Bulletin - The Credit Crisis
In the course of the last few days we have witnessed extraordinary events in financial markets.
In the US Fannie Mae and Freddie Mac, the largest American mortgage institutions, have been nationalised; Lehman Brothers, the fourth largest investment bank, has failed; Merrill Lynch has been sold to Bank of America; and AIG, one of the world’s largest insurance companies, has been kept afloat by a credit line from the Federal Reserve, and the US Treasury has taken an 80% stake in exchange. In the UK our largest mortgage provider, HBOS, is believed to be in merger talks with Lloyds TSB. A few months ago Northern Rock was nationalised.
Why have some institutions been rescued by the US and UK governments, while others have been left to the rigours of the market?
Briefly there appear to be two dominant reasons for government intervention: first, the institution must have such a market position that the authorities cannot risk its possible failure because of potential repercussions in the financial system; second, the company must have extensive exposure among consumers. Thus giant mortgage providers are protected while investment banks dealing predominantly with professional investors are not. In this context it is highly unlikely that Lloyds TSB’s acquisition will be held up by the Competition Commission which, under other circumstances, would have been a certainty.
We do not believe that the financial system is in meltdown, or that capitalism has been seen to fail. We do believe that it was inevitable that after such a long, debt-fuelled, economic expansion a period of de-leveraging was going to occur. This is happening more quickly than one might have expected, but it is in the nature of US commercial practice to act quickly.
The economic impact of this is deflationary. It is also likely that the effect of reviews of banking regulation will be to cause banks to hold more capital. Thus we expect that loan growth will recover slowly and that it will not then grow at the rates of the last decade. In consequence economic growth in the western world will be muted for at least two years.
We have said previously that inflationary stimuli have passed their peak, and we are now very confident of this. Retail inflation rates will fall markedly over the next two years, and the Bank of England will cut interest rates significantly over that time. We should not be surprised if the first cuts occur soon.
In the short term markets will remain volatile, bonds should outperform equities, and anxiety will remain elevated. Ultimately this will be good for market-based economies, and it should present a more soundly based environment for long term equity investing.
17 September 2008