Credit Crunch

Background to Recent Market Events

The last month has seen an episode of financial instability that was, arguably, the most serious since the 1930s.

The Mortgage Market

As well as the much covered effect on investments, the mortgage market has been strangled by the inability to obtain credit, and estate agents in the UK recorded record low sales of only 1 house per month over September. The risks of negative equity (where mortgages are greater than the value of the property) became a reality and mortgage defaults hit record highs. Banks have lost the trust which is a pre-requisite to the efficient functioning of credit markets. Recent measures should help to remedy this situation as the UK government has agreed to provide liquidity to banks on the condition that mortgage lending is returned to 2007 levels. Despite this condition banks are likely to increase constraints on income multiples, and first time buyers or those with a poor credit history may struggle to find finance.

There are also likely to be severe difficulties for those looking to sell houses. Reports of gazundering (where an offer is put on a house and then lowered as completion nears) have increased substantially as buyers take advantage of sellers’ desperation.

What has happened to investment markets?

The table below shows the falls in the world’s major equity markets since June 2007:

Change in Value of Markets (Local Currency)
Equity Market Year to 30/6/2008 (%) 3rd Quarter 2008 (%) 1 to 10 October 2008 (%) Cumulative Change 30/6/2007 to 10/10/2008 (%)
UK (FTSE All-Share Index) -16.1 -13.0 -19.0 -40.9
US (S&P 500) -14.9 -8.9 -22.9 -40.2
Europe (MSCI Europe ex-UK) -25.2 -11.3 -19.9 -46.9
Japan (Nikkei 225) -25.7 -16.5 -26.5 -54.4
Emerging Markets (MSCI Emerging Markets) -0.6 -21.6 -19.7 -37.4

Source: Datastream

The scale of the market falls, since the onset of the ‘credit crisis’ (taken to be mid 2007), is very substantial and represents more of a ‘bear market’ than any other in the post-war years – with the exception of the 1972-74 period (in the UK). What is more, the speed and scale of the market falls in the last weeks are the most extreme since the 1987 market crash, but this recent c20% fall comes on top of substantial weakness over the previous 15 months.


There has been a series of successive news items which has largely driven these falls:

  • 7th September – the US mortgage agencies Freddie Mac and Fannie Mae were effectively nationalised.
  • During the week commencing 15th September, Lehman Brothers was declared bankrupt, Merrill Lynch was taken over by Bank of America, Halifax Bank of Scotland was taken over by Lloyds TSB, and the insurer AIG was put under government control.
  • 19th September – the US authorities announced a plan for the government to spend up to $700 billion (the Paulson Plan) buying mortgage debt and related securities, the decline in value of which had been one of the underlying causes of the crisis.
  • Week commencing 6th October – German and Icelandic banks faced a bail out from their respective governments. The announcement by Angela Merkel, German Chancellor, caused wide-scale falls in equity markets as Germany had been seen as one of the world’s strongest and safest economies.
  • 8th October – Governments and central banks cut interest rates by 0.5% in most major markets and announced plans to provide liquidity and capital support to the banking system.
  • 13th October – the UK government launched a substantial re-capitalisation programme effectively nationalising the UK banking system and providing a total package to banks of approximately £500bn.

Some of the results

  • America’s national debt is now so great that the clock on Times Square erected in 1989 will have to be re-built (the clock allowed for sums of $9 trillion but the Paulson Plan will take national debt to $10 trillion plus i.e. $10,000,000,000,000).
  • Initially the announcement of intent by the US government led to an equity market rally, but the delay in passing legislation to support this plan limited its impact on credit markets and renewed doubts over the stability of the banking system.
  • The International Monetary Fund (IMF) has been active in offering further capital for the beleaguered economic system.
  • These developments are likely to have widespread implications for both the global economy and the structure of financial markets. It is anticipated that these effects are likely to be felt well into the future and are likely to impact the real economy as companies are unable to obtain the loans necessary to keep growing their businesses.

What does it mean for investments?

From an investment perspective the difficulties have manifested themselves across the full range of asset classes:

  • Equity market volatility has been self-evident with positive news flow often failing to manifest in increasing stock prices and negative news impacting valuations significantly.
  • Spreads on Corporate Bonds (loans made by companies to raise money for new projects) have widened due to increased demand and supply constraints.
  • Property prices have exhibited their most significant falls in 20 years.
  • Even cash deposits and money market funds have come under scrutiny with the former receiving much attention from the Financial Services Compensation Scheme.

At the time of writing, financial markets remain exceptionally volatile. In the longer term, many commentators now believe that the US economy will inevitably go into recession and there is a strong likelihood of a similar outcome in the UK. Sharply lower house and asset prices, declining consumer confidence and spending are all pointing to a significant weakening in growth.

The worst case scenario is the risk of an early 1930s ‘depression’ although governments are sufficiently aware of this risk, and should be able to reduce the likelihood of this scenario.

An International Crisis

The impact of globalisation, so often seen as testament to the wonder of capitalism, has meant that this crisis has become an increasingly global phenomenon because of the linkages in the global financial system. The global nature of the crisis has perhaps been most evident in Iceland where supposedly independent banks have filed for bankruptcy and insolvency. Ultimately the internationalisation of the crisis increases the risk of a more systematic failure in economies and represents the largest threat to capitalism because there are some countries where governments are too small to rescue their banks.

So what should I do?

Much of the chaos in recent weeks has been driven by market sentiment. As long as the risk of a systemic failure remains in the minds of investors, fear and illiquidity will drive markets, overlaid by reaction to the authorities’ actions.

There is very little the average person can do now. Commentators in America have induced wide-scale panic through doomsday predictions. However, in reality most people are unable to simply shut up shop and sell their house (especially given market conditions) and only have exposure to investments through their pensions. It is imperative to remember that most investments are there for the long term and taking money out now could be effectively realising a substantial loss. It is doubtful that equity markets and other investments will recover quickly given the probability of recession but studies have shown that even professional investors cannot normally beat the market. Simply put, if you can’t beat them, join them.

What is more important is the action of others and governments in the current situation:

  • The authorities need to demonstrate that they can stave off collapse in the global financial system, and the markets and investors need to regain confidence that such a collapse won’t be allowed to happen, because the authorities have the will and wherewithal to prevent it.
  • Once this first, very difficult, task is achieved, we should then be dealing with “just” a global economic recession. The good news is that the central banks, through a coordinated round of interest rate cuts last week, have demonstrated that the direction of policy has changed from worrying about inflation to focusing on the risks to growth. Interest rate cuts are likely to have to come thick and fast in order to stimulate economic activity effectively. The unknown is the extent to which these expansionary monetary policy moves (and fiscal measures too) will be able to kick-start growth if the banking system is still seeking to de-leverage. Hence the severity and length of the recession is largely unknown as is the timing and vigour of the subsequent recovery.

Stockmarkets are more experienced in coming to terms with recessions, albeit this one could be unlike any seen in recent years.