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Article by: Sam Orgill info@proactpartnership.com Published: 13/11/2008

Mark O'Shea of Alexander Beard provides ProACT's clients' with an Investment Overview.

Following extensive media coverage of recent events in financial markets, we are writing to put these recent events into context and offer our take on the implications for economic policy and investment returns.

September 2008 will merit a chapter in the history books of financial markets owing to the massive state intervention employed (in the home of capitalism) to stabilise the US financial system. The two state sponsored entities responsible for underwriting most US mortgages (Fannie Mae and Freddie Mac) proved to have too little capital to support their business and had to be brought into a form of nationalised management dubbed “conservatorship”. The major investment bank Lehman Brothers filed for bankruptcy and the giant insurer AIG was taken over by the Federal Reserve. Bank mergers were announced both sides of the Atlantic, as institutions sought combinations that would increase their financial strength and enable them to reduce costs. Bank of America took over Merrill Lynch and Lloyds Bank performed a similar role with HBOS in the UK.

The roots of these events lie in the unprecedented expansion of borrowing undertaken in the US, particularly the housing sector. A prolonged period of low interest rates in 2001-5 encouraged people to take on high debts since the servicing costs were low. Financial innovation enabled organisations to make loans which were then bundled together and sold to other investors who sought higher returns than were available on bank deposits. In the course of this, lending standards deteriorated as the investors receiving the interest had no knowledge of the underlying borrower and organisations grew to place more emphasis on making loans to sell on than on checking the borrowers’ ability to repay it. The resulting under pricing of risk meant that the loans did not earn enough in the good times to pay for the inevitable bad debts when the markets turned sour. This problem was compounded by the complexity of some of the packaged loans which meant that many investors had little idea of their underlying risk exposure. On top of poor lending decisions and inadequate pricing of risk many parts of the financial system employed high levels of leverage in an effort to gear up the returns on offer.

As the US housing market deteriorated in 2007, many of these loans began to default. This sparked off liquidity problems for markets in August 2007, as investors withdrew funding from these packaged loans, resulting in the banks having to finance them from internal funds. This put strain on banks’ balance sheets which was compounded by losses as the loans went sour. A slow motion chain reaction ensued, resulting in increased stress in most parts of the financial system, which revealed that the borrowing excesses of recent years had been much greater than realized at the time. Some institutions experienced liquidity problems (needing more cash than they had available) while others had credit or solvency problems, as losses eroded their capital base. These problems prompted a variety of liquidity assistance mechanisms from the Bank of England and other Central Banks and successive waves of capital raising by the banks under most pressure.

A further consequence of the pressure on bank balance sheets was that lending policies swung from excessively liberal up to 2007 to offering fewer loans and on more expensive terms. This has had the effect of exacerbating the slowdown in economies as the supply of mortgage finance dried up and companies found loans harder to obtain. In this way, what was initially a financial market problem spread out to the wider economy. Compounding this credit squeeze, a surge in oil and other commodity prices earlier this year raised inflation rates and hit economic growth owing to the squeeze on consumer incomes and corporate profits.

It became apparent in summer 2008 that the deterioration in the global economy, with concerns centred on US housing, was happening more rapidly than the banks could recapitalize themselves. Although it had been hoped that the collapse of the US Investment Bank Bear Stearns in March would be an isolated event, doubts began to emerge about the solidity of a number of other banks. This was the background to the sequence of dramas affecting the global financial sector this September.

A number of observations stand out. First, the crisis has been much more acute in financial markets than the broader economy, where growth has slowed by less than the disorderly conditions in the markets might suggest. However, it is not safe to assume this decoupling will continue in view of the banks’ reduced willingness to lend and the impact on confidence arising from the twin falls in house and share prices. The banking system is likely to need more capital in order to absorb losses from past lending decisions while retaining capacity to make new loans to creditworthy borrowers. Furthermore, investors no longer have confidence in the degree of financial leverage in the banking and investment world, which is prompting falls in most asset prices as organisations (willingly or under pressure) reduce their risk. Some of the “losses” might eventually be recouped as forced selling may reduce investment values below their recoverable worth. A number of financial structures devised for distributing loans throughout the investing world have fallen into disfavour and the means used to hedge risk by using derivative contracts have also proved vulnerable as confidence in the counterparties to those contracts has evaporated. The financial world has abandoned one system of “plumbing” without yet having found a replacement. Finally, it is likely that corporations will begin to behave in a more conservative way, building up a greater cushion of their own liquidity in order to avoid being forced to go to the banks. This in itself would entail reduced capital expenditure and employment plans - in short reduced growth for the economy as a whole.

These unprecedented events have led to extraordinary volatility in financial markets, partly owing to the unwinding of arrangements with banks which have failed and partly owing to uncertainty over the impact that increasingly conservative bank lending policies will have on economic growth. The credit crisis appears to be moving rapidly towards a phase when the losses arising from poor lending decisions and excessive leverage are fully disclosed and the losers pay the penalty. The problem facing policy makers is how to re-instil confidence in the solvency and effectiveness of the global financial system. Without an effective system for funnelling savings towards productive use, modern economies cannot function effectively. What needs to happen, in our view, is the disclosure of losses by financial institutions (to dispel the fear of “black holes”), recapitalization and restructuring by the banks (to rebuild trust in their ability to finance economic growth) and for regulatory

 

External Article Link: http://www.property-partnership.com/overseas-property-guides/overseas-property-guide.cfm?id=180

Article Link: http://www.property-partnership.com/overseas-property-guides/overseas-property-guide.cfm?id=180

Please contact the author at info@proactpartnership.com for more information.

 

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