Debt storm likely to head west and engulf Japan

Debt storm likely to head west and engulf Japan

By Damian Reece, City Editor
Last Updated: 12:10am BST 16/09/2007

The global credit crisis has hit our high streets again. Having seen mortgage rates rise this week, people were left standing in Depression-era queues waiting to get their cash out of Northern Rock, now being shored up by the Bank of England.

Predators circle ailing lender Northern Rock

But the focus of this debt storm rolling round the world’s financial system will shift again next week, this time back to the US. If a UK lender can get into so much trouble, think how bad it is for lenders in America, where the credit crunch has its origins.

Monday sees the start of the third quarter reporting season for US banks. Under strict rules, American banks are required to tot up the value their debt-related investments, a process called marking to market. But most of the markets for these instruments are closed. You can’t get a price for these assets, never mind trade them. These securities have plummeted over July and August, which means banks are sitting on huge losses. That is unless US regulators go easy on them — the sort of moral hazard they seem comfortable with these days.

But even if the most liberal interpretation of the mark to market rules are applied, it’s going to get bloody with all the inevitable consequences for stock markets. Analysts calculate there could be as much as $230bn of losses lurking, waiting to be disclosed, which is more than three times the $70bn a year that experts reckon the banking industry can absorb with any degree of comfort.

With the Fed’s interest rate call on Tuesday, September will be a key month in dictating how much damage this debt storm causes.You can read a more detailed analysis of the key events looming this month written by Tom Stevenson on www.telegraph.co.uk/business. After America, where the debt storm makes landfall next is anyone’s guess, but the likelihood is that it will move west, gathering intensity over the Pacific, with Japan next in line. Rock should have been seeking buyer weeks ago

Inevitably the post mortems have started into the role of the regulators in the Northern Rock bail out. Should the Financial Services Authority (FSA) have encouraged Northern Rock to seek help from the Bank of England sooner? Was the news handled properly? Waiting until the next morning to tell the world what it knew the previous evening exacerbated the problem, which is why some of the “don’t panic” messages were ignored. I don’t believe, having concluded the emergency funding, a TV appearance wasn’t beyond those involved. The whole story is laced with irony.

In the end, the Bank of England did not have to open its cheque book because of vast losses on an exotic hedge fund or a collapsing sub-prime lender, as feared. Northern Rock is the UK’s fifth-largest mortgage provider with high-quality assets. It got into trouble not because of the excessive lending practices that Alistair Darling was warning about in The Daily Telegraph on Thursday but because the assumptions in its previously proven business model no longer held true. That was always a risk and the City of London is lucky enough to operate under a regulatory environment that allows for risk taking.

But the regulator was talking to Northern Rock for weeks about its funding problems which were obvious, high-profile issues detailed in the press. My instinct is a bail-out from the Bank of England should have been organised earlier, to give all parties more time to prepare the announcement. This could then have been handled with more aplomb than the late-night cloak-and-dagger stuff we witnessed on Thursday.

It was a rush job that was entirely avoidable given the weeks of warning that all parties had that Northern Rock was heading for trouble. According to some, the final irony is that Mervyn King’s hawkish stance in avoiding moral hazard by not intervening in the markets might have exacerbated Northern Rock’s position. If he’d been more willing to pump cash into frozen markets then maybe it could have found a market solution to its funding problems. I disagree.

The Fed and the ECB largely failed to ease market rates despite making billions of dollars available. I hope King intervened with the utmost reluctance and I hope he, and the FSA, encourage Northern Rock to find a long-term market solution immediately. This means finding a buyer, something Northern Rock should have been seeking weeks ago rather than its forlorn attempt at staying independent which has cost shareholders dear.

damian.reece@telegraph.co.uk

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