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"It's not over, but it should be OK"

19 September 2007 Investec Asset Management

The world's leading banks this week delivered their quarterly results, outlining the full extent of any damage suffered as a result of the recent credit crisis.  Share prices had mostly factored in the losses (many sometimes a lot more), so the news should not see much more share price downside.
 
The collapse in confidence and subsequent "run on the bank" of Northern Rock in the UK once again illustrated just how sensitive banking is to the "mood" of its clients.  In scenes horribly reminiscent of Saambou a few years back, investors queued outside Northern Rock branches in a desperate attempt to salvage their savings before "The Rock" hit the rocks.
 
What is happening at the moment should not come as an enormous surprise.  Lending in the United States was too easy. Times were too good, consumers were greedy, and egged on by the fact that previously the Fed came to their rescue during troubled times, they took on more debt than they could comfortably digest (the average American household has 11 credit cards!) and the consumption bubble was fuelled.  This is not the first time that interest rates then rose, and obviously those at the tighter end of the lending market would get squeezed first.  
 
This has of course all happened and more.  The "and more" part which was not expected, was the fact that the banks then, unaware of who was exposed to what, and by how much, refused to lend to each other.  Now as a bank, or any lending institution, when your clients want their money back, you have to give it to them.  Generally, they carry just enough cash to cover normal daily withdrawals.  If short, they borrow from other banks, so when the banks stop lending to each other, you have to go to government as an emergency measure, and when word leaks about that, confidence evaporates and people start queuing up, which further exacerbates the situation!
 
As the carnage was about to spread further than Northern Rock, the Bank of England promised to guarantee all deposits.  In addition, the US Fed dropped rates a full 50bps (rather than the expected 25bps) with another 25bps probably on the way before year end.  These were tough decisions for the monetary authorities, who do not want to be seen as bailing out those who took on too much risk.  However, in this case, the desire to maintain financial stability, i.e. avoid a credit crunch has won out.
 
Monetary authorities have made it clear that they will do "what it takes" to head off instability.  Whether it is within their control is a subject of much debate.  There is also the risk that if they reduce rates too much, they will simply re-inflate the bubble pushing a collapse another year or two out.
 
The monetary authorities have won the first two rounds.  It certainly is not over, but so far they seem to have sufficient ammunition to defend where necessary.
 

Jeremy Gardiner, director, Investec Asset Management

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