Credit crunch fallout continues to bite

The collapse of Bear Stearns has struck fear into the hearts of investors, who are now apprehensive that the credit crunch is getting worse rather than better.

If this is the case, then more market turmoil is likely ahead causing losses for businesses and investors, and difficulties for mortgage and credit card borrowers.

Monday's plunging stockmarkets sparked forecasts that other investment banks, tired of treading water during the credit crunch, would be forced to give up and admit defeat.

However, following JPMorgan Chase's acquisition of Bear Stearns for just $2 a share (later revised to $10), Lehman Brothers and Goldman Sachs gave some relief to the market by posting better than expected results. Despite this, both banks have seen their profits more than halve during the first three months of the year.

Lehman's net income was $489 million (£242 million) during the first quarter of 2008, down from $1.15 billion in the same period in 2007, while Goldman Sachs's net income fell from $3.2 billion last year to $1.51 billion (£750 million) in 2008 to date.

Morgan Stanley also reported a 42% drop in profits during the first quarter, but again analysts expected its losses to be higher.

In the US, the Federal Reserve has slashed interest rates by 75 basis points to 2.25% in a bid to "promote moderate growth over time and to mitigate the risks to economic activity".

But it warns: "Recent information indicates that the outlook for
economic activity has weakened further. Growth in consumer spending has
slowed and labor markets have softened.

"Financial markets remain under considerable stress, and the
tightening of credit conditions and the deepening of the housing
contraction are likely to weigh on economic growth over the next few
quarters....downside risks to growth remain."

In Hong Kong, the Bank of East Asia has said it will cut its prime lending rate by half a percentage point to 5.5%

Stockmarkets have stabilised following steep falls on Monday 17 March. Despite the FTSE 100 closing over 200 points down on Monday, it recovered by 90 points during the first few hours of trading on Tuesday and eventually closed 191 points up. Similar rises were seen across Europe with the Dax in Frankfurt rising by 1.8%, and in Paris the Cac was up 1.9%. In New York the Dow Jones started Tuesday with up 21 points and...

There have been calls for the Bank of England to follow the Federal Reserve's example and cut interest rates, but this looks increasingly unlikely after official figures revealed inflation rose in February to 2.5%. However, the UK's central bank did respond to the crisis on Monday by making £5 billion available for cash-stricken banks - its first emergency provision of liquidity since September.

Bear Stearns' collapse and subsequent rescue compares unfavourably with the downfall of Northern Rock - with renewed criticism over the way the crisis was handled. The Financial Services Authority has now announced that Clive Briault, the executive charged with handling the Northern Rock crisis, has left the regulator by "mutual consent".

It has also admitted its role in the downfall of the Rock, confessing to a lack of supervision and dedicated resources.     

What next for the UK?

Rumours have been rife about some UK institutions - including HBOS - seeking emergency funding from the Bank of England. HBOS saw its share price fall by 10% on Wednesday 19 March despite denying approaching the central bank for a loan. 

The Financial Services Authority has condemned such "unfounded" rumours and says it is investigating trading in UK financial shares amid fears that some market participants are taking advantage of the current market conditions to spread "false rumours" and dealing on the back of them.

Simon Denham, managing director at Capital Spreads, says some institutions will be insulated against any further collapses: “The slow decline in major bank names has been going on for some considerable time. The UK now has only a small handful of players, Europe and the US have seen a veritable tidal wave of mergers and acquisitions over the past decade and the current situation would seem to indicate that the stronger placed institutions may well come out of this in rather a nice position.”

But he added: “...the hunt for the next weak link goes on.”

Experts predict stockmarket turmoil will continue to be seen going forward. Rebecca Chesworth, equity investment specialist at Threadneedle, said: “We expect the volatility and uncertainty to continue for some months.

“The stockmarket has yet to appreciate the impact of tighter credit on the wider economy as well as the major dislocation between the pricing of equities and bonds.”

However, she adds that attractive valuations and the good financial health of UK PLCs cast a positive light over UK equity markets over the longer-term.

And despite write-downs and the deteriorating credit markets, Chesworth says low bank valuations mean this sector remains of interest to Threadneedle’s funds.

“Given the deteriorating credit cycle and concerns over the UK consumer funds, we remain underweight in banks but valuations are low and some of the UK funds have been added selectively,” Chesworth said.

The light at the end of the tunnel seems to be some way off. Simon Denham said: “… unfortunately if this is the beginning of a recession then we probably have months, if not years, before the good times return.”

However, Norwich Union argues the current turmoil offers opportunities for investors in the large cap sector.

Mervyn Douglas, manager of the Norwich Union UK Focus fund, said: “The turmoil in the stock market is throwing up real opportunities for long-term investors. Many companies look good value with the dividend yield of the UK market now equal to the yield on gilts. In particular, many mega caps offer dividend yields well in excess of 5% backed by strong balance sheets.

“Even within financials there will be long term beneficiaries of the current distress, two good examples being Intermediate Capital & Lloyds.”

Max King, strategist at Investec Asset Management, says history shows every moment of crisis is also one of opportunity.

He admits that the collapse of Bear Stearns has created a “universal fear of a domino effect of further collapses” with participants in all markets frozen into inaction, equity markets trapped in a “remorseless downward momentum” and all hopes of a turnaround “indefinitely postponed.”

But, as King points out, while the news appears to be getting worse, a recession and housing market crash in the US have been on the cards for some time. Moreover, they are close to a low point and while further write-offs by banks are “inevitable”, these have already been accounted for and total estimates of losses are no longer rising.

King said: “Credit markets are the dominant short-term influence on equities in the short term, but valuation, earnings growth, the support from government bond markets and sentiment are decisive in the medium term.

“Valuation is excellent, and the low yield on government bonds makes equities excellent value in relative terms. Sentiment is at rock bottom, and we believe it can only improve – it is just a matter of when. The fall in corporate earnings forecasts has been the factor holding us back from short-term bullishness, and that fall is continuing. However, there is a glimmer of light at the end of the tunnel.”

Impact on consumers

As banks suffer the after-effects of the credit crunch, they continue to take steps to recoup their losses. Unsurprisingly, mortgages are one area nearly all banks have cracked down on – partly because lax lending in the US is one of the main causes of the current market turmoil but also because a slowing housing market means this sector doesn’t look as attractive as it did a year ago.

Banks are no longer willing to lend money to just anybody. In fact, the criteria they look at to determine your borrowing risk has tightened significantly. This means that if your credit profile is not squeaky clean you may find it hard to get a mortgage or loan at an attractive rate.

Secondly, lenders are also expecting borrowers to put more of their own money into a property, which means borrowers will have to put down larger deposits before they can get credit.

Finally, mortgage rates have increased and are likely to continue to do so. Interbank interest rates – known as LIBOR – have been creeping up for some time and now stand at 5.84%, meaning it is increasingly expensive for banks to borrow credit to fund their lending activities.

It's not just mortgage borrowers who are suffering. Some credit card customers have already seen their credit limits slashed, and providers such as Egg have withdrawn cards from customers they deem high risk.

However, one silver lining could be for savers. Banks are keen to increase their customer deposits and may therefore increase their rates in order to entice more savers through their doors.

The Bank of England might also be forced to react to the turmoil, cutting interest rates when it next meets in April. This could ease pressure for banks and bring mortgage rates down but seems only a distant possibility considering the rise in inflation to 2.5%.

Pension fund holders concerned that volatility could impact their retirement funds have been reassured by the National Association of Pension Funds (NAPF). It says stockmarket volatility will not have an enduring effect on workplace pensions as these types of funds are a long-term investment.

Nigel Peaple, policy director at the NAPF, said: “Pension funds invest in a range of assets, so to some extent, they are cushioned from such movements and have been reducing their equity exposure for some time.

“The continued volatility will also not affect the ability of schemes to pay the pensions due to their members.”

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