As US banks reap the rewards of ill-considered lending practices and America sinks deeper into recession, the pain is beginning to be felt in the UK. John Stepek explores why and what investors can do to minimise its impact.
For most people in Britain, the ‘credit crunch’ began with the queues outside Northern Rock. But before that, in July 2007, one of the first clear signs that the financial system which had given us one of the biggest property bubbles in history was beginning to unravel was a letter from Bear Stearns to investors in two of its hedge funds. The letter effectively warned them that, due to losses on securities linked to subprime mortgages, there was little or no value left in the hedge funds.
Within a few months, there were people queuing outside Northern Rock as the freezing up of the credit markets left the bank seeking emergency funding from the Bank of England. Since then, stockmarkets have been on a volatile downward trend, with huge hopeful rebounds after each piece of potentially good news, later dashed as a new crisis rears its head here.
And now Bear Stearns has taken us into a whole new phase of the credit crunch, by giving America its very own Northern Rock experience. Last Friday, the fifth-largest investment bank in the US was forced to turn to the Federal Reserve (via fellow investment bank JP Morgan) for emergency funding, after jittery hedge funds – on edge after the collapse of Peloton Partners and Carlyle Capital Corp – pulled their assets out of the bank. By Monday, Bear Stearns was being bought by JP Morgan for just $240m. Before the crisis, it had a market cap of around $17bn.
Yet even with the hefty discount, the sale only came about after the Fed had guaranteed $30bn worth of Bear Stearns’ more illiquid assets with taxpayers’ money, something not seen since the days of the Great Depression. To prevent the same thing happening to another bank (many investors feared for Lehman Brothers, which had a similar business model to Bear Stearns), the Fed took several other steps to allow banks to borrow money from it directly at cheaper rates and against a wider range of collateral. Meanwhile, on Tuesday, it slashed the key interest rate by three-quarters of a percentage point, to 2.25%.
The Fed’s measures might be seen as panicky. But the truth is that it’s right to panic. As Nick Louth points out on MSN, “had Bear Stearns actually collapsed, the market would have had to unpick the complex crochet of derivatives trades the bank had undertaken, and assign a value to them. Given the current mood of the market, those values would probably be very low”. That would have had a knock-on effect on banks across the globe.
Some argue that the Fed should have let Bear Stearns go to the wall and that government intervention merely encourages more bad lending. But John Mauldin of Investors Insight argues that the time for worrying about “moral hazard” has passed. “The time to worry… was two years ago, when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets.” He says that “to decry this deal means you just don’t get how dire a mess we were almost in.”
Of course, you can argue, as MoneyWeek does, that we got into this mess in the first place precisely because the Federal Reserve under Greenspan was always too quick to intervene to keep the market propped up. But with comparisons with 1929 and the Great Depression now rife across both the press and the financial sector, Fed chief Ben Bernanke is set to do whatever he thinks it takes to keep the US from running into a deep recession or worse. The big question is – has the Fed done enough? Does Bear Stearns mark the beginning of the end of the crunch?
We don’t think so. And here’s why.
America’s woes have just begun
The truth is, Bear Stearns doesn’t change anything. Yes, it was a shock for global markets. But all that’s happened is that the market has had yet another wake-up call. As Bill Emmott, former editor of The Economist, points out in The Guardian: “Whenever financial crises have occurred… the vital moment has been the one when reality strikes home… the fall of Bear Sterns suggests [that moment] is now here”.
What the markets are now waking up to is the fact that, as Tom Stevenson puts it in The Daily Telegraph: “We have forgotten the simple truth that ultimately you can only spend what you earn”.And that’s not a situation that can be remedied simply by slashing interest rates. Banks have stopped lending to one another, but that’s not because of a lack of money in the system – anything but. The Fed has been cutting rates and delivering ‘liquidity injections’ for several months now. In the words of Bob Eisenbeis of Cumberland Advisors, “If this were a simple liquidity problem the actions that the Fed has taken would have dealt with the problems by now”.
The real problem is one of solvency. The assets that banks are sitting on simply aren’t worth what they thought they were worth. All the rate cuts in the world can’t help with that. As Wolfgang Munchau says in the FT, “When you are insolvent, the rate of interest is irrelevant because no one will lend you money in any case. And if someone did, the interest rate would still be irrelevant, since you are not going to pay them back.”
Despite all the complexities of synthetic CDOs and credit default swaps, the plight of the banks comes down to one simple thing. Namely, they made too many loans to the wrong sort of borrowers – to people who couldn’t afford to pay them back. And nowhere was this more extensive than in the housing market.
Usually the best way to end a financial crisis like this is to find a ‘clearing’ price for the bad assets. That enables everyone to see what the real damage is, be confident they’ve found a bottom, and then the strong players can buy up the best parts of the weaker ones and the market clears itself out. But this time around, as Gillian Tett puts it in the FT, revealing the true value of many of the assets in question would almost certainly mean “blowing up more banks”. And the other problem is that the assets underlying the most troubling junk on banks’ balance sheets are still deteriorating.
Why the credit crisis won’t end any time soon
Years of easy money policies by central banks encouraged many bad investments, but the bubble that finally choked the financial system has proved to be in housing. Bear Stearns’ original woes extended from bad bets taken on the housing market. As subprime borrowers started to default on their mortgages in vast numbers, financial institutions rapidly realised that the AAA-debt they thought they’d bought into was nothing but junk.
The trouble is that the housing woes are spreading far beyond subprime and infecting every other part of the credit market. Alt-A (a notch above subprime) and even prime mortgage debt, backed by quasi-government bodies Fannie Mae and Freddie Mac, has been hit as America goes through its worst housing crisis since the 1930s.
According to the S&P Case-Shiller index, prices fell by 9.1% in 2007, and there’s nothing the Fed or the government can do about it. As BusinessWeek puts it, “there’s no way to stop home prices from falling; they got way too high, and the current crisis won’t end until they get back to what the market concludes is a sustainable level.” The magazine quotes Harvard University economist Kenneth S. Rogoff: “We saw a once-in-a-hundred years run-up in housing prices, and now we’re seeing a once-in-a-hundred years collapse”.
As Mauldin puts it: “The Fed move [to bail out Bear Stearns] keeps the system together, but it does not do anything to stave off a fall in consumer spending, a fall in house prices, the increased difficulty of getting consumer loans, falling construction, etc., which is what normally happens in a recession.”
The bad news is that most commentators now agree that America is in recession, with unemployment starting to rise, and consumer confidence and the manufacturing sector firmly in the doldrums. Meanwhile, there is no sign of the US housing collapse bottoming out. Construction activity is still in decline, while in February repossessions jumped by 90% year-on-year, with total foreclosure proceedings up 57%, according to property group RealtyTrac. A further $460bn of adjustable-rate mortgages is due to be reset this year, raising payments for hard-pressed borrowers, says Citigroup.
Another problem is that as more and more borrowers find their mortgages are worth more than their homes, many are simply giving up and walking away. As financial analyst Paul Amery points out in Why the UK’s property downturn will be worse than America’s, unlike in the UK, where lenders can and will pursue such debts, in practice, US lenders tend not to. This is down to issues ranging from problems with mortgage documentation (as most mortgages were sold onto investors, record-keeping was sloppy), to the simple “realisation that often there is little money left to pursue”.
Other homeowners are starting to challenge foreclosure proceedings, and “judges are being surprisingly sympathetic”, reports Moneynews.com. A judge in Massachusetts stopped all foreclosures from lender Fremont, “as his honour sought to determine whether the loans were made on terms that violated state lending laws. In a sense, judges are regulating the industry from the bench”. These moves are “further skewing the secondary market for securitised loans” as the prospect arises of investment banks becoming the new slum landlords – unable to offload their properties, and unable to get rid of the tenants within them.
So with the housing slump ongoing, we can expect more rate cuts, more intervention from the Fed and, eventually, more bail-outs for banks. According to BusinessWeek, a 25% fall in house prices, which seems more than plausible, would amount to a $5 trillion loss of wealth. That level of loss suggests there are a lot more Bear Stearns waiting in the wings.
What does this mean for the UK?
The bad news for British investors is that the UK is vulnerable to all the same problems as the US. Many of our own banks have heavy exposure to the kind of toxic debt that has inflicted such carnage on US balance sheets. Our house-price bubble was even worse than America’s, and our consumers more indebted (UK consumer debt stands at 175% of disposable income, compared to 138% in the US).
With banks unwilling to lend to each other for fear that either they, or the banks borrowing from them, are insolvent, they’re certainly not happy about lending to you or I. That has transformed the mortgage market in the UK, with lenders pulling products and interest rates and minimum deposits rising sharply, despite the base rate falling (see Tightening crunch pounds sterling for more). As past experience and current events in the US show, once a house-price bubble bursts, recession is set to follow as debt-dependent consumers find their credit lines drying up.
So the pain certainly won’t be restricted to the US. And given that house-price crashes take several years to pan out, the end of a difficult adjustment process is a long way off yet. So what can investors do to protect themselves? We have a few suggestions below.
How to thrive as the credit storm rages
It’s always advisable to clear off any debts before you start investing, but that’s now doubly the case, even for your mortgage debt. Warren Buffett once said, “the best investment anyone can make is to pay off their mortgage early,” and that’s particularly important now at a time when anyone remortgaging in the near future is likely to find that their payments rise sharply – and that’s assuming they have a decent amount of equity in their home.
Equally, if you haven’t sold off any investment property you own already, then now is the time to look at your outgoings and consider how bad your position would be if house prices fell substantially, by 20% or more, or if you were unable to rent out the property for any reason.
After you’ve taken care of your debts, another good investment right now is plain old cash. Cash has been cheap for so long that we’ve forgotten its value, but now that banks are clamouring for it, you can find some very good interest rates on savings accounts. However, given the woes afflicting banks, it’s important to remember to keep your money safe by avoiding putting more than £35,000 with any one provider – the amount guaranteed under the Financial Services Compensation Scheme.
Once you have your debts and an emergency fund covered, investments we like include Japanese stocks. In common with most other stockmarkets, Japan’s major indices have taken a hammering in recent months as the yen’s strength against the dollar has hurt exporters. However, stocks are extremely cheap – Japan is one of the few countries where many shares still trade below their book value.
One fund to take a look at, says independent financial adviser Brian Dennehy in The Daily Telegraph, is Invesco Perpetual Japanese Smaller Companies, which provides “deep value in an overlooked asset class”. Japan may well continue to suffer as the credit crunch rolls on, but at current levels, anyone who buys now shouldn’t regret it.
As for other markets, there are still individual stocks that are worth looking at, particularly in defensive sectors such as pharmaceuticals, but in the current climate, even good stocks are likely to be caught up in wider sell-offs. For more on what to look out for when choosing a stock that should withstand the credit crunch, see One stock set to profit from oil – even if prices fall.
For those who have an appetite for risk, there are now several exchange-traded funds (ETFs) available that allow you to short various stockmarkets and sectors. If you believe that the only way is down for the financial sector, for example (which seems reasonable to us), then the Proshares Ultrashort Financials (US:SKF) is designed to rise by twice the amount that the Dow Jones US Financials Index falls, or vice versa. Proshares also has a range of other shorting products, including ETFs inversely tracking all the major US stockmarket indices, from the Nasdaq to the Russell 2000. As for international markets, Proshares will also allow you to short China via the UltraShort FTSE/Xinhua China 25 (US:FXP).
The dollar, already weak, may be due a rebound if banks in Europe and Japan agree to get together to prop it up, but as David Fuller says on Fullermoney, with “US interest rates declining” while America is “the epicentre of global weakness”, the dollar is unlikely to see any long-term recovery until “the US economy is recovering and the Fed raising interest rates”.
So we think there’s still plenty of room for more gains in gold in the longer term, despite its recent run above $1,000 an ounce. We are still nearer the beginning than the end of this crisis, and at such times, demand for a ‘safe haven’ like gold will remain high. You can buy gold for your individual savings account (Isa) via the London-listed ETF, ETFS Physical Gold (PHAU).