Article

ANOTHER VICTIM OF THE CRUNCH
- September 2008

By Frances Kemp - (Knowlden Titlow Financial Services Ltd)

Address: 36 Unthank Road, Norwich, Norfolk, NR2 2RB
Tel: 01603 661156
Fax: 01603 614956
E-mail: frances.kemp@ktfinancial.co.uk
Visit our Web Site: www.ktfinancial.co.uk

The shockwaves from the collapse of the US sub-prime mortgage market continue to reverberate around the world and have now claimed a further two high-profile victims. In a single September weekend, Merrill Lynch was unexpectedly taken over by Bank of America, while beleaguered Lehman Brothers shocked the financial community by filing for Chapter 11 bankruptcy protection after talks with potential buyers broke down. Interested parties had included Barclays and Bank of America, but both walked away when the US Treasury refused to underwrite the deal.

Unsurprisingly, investor sentiment has been sent reeling by news of the collapse, and share prices dropped sharply. It could take some time for financial institutions to determine the extent of their exposure to Lehman, and this uncertainty will further undermine confidence. Nevertheless, the Bank of England and the European Central Bank moved swiftly to boost investor confidence by pumping billions of pounds into the financial system, while the US Federal Reserve relaxed the terms of its emergency lending scheme.

The fallout from the credit crunch is now reshaping the face of Wall Street. Three of the top five American investment banks – Bear Stearns, Merrill Lynch and Lehman Brothers – have all succumbed; meanwhile, leading US insurer AIG is now 80% owned by the Federal Reserve as they funded an US$85 billion loan to bail the company out. Investors’ nerves, already stretched, are likely to remain firmly on edge for the time being.

Freddie and Fannie
Stressed investors were briefly heartened by the news that ailing US mortgage giants Fannie Mae and Freddie Mac have been rescued by the US government. Both firms have been placed in a "conservatorship", whereby the US Treasury will underwrite their debts, introduce new management and provide funds to strengthen their businesses. The US Congressional Budget Office estimated the likely cost to the American taxpayer will be in the region of US$25 billion (as at 22 July 08).

Freddie Mac and Fannie Mae are shareholder-owned companies that provide funding for the US housing market, underwriting approximately half the multi-trillion-dollar value of US mortgages. The two organisations are instrumental in keeping the US mortgage market moving, providing the connection between lenders and investors, ensuring a plentiful supply of money.

As underwriters, Fannie and Freddie are obliged to pay out whenever a homeowner defaults, and both companies have therefore sustained heavy losses amid the flurry of defaults and repossessions. Had they been allowed to collapse, it would have undermined the government’s credibility, paralysing the US property and mortgage markets, spiralling the US economy further into recession and dealing a knockout blow to investor confidence around the world. Their survival, however, should provide vital ongoing support to the US housing market.

Q: Why is making...
…a decision on interest rates so difficult?

A: In January, Mervyn King, Governor of the Bank of England, warned 2008 could be a tough year for the UK economy. He forecast a slowdown as consumers tighten their belts and reduce spending. This fuelled expectations of an interest rate cut. However, fuel prices and energy bills are high and King predicted “a period of above-target inflation”. This leaves the Bank caught between a rock and hard place. If rates are eased further, it could fuel inflation – but if rates stay on hold, this risks suppressing the prospects for economic growth.