Sub-Prime

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.

In another example of shutting the stable door once the horse has bolted, the US House of Representatives has voted to regulate mortgage brokers and lenders.  Although this Bill is unlikely to find its way past the Senate and the Presidential veto, it gives an insight to those of us in the UK into how the sub-prime crisis came about.  Some Members of Congress are seeking to force a degree of responsibility upon mortgage brokers, requiring them to select a suitable mortgage rather than the one paying the most commission, and upon lenders to take some steps to confirm affordabilty of the loan.

This commonsense proposal would impose some rather belated order, preventing America's poorest being stitched up with truly dreadful loans, which all but guarantee default in many cases after the 'teaser' introductory rate finishes and higher interest payments kick in.  By this time, however, from the lenders point of view, the loan has been securitised and parcelled off by an investment bank to some 'unsuspecting' hedge fund, insulating the lender from the consequences of its actions.

If there is a crumb of comfort for us over here, it is that these lending practices did not cross the pond to any significant degree, at least for mortgages, and the impact on the UK property market may be different.  Also, residential mortgages have been regulated since 2004 in the UK.  None of this inures us from the effects of the global fallout, however, as the international capital markets struggle to quantify the problems and regain stability.

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.