The American government’s dramatic intervention in the financial crisis last week averted meltdown, but a return to normal is still a long way off.
Financial markets calmed down after news broke of the US Treasury’s plan for a $700 billion fund to buy up banks’ doubtful mortgages, causing share prices to recover sharply worldwide.
The previous week saw the most dramatic series of events since the 1970s. The failure of bankers Lehman, followed by the rescue of insurers AIG with a $85 billion loan, prompted a huge outbreak of panic.
The question people asked was: If the world’s largest insurers could go bust, who couldn’t? Bank shares came under huge pressure from short sellers, forcing Halifax-Bank of Scotland - whose shares hit a low of 86p, under a tenth of their level 18 months ago – into a takeover by Lloyds TSB. Merrill Lynch agreed to be taken over by over by US banking giant Citigroup. Rumours swirled about possible failures of other banks.
So the US government’s bold decision to launch a fund to swallow up all the American banks’ dodgy mortgage debts gave the markets the respite they needed and shares in London and New York registered big gains last Friday. Thanks to a ban on the practice of short selling in financial stocks, prices of bank shares rocketed by as much as 40% in one day.
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Is $700 billion enough?
So doomsday has been deferred. But is this really the end of the crisis? Maybe not. The proposed $700 billion fund will, it seems, have powers to buy up any variety of financial instrument, not just mortgages, suggesting that the US authorities foresee that it will have to sort out the chaotic mess of Credit Default Swaps (CDS). The multi-billion interconnected web of liabilities involving these complex derivatives still has the potential to destabilize insurers and banks in Europe as well as the US.
What will happen next is that the new US fund will strong-arm the banks into offloading all their dubious mortgages at low prices. The banks will get cash in exchange, so even though selling off their loans will penalize them financially, it will remove fears of further losses and enable them to return to business-as-usual. Investors will not have to fear any more skeletons emerging from cupboards, and may even decide that some bank shares look good value.
Already some are calling for the UK to follow the Americans’ lead and set up a Treasury-backed fund to buy up the UK banks’ dodgy loans. This may not be necessary, because the Bank of England already has a Special Liquidity Scheme that enables banks to borrow against mortgages. And thanks to the fact that they raised lots of cash from issuing new shares last year, the UK banks have enough capital to withstand far bigger losses on mortgages than they incurred in the last property crash in 1989-91.
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Credit problems will persist
So it could be that the worst of the mortgage-related problems are over for the financial sector – assuming that house prices don’t melt down here or in the US. Worryingly, some economists still say US house prices could fall another 20%, even though they are already almost 25% down from peak levels. Some UK economists like Roger Bootle also predict overall house price falls of 30% here. They are, though, in a minority - most expect US house prices to stabilize around current levels and UK prices to level off after falling another 10% or so. This may sound bad, but for long-term homeowners these theoretical changes in value are largely irrelevant. And most agree that only a much bigger rise in unemployment than looks at all likely would be required to send house prices through the floor.
But residential mortgage finance is only part of the financial crisis. All over the world, there are still thousands of banks and companies that lent or borrowed too much during the credit boom, need to refinance and won’t be able to. The Russian mini-crash last week showed that even a country with vast foreign exchange reserves, a giant government financial surplus and enormous natural resources can still have a stock market collapse and banks going under - simply because when trust evaporates, cash is hoarded and those who desperately need it but can’t get it go bust.
So the crisis will roll on for many more months, and we will likely see a good few small European banks and other financial institutions fail. And the process of ‘deleveraging’ - removing excess credit from the system – will probably take years to complete. For a long while to come, credit of all kinds - mortgages, personal loans, finance for private businesses, even trade finance - will be more expensive and harder to come by.
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Too soon for rainbows
The good news is that with inflation likely to peak soon, interest rates will fall next year. And the continued economic growth of China, India and other emerging countries means the world as a whole is very unlikely to enter a recessionary phase as it has done in the past.
So the most likely scenario is a few years of slower-than-normal growth in real disposable incomes in the Western economies at the same time as incomes continue to grow fast in the emerging economies. That means old-fashioned exports are likely to grow quickly, and in the UK, the drop in the value of sterling means export-oriented businesses should do well over the next few years.
But whichever way you look at it, the outlook for the public finances isn’t good, and whichever party forms the next government, spending cuts and shrinking the size of the public sector are going to be necessary.
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Time for old-fashioned values
So a happy-go-lucky, buy now-pay later era has ended. For the next few years at least, I advocate a return to more old-fashioned values:
• get a secure job even if it pays less
• don’t borrow heavily and pay off consumer debt as fast as you can
• put money aside each month both in cash deposits and long-term savings plans
• buy insurance against unemployment or ill health
• budget sensibly and eliminate as much extravagant spending as you can
We’ve been though a long period of steadily rising incomes and living standards, which is why the current adjustment is going to be painful. But it still won’t be nearly as nasty as the recessions of the 1990s, 1980s or 1970s. And in a few years’ time, the Western economies are likely to pick up speed again as the emerging markets power ahead.
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