Crisis

It is quite possible that we shall look back on the current credit crunch as the moment when the USA’s dominance in the world’s capital markets finally ended.

The biggest financial institutions in the world have spent the last few years busily taking on a great deal more risk than they understood in the pursuit of profits.  There is nothing wrong with a company making profits, that is why they exist, but many years of profits are being wiped out in one fell swoop.  It is safe to say that most shareholders would have foregone some of the profits of the past in order to preserve more of their capital value, had they but known.  Only, they could not have known because the finest minds available to the likes of Citi Group and Merrill Lynch at incredible cost did not know that their money-making schemes were so fundamentally flawed.

Of course, had these banks adopted a more cautious approach, their executives would have been pilloried and then sacked or the bank would have fallen prey to a takeover, such are the demands of shareholders.  We sow what we reap.

Now, these great institutions, and others, have had to go cap in hand to China and the Middle East for capital.  When the dust has settled, much of the intellectual capital within these firms will partly belong to their fiercest rivals, sold on the cheap.  Oh, how the mighty have fallen.

From here in Perth, capital of Western Australia, where I am visiting, the residential property boom looks somewhat different from the one we have experienced over the last ten years in most of the UK.  In the UK, we have become accustomed to explaining away the furious rise in the prices of homes in terms of supply and demand, i.e., there is insufficient supply to satisfy the demand, which is rising.  There is plenty of land, it is just that we will not let anyone build on the bits of it which are sited where people want to live.  We have surrounded our cities with greenbelt, and very nice it is too, but it does nothing to alleviate the lack of supply.  That lack of supply when coupled with a seemingly limitless supply of easy credit, secured against ever rising prices, has fuelled a tremendous boom.  Now that one of those elements may have been removed as the credit crunch takes hold, it may be that the market will grind to a halt.  The fact that supply is inflexible makes the residential property market inefficient, amplifying the boom and bust cycle.

In WA, some things are similar; the economy is booming creating a surge in demand and mortgages are relatively easy to obtain.  The residential property market in WA, and probably most of Australia, is dominated by new homes.  Not for Aussies the problems and expense of living in a home built for the needs of a different century.  Also, WA is hardly short of land; an area the size of Western Europe accommodates just two million people, mainly around Perth, which is growing at a frightening pace.  Of course, some suburbs trade at a premium as the rich prefer to congregate together but bulldozers carve out new land for building every year.  Want a home?  There is a plot ready and waiting for you to build upon.  This ever increasing urban sprawl brings with it other problems but short of land they are not.  Those hoping for a home in WA may have to wait up to two years for a builder to get around to them, though.

So why have house prices in WA and the rest of Australia been booming much like the UK (and the US, amongst others)?  I put it down to confidence in the economy and easy credit.  It does not really matter what you pay for your home so long as you believe that someone will buy it off you for more (the greater fool syndrome) and the borrowing is cheap and expected to remain so.  No one cares that they are paying twice as much for their home as they would have done ten years ago so long as it doubles in value over the next ten years.  Thus do asset prices lose any connection with the fundamentals.  What’s more, the more they go up, the happier we feel.  Warren Buffett has spoken rather disparagingly of those buyers who wish up the price of investments and it does seem a little irrational to draw comfort from the fact that you will have to pay a great deal more for your next purchase.

Whilst we were in the throes of the boom, here, as in the UK, those who should know better explain things away as being different this time.  If, as seems increasingly likely, this boom derails next year, the same commentators and economists will be telling us how it was all so blindingly obvious that it was going to end in tears.  We wait with bated breath.

It really is the time for a few well worn clichés, the world's stock markets are having a real roller coaster ride, at the moment.  It is by no means unusual but they seem to be taking their cue from the US and the sentiment over there is all over the place.  No one is quite sure how big a problem the sub-prime crisis is going to be but it starts at huge and goes up to cataclysmic.

The big worry, assuming that the financial system does not implode, is whether the US will slide into recession.  The government, in the form of the Federal Reserve Bank, is pumping vast quantities of cash into the system in the hope that it can prevent it seizing up.  In this, they are being strongly supported by the European Central Bank.

The financial system has shown itself to be remarkably resilient in the past in the face of some very worrying events but, for many investors, this is probably a time to switch off the computer and not look at values for a year or so on the basis that investment portfolios are for life, not just for Christmas.

It is all getting a little hairy in the markets at the moment; all major markets posted significant falls yesterday and the news may not be much better today.  Are we witnessing (or, for those of us with investments, experiencing) the final act in the credit crunch tragedy or merely another scene?  Also, what course of action should a rational investor take?

No one can be sure where this crisis is heading; quite a few problems have been brought to the fore but there may be more to come.  It is almost laughable now that, only a matter of weeks ago, our august politicians were focused on the rate of tax paid by Private Equity to the extent that they restructured our entire tax system in an attempt to penalise them.  Meanwhile, in the real world, things were going pear shaped.

Poorly diversified investors may have the least comfortable experience, particularly those poor private investors who held significant chunks of Northern Rock stock for no real reason.  Also, those with too large a proportion of equities may find themselves ruing their lack of investment spread and property looks set for a difficult period.

What is holding up?  Well, the bond markets, unloved of late, may find themselves viewed more favourably (especially government and high quality) and commodities may continue their climb.  But it seems, oddly enough, that emerging markets may emerge (pardon the pun) the real winners from this period of instability.  A year or so from now, they may look quite grown up, while some of the racier classes of investment, such as private equity, may look a little discredited (another pun?).

As ever, the advice to any investor is to ensure that you are properly diversified.  Do not get drawn into this year's must have (or have not) sector and only invest if you have a long term outlook.

The hunt for more scalps over the Northern Rock fiasco rumbles on in Parliament.  The most recent visitors to the dock have been the ratings agencies, who have found themselves widely vilified for their role, real or apparent, in the credit crisis globally and the small matter of a run on a bank here in the UK.

The ratings agencies, of which there are three major players, credit score companies and other institutions who are looking to borrow money in the capital markets.  There has long been a concern over the potential conflict of interest which arises because the borrower pays for their own rating, the concern being that they may shop around to get a higher rating.  Also, the agencies may be reluctant to downgrade the debt in future as it may put off future customers.

So, the ratings agencies have a fine line to walk and it cannot help having governments the world over queuing up to give you a duffing over (the US has already had a go) but it is a lucrative business and, effectively, a closed shop so they don't have to fend off too much competition.  Also, whilst there are concerns, an obvious solution does not seem to be presenting itself so, although we can expect a period of circumspection (probably when least needed), I imagine it will be business as usual pretty soon.

With Wall Street banks set to lose Half a Billion Dollars between them, according to the BBC, could the world be set for very rocky times.  If nothing else, individuals and corporations will find it quite a bit harder to borrow than before.

Companies could be caught in a bear hug; their costs, in the shape of credit and ever rising commodity prices, are being pushed up and consumers are running for cover.  We are entering uncharted waters here and Central Banks (so long the heroes) are undecided on how to react.  The US Federal Reserve has cut rates aggressivley but the European Central Bank faces inflationary pressures and a two speed economy in the Eurozone.  The Bank of England, still smarting from a couple of humiliations this year, feels the need to look resolute and may find it hard to cut rates quickly, even if needed.

It may get quite a bit worse before it improves.

Will our house prices go the way of those in the US, i.e., downward?  Well,  our American friends were until recently busy building houses at the rate of 2million a year, which is a pretty astonishing rate of activity compared to us in the UK, where we build about 200,000.  Given that their population is about five times ours, that means they are building twice as many new homes per head of population than we are.  It would seem, therefore, that their supply of property is better than ours.  Here, it is difficult for young professionals with good jobs to buy a home, let alone the much discussed sub-prime sector.  In the parts of the UK were people most want to live, the South East, mainly, there just are not the numbers of homes being built.  Other places, such as Liverpool and Manchester may find the market in a slightly weaker state over the coming couple of years but there seems to be no reason for too much gloom amongst those who have a home.

Here, there seems to have been much less of the sub-prime lending that is causing so many ructions in the markets at the moment, so, perhaps we shall avoid most of the dislocating problems associated with widespread repossessions.

Of course, if you do not have a home, a crash is exactly what you may need to be able to afford a place.  The trouble with property is that people do not flood the market with cheaper places when prices are under pressure, for the mos part, they stay put until they can sell it at a price with which they are happy.  Developers, also, may just sit tight and wait for better times, except for those who have over built.   

Things may get sluggish here but a crash in the places were some need it most seems highly unlikely.  Even in the early nineties, prices did not fall except were there was a distressed borrower and back then we had a recession and very much higher interest rates to spice things up.

Certainly, parts of the States are seeing some more 'realistic' pricing and some borrowers will struggle with affording their mortgage but interest rates have come down a fair bit over there and this may ward off the worst that could have happened.

Still, expect to see many more headlines of the scary sort in months to come even if there is no good news for would be first time buyers.

It seems that the hapless executives at Northern Rock have upset the MPs on the Treasury Select Committee.  It seems that despite pay packets running into seven figures, they did not feel they could be held responsible for the fix the bank got into and they should keep their jobs.  Not surprisingly, this did not impress the committee investigating the first run on a British bank since the nineteenth century which heaped embarrassment on one of the world's leading finance economies.

In fact, it seems that Northern Rock fell over at the first sign of a crisis and, to most people, that would signal problems with its business model and failings at every management level to anticipate anything other than plain sailing in the credit markets.

Anyway, having managed to hoodwink the regulators, Northern Rock's Chief Executive, Adam Applegarth, seems not to have found such an impressionable bunch in the House of Commons.  That said, the MPs have the distinct benefit of hindsight and are prone to a degree of headline grabbing over reaction.

Once Northern Rock has been taken over, I would be surprised if the new owners decided that it would be in their interests to retain the current management.  I suspect that this saga will run for a while yet.