Banks Beyond The Brink

Posted on: 29 September 2008 by Gareth Hargreaves

The domino-like collapse of banks stole the week's headlines, as expert Graham Kerner explains.

It was a week of significant developments as the credit crunch claimed more victims.

This time it was Washington Mutual that acted as the catalyst for jitters to spread to other banks including Belgium's Fortis and the UK's Bradford and Bingley.

The yet to be finalised US government's $700 billion Troubled Assets Relief Programme (TARP) couldn't come in time to stop the failure of one of the US's biggest banks - Washington Mutual, which was closed by the federal Office of Thrift Supervision on Thursday evening after customers withdrew $16.7 billion from accounts over the previous ten days, leaving the bank "unsound" according to the regulator and as reported in The Daily Telegraph.

The Washington National Building Loan and Investment Association, was formed in 1885 to refinance an economy following a Seattle fire that destroyed the city's business district. As The Sunday Times summarised, Washington Mutual, or WaMu as the bank become known, has survived two World Wars and the Great Depression to become the largest savings and loan firm in America, with 2,200 branches, 43,000 employees and $188 billion on deposit, and "recent events have levelled the financial giant."

Out of its ashes, JP Morgan Chase, which acquired Bear Sterns only six months ago, has paid the US regulator $1.9 billion to acquire Washington Mutual's deposits and retail branches to become the largest US depository institution. According to the weekend's Financial Times, JP Morgan has also taken on WaMu's 'soured' mortgage portfolio, but has not taken on any of its £14.6 billion in unsecured debt or any of the assets or liabilities of the holding company.

The people set to pay the price for the bank's failure include its equity and bond holders. One of the more publicised losers was TPG, a private equity firm, which is reported to have lost the entire $7 billion investment it made into Washington Mutual earlier this year.

Pick 'N' Mix

The ability to pick and choose which parts of a failed business to buy appears to also apply to the UK's Bradford and Bingley.

The Treasury, Bank of England and the Financial Services Authority have been in urgent discussions with the Spanish bank Santander over the weekend to try to find a private sector deal to save the bank. However, it has been confirmed this morning by The Financial Times that the government was taking B&B into national ownership after finalising a deal with Santander that it will buy the £21 billion deposit book and branch network for around £600 million, with the government taking on the £42 billion mortgage and loan book, which consists of more risky buy-to-let and self certificated mortgages.

Belgium's central bank and regulator are paving the way for a bail out of Fortis, the largest continental banking and insurance group, which has a £540 billion balance sheet and a market value of £12 billion, according to The Sunday Times. Shares in Fortis fell for five consecutive days last week, slumping by as much as 14 per cent to a 14-year low of €5.50, as reported in the weekend's Financial Times.

The Rescue Plan

Details of the $700 billion Troubled Asset Relief Programme, designed to strip all of the 'toxic assets' from the balance sheets of financial institutions should be finalised and communicated later today when the US wakes. The Daily Telegraph examined some of the positives of the deal in its current form.

First, it should provide a welcome boost of liquidity to a market that has all but frozen as institutions hoard cash and refuse to lend to each other.

Second, it should avert the collapse of another major bank, which has already seen Bear Sterns, Lehman Brothers, Fannie Mae, Freddie Mac, Merrill Lynch and AIG either collapse or nationalised.

Third, "it draws a line in the sand" by removing the toxic debt from the balance sheet of banks enabling them to then concentrate on lending what they have in their 'kitty' - a business model that served British building societies well for most of the last century.

Lastly, it may end up costing the US government less than $700 billion if the economy improves and the toxic debt retains its value. In theory, they could even end up making a profit!

London also acted to help unfreeze money markets as the Bank of England announced it would lend £40 billion to banks until mid January and was willing to accept a wider than usual range of collateral.

Retailers Needing Therapy

The fragile state of the UK economy is having knock-on affects on the high street, as the auditor of sports chain JJB warned it could not guarantee the business would survive. The share price of JJB fell by 50 per cent to 52.2p as it emerged that it has slumped nearly £10 million into the red in the six months to July.

As also reported in The Guardian, soft furnishing group Rosebys collapsed into administration and John Lewis announced another week of poor sales. MFI also appears to be searching for a financial lifeline before its quarterly rent day today, when the group has to pay three month's rent in advance.

Cap On The Rock

Under caps imposed by the European competition laws, Northern Rock is days away from having to stop taking new deposits from savers. Northern Rock has agreed to hold no more than £17.6 billion in customer deposits - equivalent to 1.5 per cent of all savings held in British institutions. In an article in The Sunday Times, more than £1 billion has flooded into the nationalised bank over the past two weeks. The bank has taken action recently to cut interest rates it offers, and it is likely to cut rates again if the flow of funds continues.

Other Economic News

Other events almost sidelined by the dramatic banking crisis, but which would normally be front page news included the biggest one day price rise in oil last Monday, with a jump of $16.37 - or 15.7 per cent - a barrel, which has led the US regulators to launch an investigation into the day's trading activity.

The Financial Times also reported that New Zealand has now sunk into its first recession in 10 years following a 0.2 per cent contraction in GDP in the three months that ended in June. This is the country's second successive quarter of weakness after a 0.3 per cent decline in the first quarter and makes New Zealand the first Asia-Pacific country and one of the world's first developed economies to fall into recession.

The Risk Of Not Being Invested

The outlook for markets and banks certainly appears to be the bleakest for 70 years. However, the time of greatest pessimism is usually the time of greatest opportunity. The Daily Telegraph provided a reminder that significant upheavals and falls in markets are often followed by the largest upswings, and that history strongly suggests the best time to buy shares is when you least feel like doing so.

The paper provided the following examples of the five-year returns from the Standard & Poor's index in America from: May 1932 - the Great Depression; July 1982 - the worst recession in the last 25 years and December 1994 - the most dramatic interest rates rise by the Federal Reserve in two decades, were 379 per cent, 267 per cent and 251 per cent respectively.

Most of these returns, however, came shortly after the bottom was reached. Half of the rise in equity markets following the events in 1929 was achieved within four years and four months. The full bounce from the 1974 slump took over five years, but half was achieved in the first six months. Recovery from the dot-com bubble bursting took four-and-a-half years, but half the gain was made within 18 months.

The message for the long-term investor with money already in the market is to stay the course, and those who are on the sidelines looking in is that no-one knows when the bottom of the market will appear, but that the rise from it can be quick and dramatic.

THS Partners are also finding reasons to be optimistic despite all of the gloom and this week provided us with the following comments:

"Compared to our outlook of last year, the outlook for the global economy as well as the UK economy has darkened substantially. We have been pretty nervous of the UK for a while, feeling that the over-indebted consumer, inflated house prices and the over-valued pound spelled trouble."

"But our view on the global economy was that the genuine growth in the emerging economies, whilst affected by the turmoil, would support global growth. The much worse financial environment has tempered emerging market growth strongly and its benign influence will be reduced. The emerging markets will continue, however, to support the global economy and world growth should continue at around levels seen before the emerging market boom began."

"As far as stock markets are concerned, there are two positives; listed equities were grudging participants in the '03-'07 boom and financials have declined in price so much and for such a long time, that their negative impact on major indices should now weaken. A substantial relief rally in financials is also a reasonable possibility."

"We have retained reasonable liquidity levels throughout the crisis, and our strategy is to reduce these - slowly and cautiously - and to invest in strong companies in the more affected sectors. We wrote last year that it was difficult to be too bearish of stock markets on low teen P/E ratios and 3-4 per cent dividend yields. These ratios are now substantially cheaper and the logic still applies that, of all the investment options available, shares are very attractively priced."

29th September 2008

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