Economic damage may not be a bad as feared

Oct 10 2007 by Aaron Boland, Liverpool Daily Post

MANY investors may have been scratching their heads at the contrast between credit markets near nervous breakdown mode, while equity markets continue to recover from the lows of mid-August.

Short-term money market borrowing rates were abnormally high throughout most of September because banks were hoarding liquidity. The fall-off in confidence in the US mortgage market meant banks were called on to provide more of the finance for the structures holding these loans, while investors' reappraisal of risk meant loans to fund takeover deals were no longer saleable to investors on the original terms.

This led to a stand-off, with banks unwilling to sell loans at a loss to investors whoreckoned they could drive a hard bargain.

The resulting drought in the inter-bank lending markets caused Northern Rock’s problems. The bank had made extensive use of securitisation and inter-bank borrowing to finance expansion of its share in the mortgage market.

This dependence on inter-bank borrowings proved an Achilles heel, when those markets dried up. It was forced to seek liquidity from the Bank of England, with disastrous consequences for depositor confidence and share value. Although management must take its share of blame for a vulnerable business model, the thought lingers that the authorities underestimated the stress within the UK's credit markets. This led the Bank of England to give less liberal assistance than Europe or the US, while the division of responsibility for regulation and financial stability, between the Bank, the Financial Services Authority and the government may also have contributed to the messy outcome, ironically occurring on the same day a US mortgage lender which had been under pressure obtained new lines of finance.

Banks have reportedly become more cautious about lending to business as well as raising their mortgage rates.

Now it appears the heat will be taken out of the housing market, but the pressure on banks could have longer-lasting effects on their willingness to extend credit. This has raised the risk of a sharper than expected economic slowdown, or even a recession. Given that until recently growth was running faster than the Bank of England desired, any early rate cut would be driven by the need to restore stability to the money markets. If this can be achieved, equities may be right to bet the economic damage from this financial crisis will be less than feared in the eye of the storm.

Andrew Bell,

Head of Research