Market meltdown

Sep 17 2008 by Ian Shepherson for The Journal

THE collapse of Lehman Brothers, a year after Northern Rock applied for emergency funding, has sent stock markets plunging. As central banks try to keep the money markets going, we asked North East business leaders for their views and former Wall Street economist Ian Shepherdson gives his analysis of the situation.

THERE will never be another Wall Street weekend like this one. In the space of 48 hours, one of the oldest and biggest investment banks, Lehman Brothers, went bust. Another, Merrill Lynch, was forced into a merger with Bank of America to avoid a Lehman-style meltdown. And the world’s biggest insurer, AIG, spent the weekend pleading with regulators and potential investors to loosen the rules and help it raise cash.

How the mighty are fallen! A generation ago, in 1986, when the UK financial services marketplace was deregulated in the Big Bang, the American investment banks rode into London like conquerors, snapping up the venerable British merchant banks. Terrible American innovations, such as breakfast meetings and in-house gyms, soon appeared, and anyone who didn’t like it was soon out of the game. Those who stayed prospered. Until now.

Today there are just two major independent investment banks left on Wall Street, Goldman Sachs and Morgan Stanley. Both appear to be in decent financial shape. The others are either bust or have been swallowed up by commercial banks, and the entire US financial system is rocking. How did it all go so wrong, so fast, and what does it mean for us?

All Wall Street’s institutional casualties made the same mistake: they failed to appreciate just how catastrophic would be the collapse in the US housing market. They continued to buy hundreds of billions of dollars-worth of mortgage bonds even after the crunch was well under way, convinced it was a temporary correction rather than a once-in-a-century bust. Their argument, which I heard time and again in meetings on Wall Street, was that although mortgage rates had risen in 2005 and 2006, they remained low by historic standards.

The fatal flaw in this approach was that it took no account of the massive rise in the stock of unsold property. The housebuilders, who also did not want to entertain the idea that the go-go days were over, kept building new homes at a frantic pace even as demand faded.

The result was a forest of ‘for sale’ signs, which persuaded potential buyers to hold back. You don’t have to be an economist to know that more supply today means lower prices in the future. Who would want to buy a rapidly depreciating house with borrowed money?

No buyers meant even faster falls in prices, and falling prices meant that the value of the security backing all those mortgage bonds was disappearing, just as borrowers were finding it hard to keep up their payments. Mortgages, which had been very cheap when they were taken out with US base rates at very low levels, suddenly became very expensive when the initial fixed rates expired, with base rates up at 5.25%. So squeezed from both sides, the value of all that mortgage paper headed south. By last Friday, Lehman’s assets were worth $26bn less than its debts.

As for us, well, the British economy has been digging itself into a deep hole for some time now. The collapse in our housing market, on most measures, has been faster and deeper than in the US, but thankfully the mortgage payment crisis in the UK is nothing like as severe as in the States. There is no direct British equivalent of Lehman, though plenty of small mortgage lenders are in trouble.

The key consequence of the convulsions on Wall Street is that a return to normal banking conditions has been pushed even further into the future. One year into the credit crisis, banks are more scared than ever to lend to each other, and the institutions which supply cash to the banking system on a daily basis – pension funds, insurance funds and others – don’t want to lend to anyone.

That means banks have to pay more for their cash, so we have to pay more to borrow from them. In other words, even though the Bank of England has not raised base rates and will soon be cutting them, the cost of mortgages, credit cards, overdrafts and personal loans is rising.

The legacy of the credit boom of the past decade will be with us for years. Both British and American families have lived far beyond their means for more than a decade, funded by lenders who could see no further than their market share numbers and their fee income.

Now that the flow of credit has stopped, we have to relearn how to live on what we have, while at the same time paying down at least some of the debt taken on in the good years. This is going to be very painful and it will last for years. Unemployment will rise and corporate bankruptcies will soar, but at least inflation will drop very sharply. There will be no quick rebound this time, even after the Bank of England waves its wand and cuts base rates. When banks are broke, low rates help them rebuild their shattered balance sheets, but they don’t make them rush out and start lending again. Brace for the long haul back.

Ian Shepherdson is a former Wall Street economist now based in Newcastle

PAGE TWO: Your questions on the crisis answered.