A huddle of emperor penguins, clustering together to ward off the Antarctic cold, swirls slowly, forcing birds in the middle of the group towards the frozen outer ranks. In the same way, continuing financial troubles have churned up the markets, exposing one set of financial institutions after another to icy scrutiny. Thanks to the difficulties faced by mortgage lenders in America and Britain, it is now the turn of institutions that rely heavily on the money markets for their funding to cower on the outside of the group. But everyone is feeling the chill.
Trouble among America’s mortgage firms continued when Impac Mortgage Holdings added to the tally of job losses on September 18th, by announcing that it was stopping most of its lending activity. The investment banks are trying to reduce commitments to leveraged buy-out (LBO) funding—commitments that now look far too generous to borrowers. PHH, another American mortgage lender, revealed on September 17th that its planned $1.8 billion sale to General Electric, a conglomerate, and Blackstone, a private-equity firm, was in jeopardy because of funding difficulties. Bank of America, one of the world’s largest banks, warned on the same day that the credit crunch would dent its earnings.
In the face of all this bad news, investors have been skittish. European bank shares were hard hit at the start of the week, with Irish and Spanish banks receiving some of the worst punishment. In Asia Japanese banking stocks also suffered, as concerns about the credit squeeze reinforced worries caused by unrelated news that Credia, a consumer lender, had filed for bankruptcy.
Shares rallied later in the week thanks to three palliatives: America’s interest-rate cut, Britain’s bail-out of Northern Rock and better-than-expected quarterly results from Lehman Brothers, an American investment bank. Still, the mood remains febrile. News of another big subprime loss could quickly spark fresh anxiety.
Re-evaluating the risky
Some worries are overblown. To date, the credit crunch has done a good job of weeding out victims. Subprime lending is an inherently risky business. The banks that have so far been bailed out after incurring heavy losses on subprime-related instruments were unusually exposed to liquidity risk. As risk has been repriced, the risk-takers have suffered most.
For the mass of banks, cushioned by years of good performance, solvency is not (yet) a worry. “The capacity of banks to absorb problems is very high,” says Ian Linnell of Fitch, a rating agency.
But if a widespread funding crisis is unlikely, fears of a sector-wide earnings crunch are much more plausible. The events of the summer will hurt banks in a number of ways. As well as the impact of direct losses from subprime securities and gummed-up LBO loans, banks will earn less money from complex structured products and private-equity deals. As loans come back on to balance sheets, institutions will need to store more capital against these assets.
Higher interbank financing costs will eat into margins and reduce lending growth. Some of this extra cost will be passed on to borrowers which will weaken demand for credit and exacerbate the risk of slowdowns in inflated housing markets.
Some institutions are better placed than others to deal with such problems. By reducing their reliance on jumpy wholesale markets, banks with a strong base of retail deposits have an advantage (such a base has potential bail-out benefits too: there is clearly nothing like a queue of worried pensioners to grab politicians’ attention). Angelo Mozilo, boss of Countrywide, a troubled American mortgage lender, announced plans on September 18th to double its branch network in coming months.
Diversification is also helpful. Bouncier equity markets can help investment banks offset weaker performance in fixed-income products. Emerging markets have looked stable throughout the credit crunch and offer the prospect of relatively straightforward growth. “In a sense, emerging markets are the new defensive markets,” says Simon Samuels, an analyst at Citigroup.
As profits in their industry come under threat and bankers look to cut costs, dealmaking among banks may quicken. Banks with small retail networks and large mortgage books look vulnerable to acquisition. Investment could well rise in emerging markets. Some speculate that America’s standalone investment banks, which are almost wholly reliant on the wholesale markets, may even seek the shelter of larger banking groups. Now is not the best time to launch ambitious takeovers but, when things are this frozen, huddling closer together makes sense.