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The credit party’s over, and now it really is time for a genuine dose of prudence

by Russ Mould

The UK banking sector has barely underperformed the All Share index at all in 2008, in spite of liquidity problems that have engulfed one bank – Northern Rock – and unfounded rumours prompting a run on the share price of another – HBOS. It is tempting to think the combination of interest rate cuts, direct intervention in the money markets by the Bank of England, and rights issues are combining to finally restore confidence in both the debt and equity markets.

Royal Bank of Scotland’s £12 billion cash call makes it the biggest UK rights issue of all time. But back in 2001, BT got away with what was then the biggest deal, a £5.9 billion issue, and was able to rebuild from there. Going further back, a host of UK firms tapped the market in 1975 to tremendous effect, helping to re-establish both their financial strength and market confidence after the falls of 1973-74.

Sentiment should be further aided by the Bank of England’s decision to accept illiquid mortgage-backed securities from banks in return for easily tradable treasury bonds. This should ensure that no bank is unable to meet its short-term liabilities; it may even help bring down interbank lending rates once banks feel able to lend to each other again.

Stock market historians will be quick to point out banking stocks tend to recover once a government has intervened directly to resolve a financial crisis. Examples include the US depression of the 1930s, the US Savings & Loan crisis of 1989-90, the Scandinavian real estate banking and real estate crash of 1991-93 and the Japanese debt implosion of the 1990s. That the Japanese government did so little until 1998’s Financial Revitalisation Law, and then finance minister Heizo Takanaka’s further banking reforms of 2002, exacerbated a situation that had started to develop by the time the Nikkei 225 peaked on 31 December, 1989.

But reality may not be so simple. 2008’s circumstances are certainly very different from those of 1975, when Britain’s corporates were burdened by inflation in excess of 20% and price controls.

Then the rights issues were designed in some cases to bolster balance sheets, but in many instances were a mechanism to get around government regulation, which limited dividend increases. Under a loophole in the regulations, firms that raised fresh equity were allowed to hike their payouts faster than the stipulated limit. Thus the stronger companies used the fresh cash they raised to raise dividends in excess of government approved levels, further fuelling what was already a market bull run.

Nor does 2001-2003’s run of issues offer encouragement. Equity markets in the US and UK bottomed in October 2002 and March 2003 respectively, but that was due to a surge in utility, industrial and commodity stocks. The technology and telecom sectors, which raised the fresh cash, have underperformed every year since the bubble burst in 2000, with the exception of 2003.

Neither precedent suggests a quick fix for the credit crunch is available. Statistics from the Council for Mortgage Lenders revealed a 17% drop in gross lending in March, while three-month UK interbank rates still trade nearly 100 basis points over UK base rates, even after a trio of headline rate cuts and a quintet of Bank of England money market interventions.

It should also be remembered the Bank of England governor, Mervyn King, is only allowing banks to swap mortgages signed before the end of last year, and the banks are retaining the risk on their debts, not transferring it. Debt has been a major fuel for the UK’s economic expansion this decade, and since it is likely to be less readily available, and only then more expensively, some degree of economic slowdown seems inevitable.

Patience required

Against such a backcloth it would be a mistake for equity markets to hastily price in a speedy economic recovery, particularly as King has done well to resist government blandishments to kickstart the faltering mortgage market.

To keep housing prices artificially high would be difficult in a free market, and wrong. It would unfairly disadvantage first-time buyers, by keeping them out of the market, and those who wish to move on, by forcing them to take on more debt than is healthy.

The Royal Bank of Scotland’s Sir Fred Goodwin has finally accepted balance sheet repair is vital, and indebted UK consumers should do so too, for both their own and the broader economy’s long-term health. The lessons of excess debt from the US in the 1930s and Japan in the 1990s should not be forgotten, even if a similar bust now is unlikely.

Recessions are neither pleasant nor welcome, but they are part of the natural ebb and flow. The UK economy has grown year-on-year since the second quarter of 1992. Something has to give and to try and buck the system by juicing it with debt merely stores up trouble. Mr King is clearly aware of this as he tries to ensure as soft a landing as possible, without facilitating further wild lending. All of us, chancellor of the exchequer Alastair Darling included, should take heed.