In January 2007, when trouble in the subprime mortgage market was brewing, optimistic pundits pointed out that subprime represented less than 10% of the US mortgage market. They predicted that once the uncertainty died away, the crisis would cost less than $100 bn and would be easily absorbed by the generous buffers of capital held by banks. Since then the world?s biggest commercial and investment banks have written down $500 bn of bad debt and have been begging for capital. The IMF estimates losses relating to the credit crunch could reach as much as $1000 bn. But the optimists are back suggesting that the worse is now behind us.
Around the world, bank stocks have bounced 21% from their lows of July 15. Hope springs from the belief that banks have now written down what there is to be written down, the authorities are extending unprecedented lengths of support and buyers of credit are finally emerging. Last month, GE Real Estate, the commercial and property arm of the industrial and financial services conglomerate bought a euro 642 mn credit portfolio from Credit Suisse. This is not an isolated trade. In the last eight months GE has purchased over $6 bn of European property-related loan portfolios.
The recent turn down in commodity prices has also helped bank stocks in one of those peculiar dynamics of the financial markets. The 45% rise in oil prices from January to July of this year and its expected knock on impact on inflation was seen by investors as a key constraint for central banks in supporting the financial sector with lower interest rates. Noticing this, unconstrained investors began to fund, leveraged, long commodity positions by shorting bank stocks. Once commodity prices began to fall back after July 3, leveraged investors were forced to unwind both their long commodity and short bank positions, exaggerating both the rise in bank stocks and the fall in oil prices. To some extent, therefore, the rally in bank stocks represents a technical dynamic tied up with commodity prices and rate expectations rather than a direct view as to the fundamentals of banking.
While commodity prices were beginning their descent to earth in early July we had the crisis at Freddie Mac and Fannie Mae. The exposure of these US government-sponsored mortgage agencies to subprime was less than 10% of their total loans and what they owned was almost entirely the senior, highly rated, tranches. Yet even they faced a liquidity crisis. Mortgage lending as a whole, not just subprime, has collapsed as finance institutions try to hoard liquidity and raise capital.
In the UK, the number of mortgages approved for house purchase fell to the lowest recorded by Bank of England since it began collecting mortgage information 15 years ago. Mortgage lending is now 70% below the peak registered in November 2006. And as the global economy slows, lending outside of the housing market will come under pressure.
Moreover, while it is true that the authorities in the US and Europe are extending tremendous support to banks, it is noteworthy that the rescue of financial institutions like Northern Rock, Bear Sterns, Fannie Mae and Freddie Mac has not extended to a rescue of shareholders, who have ended up nursing dotcom-like losses. Fannie Mae?s stock is down 80% year-to-date.
Markets are forward looking and so bank stocks will recover before the cycle of write-downs is complete. But it is hard to see how banks in particular and stocks more generally can be on the verge of a lasting recovery yet. Banks do hold some seriously undervalued assets, and in time, valuations will revive. The 60% drop in bank share prices since the beginning of the year is based on an excessively pessimistic view of the quality of their balance sheet once liquidity issues pass. But maybe these valuations are a reflection of the new world of banking.
Banks own discredited business lines. Past bumper revenues from securitisation and mortgage businesses will not be easily replaced and it will take time to find new business models. Clearly this is a general view and there are exceptions, of which HSBC, Goldman Sachs and ICICI come immediately to mind, though even ?good? institutions will be affected by the coming regulatory backlash that is likely to raise their cost base and that of the economy as a whole. Finally, in taking a more pessimistic view of the speed and sustainability of any early recovery in economic expectations I side with JM Keynes in thinking that monetary policy is not very effective when the animal sprits are deflated. We should not place great hope in the interest rate reductions that have been made possible by a drop in oil prices back to the levels of a few months ago.
The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and Emeritus Professor of Gresham College in the UK