bn mountain of debt. That it continues to trade at all is only because of the French state, which is the majority shareholder and which is the key to any refinancing. In the meantime, it's all hands to the tiller, and that includes Orange, which is 87 per cent owned by France Telecom.

The 13 per cent of the equity that France Telecom sold to the public a year and a half ago theoretically prevents France Telecom raiding the Orange piggie bank to prop up the rest. But the lines can often get blurred, especially when the need is great. This is also France, where the distinction drawn in Anglo-Saxon markets between different pots of money isn't always properly understood.

Confusing the picture is the fact that up to €5bn of Orange debt is by way of a loan from France Telecom. In effect, then, part of Orange's cash flow already goes to service France Telecom's debt. Orange is also consolidated in the France Telecom accounts as if its assets and cash flow were a part of the whole, thus helping support the balance sheet. Orange is thus already well on the way to being run to suit the cash-strapped priorities of the French parent – planned investment is being cut and expansion plans are being curtailed.

There's talk of France Telecom buying out the minority so as to free itself of all constraints on use of Orange's cash flow, but since when has a debt-heavy company solved its problems by taking on even more debt? Richard Lapthorne, the only British non-executive on the Orange board, may have to more than earn his fee over the months ahead looking after the minority. The appointment of Graham Howe, deputy chief executive, to succeed the outgoing CEO, Jean-Francois Pontal, would help calm nerves, but he's by no means assured of the job. Much more likely it will go to a France Telecom place man.

Colt Telecom

Elliott Associates LP is a US-based firm of hedge fund operators. By all accounts it is exceptionally good at what it does, but what it does, which is to make money out of other people's financial distress, essentially stinks. The present business downturn provides rich pickings, especially in the bombed out telecoms and technology sectors.

In a typical transaction, Elliott will buy bonds at distress prices while simultaneously shorting the equity. Elliott will then threaten to declare the company in default unless the bonds are redeemed at full value. If the company gives into the greenmail, then Elliott makes lots of money. If it does not, then Elliott makes lots of money on its short position instead.

Up until recently, Elliott has tended to confine its activities to the great sea of the US capital markets, where they tend to go largely unnoticed. Just recently, however, it has been dabbling in European markets as well. Gordon Singer, the son of the founder, has been sent over to spearhead the assault, and a pretty bloodying experience the 28-year old is finding it too.

With Colt Telecom, the alternative network operator, he's managed to get himself into the most terrible mess. True to form, a big position was built up in the bonds. Mr Singer then marched into the company and demanded the bonds be redeemed at par or he would petition to have the company wound up. Colt Telecom is in a troubled sector, but it is not obviously in any financial difficulty. On the other hand, it is burning cash fast as it completes its European buildout. Insolvency is inevitable, says Mr Singer, so liquidate the company now while there is still cash left to distribute. Never mind that the company was refinanced through a £500m rights issue only a year ago, so that customers could have confidence in its long-term future. Elliott's intention is to have that money.

Mr Singer may not have expected it, but Colt called his bluff. Furthermore, it publicly announced what was going on, again something that rarely happens in the US. Elliott now has no alternative but to go through with its threat and petition the courts for a winding up order, despite the fact that its case is so weak as to be almost laughable. If it backs off now, the winding up threat will look hollow when Elliott comes to use it again.

Round one of the court proceedings has already gone to Colt. The judge dismissed Elliott's application for discovery as a fishing expedition and said that in essence Colt was being asked to make the petitioners' case for them. Mr Singer scarcely looks likely to fare any better in the main proceedings, due to start in the next couple of weeks.

In trying to prove his case that "insolvency is inevitable", he's had KPMG calculate an asset impairment charge for Colt using a 24.7 per cent weighted average cost of capital. When doing the same exercise for Cable & Wireless, a not dissimilar company, the same accounting firm applied a figure of 11 per cent. The number, it appears, is made to fit the needs of the client.

Maybe Colt will eventually fail, but from this vantage point it looks much more likely to be one of the sector's long term survivors. Elliott's techniques are tantamount to day-light robbery. Mr Singer will get the spanking he deserves when the case comes to court, and there will perhaps be sharp words from daddy too when he finds out quite how naive his son has been in believing you can get away with the same thing over here as you can over there.

jeremy.warner@independent.co.uk