World Markets in crisis: will it get worse?
Pastor Dale Morgan
World Markets in crisis: will it get worse?*
Offering mortgages to poor Americans has backfired badly on the banks.
As lenders are forced to put their houses in order, the effects of their
actions are hitting markets on both sides of the Atlantic, writes
Heather Stewart
Sunday August 5, 2007
The Observer
Roller-coaster. See-saw. House of cards. Wall Street watchers' wildest
metaphors were strewn liberally around last week as investors fought to
describe the latest ramifications of a global financial scare that began
in the homes of overstretched Americans struggling to pay the mortgage.
Share prices on both sides of the Atlantic plunged last Monday; shot
back up last Tuesday; plunged again last Wednesday; bounced back last
Thursday, and endured another savage sell-off at the end of the week,
with the Dow Jones closing 280 points down on Friday.
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Ever since it became clear that 'sub-prime' mortgage-borrowers with poor
credit records, who had piled in at the peak of the US housing boom,
were defaulting on their debts in droves, markets have been adjusting to
the cruel reality that lending is a risky business.
Several mortgage lenders with heavy exposure to the market have already
gone bust, but last week's sell-offs were a reminder that lax lending
has taken place well beyond the housing market. Investors on both sides
of the Atlantic waiting for the next domino to fall last week were not
disappointed. In Germany, a coalition of banks stepped in with a €3.5bn
(£2.4bn) rescue deal for one of their rivals, IKB, after it revealed
that it was heavily exposed to the sub-prime sector.
Bear Stearns, the Wall Street bank which has already watched two of its
hedge funds crumble as a result of the mortgage crisis, told investors
that they would not be allowed to withdraw cash from a third fund - this
one supposedly with a less risky strategy - to stem panic withdrawals.
Bear's chief financial officer, Sam Molinaro, said the turmoil in the
credit markets was the worst he had seen in 22 years in the business.
Mortgage-lender American Home, which lends to mainstream homebuyers with
healthy credit scores, not sub-prime borrowers, saw 90 per cent wiped
off its value, and announced thousands of redundancies, after admitting
that it was facing a cash squeeze.
It is not only the direct losses from sub-prime defaults that are
troubling investors: it is the fear that lenders, jolted by the scale of
defaults, would take a long, hard look at their portfolios. Since
mortgage debts are now often bundled together, repackaged and resold in
complex new financial instruments such as 'collateralised debt
obligations' (CDOs), no one is quite sure where the buck stops. Many US
banks - more than at any time since the recession of the early 1990s -
are already tightening their lending criteria (see chart), but the
fallout is likely to spread well beyond households looking for a mortgage.
Charles Dumas, of Lombard Street Research, speculates about the frenzied
conversations that will have been taking place in bank boardrooms on
both sides of the Atlantic since the fallout from the 'toxic waste' of
sub-prime lending began to spread.
Chairman/CEO: 'How much of this stuff do we own, and what's our exposure
- to hedge funds owning toxic waste, as well as to the waste itself?'
Chief credit officer (I paraphrase): 'I haven't the faintest idea.'
Chairman/CEO: 'You've got two weeks to sort it out, and meantime no more
lending.'
So the credit business closes down while the bean-counters work 24/7.
What gets caught? Huge leveraged buyout deals that have little to do
with mortgages.
A bottleneck of deals has been held back since the borrowing taps were
tightened. Toby Nangle, fixed income investment manager at Barings,
reckons 13 deals, worth $43bn (£21bn), have been postponed or cut back
in the past two weeks - and banks are sitting on a total backlog of up
to $400bn (£200bn) of incomplete deals, which are financed with
short-term borrowing, and stuck on their balance sheets, waiting to be
sold on. The latest casualties were the banks backing KKR's £9bn
takeover of chemist Alliance Boots, which conceded on Friday that they
had been unable to sell on any of the debt that funded the takeover.
Debt-backed buyouts have been a key source of demand for equities, so if
the lending tap is turned off, share prices will suffer.
Stephen Lewis, of Insinger de Beaufort, says it's too soon to call
what's happening a full-blown 'credit crunch', but lenders that have
spent the past few years lavishing cash on eye-wateringly leveraged
deals are likely to be seriously wary in the months ahead.
'A "credit crunch", properly understood, occurs when would-be borrowers
with plans for productive capital expenditure are denied access to
loans,' he said. 'Not when lenders are leery of meeting the demands of
any speculator who would like to gear up.'
Central banks, including the Bank of England, are likely to be mightily
relieved if lenders start being a bit more wary. They have been shocked
by the rapid pace of credit growth despite repeated interest rate rises
in recent years, and have warned that CDOs and other new-fangled
financial instruments may simply be hiding risk, instead of helping to
spread it around.
Any sector that has flourished as a result of cheap, few-questions-asked
lending ('covenant-lite' is the City parlance for loans with few
conditions) is likely to suffer if sub-prime ushers in a stricter
financial era. Analysts say that everything, from commercial property,
to fine art to Britain's overvalued housing market, could be vulnerable.
And if the supply of super-leveraged megadeals starts to slow, a whole
industry of advisers, lawyers, ratings agencies and bankers will see
their fees decline. Consultancy Oxford Economics warned last week that
because of the UK's reliance on its rip-roaring financial services
sector, the knock-on effects of the sub-prime crunch could depress GDP
growth by up to 0.4 per cent.
As David Brown, chief European economist at Bear Stearns, says: 'For a
number of years financial markets have partied on the liquidity as asset
prices surged and financial innovation boomed. After the party comes the
hangover and, as the market is finding out, the bigger the party, the
worse the hangover.'