The credit crunch: why there's far worse to come

By Associate Editor David Stevenson Aug 14, 2008

David Stevenson
Oppenheimer analyst Meredith Whitney

"The moment of the greatest stress in the markets is behind us – and that was the large liquidity crunch. The steps taken by the Bank of England, the US Federal Reserve and the European Central Bank have significantly alleviated the risks. Confidence in the system is returning."

So said John Varley, Barclays' chief executive, last week. He's just the latest banking grandee to tell us that the worst of the credit crunch is over. Yet while he probably won't be the last, sadly this looks like the latest bank statement to get it more than slightly wrong.

Don't just take my word for it. In the US, the Federal Reserve has just unveiled its latest insight on what's happening with American borrowers right now. And it's completely different to the boss of Barclays.

The Senior Loan Officer Opinion Survey on Bank Lending Practices is one of the more obscure economic indicators, but it's one of the most useful.

Every three months, the Fed basically sends its minions out to find out how hard or easy it is to borrow money at a broad range of banks, for various purposes, from corporate loans to consumer credit cards.

And the report won't make happy reading for Mr. Varley. It suggests that the "impact of the credit crunch is still intensifying", says Capital Economics, "and has become even more broad based. Banks intend to tighten lending criteria further in the third quarter for nearly every conceivable type of loan, as what started initially as a squeeze on mortgage lending is now affecting all forms of borrowing."

Doesn't sound like the worst is over, does it? But let's not just take the Fed at face value. Oppenheimer's star bank researcher Meredith Whitney was the first analyst to ring the bell on subprime, back in October 2005. Then, she warned there'd be "unprecedented credit losses" for subprime lenders.

Last year, she warned that the "incestuous" relationship between the banks and credit-rating agencies during the property bubble will hamper those banks' ability to recover for a long while. That's a pretty good track record, unlike the banks' supposed hot shots.

And last week she told Fortune magazine some more. In fact, she was even more bearish than before. Ms Whitney is currently fretting that banks aren't slashing costs and cutting loan portfolio losses fast enough, and in particular that lenders need to "get real" about their mortgage-related debt valuations. OK, Merrill Lynch may have bitten the bullet, recently selling a large chunk of toxic mortgage debt for just 22 cents on the dollar, but the other banks need to join the party.

"I don't think we're near the end of write-downs," Ms Whitney tells Fortune, "so I continue to see capital levels going lower, capital raises diluting existing shares further, and stocks going lower." She was slashing her bank profit estimates again this week.

In other words, banks will be writing off much more money and scrabbling about grabbing as much cash as possible to stay afloat, let alone increasing their lending. Sounds similar to the Fed.

Talking of good track records, you would certainly be hard pressed to find a better recent history amongst bond fund managers than Pimco, who correctly called the 'crunch' about a year ago. So - after so much financial suffering, does co-chief investment officer Mohammed El-Erian see the end in sight?

Well, no. "Given the outlook for a further decline in house prices, there's simply not enough cash on the sidelines willing to absorb banks' asset sales and provide the necessary new capital. Valuations will have to go even lower", he said in last week's FT. Again, that doesn't sound like the credit crunch is anywhere near over.

For a final shot, cue Richard Bernstein, chief investment strategist at Merrill Lynch – a firm that should know after all those debt hits. The credit crisis is "broad, deep, and global" and "far from over" for financial firms, despite $500bn so far being written off, he told Bloomberg yesterday, as "investors are significantly underestimating both the scope and the extent of the credit bubble and the impact of its subsequent deflation. The problems aren't confined to large institutions that are overexposed to US subprime loans."

Couldn't be clearer. Yet it's tempting to dismiss all this depression from the States as exactly that, i.e. something that won't do too much damage on this side of the pond. Unfortunately, that isn't likely to be the way it plays out. We've already seen how US subprime has spread around the world. If US banks still have a long way to go before they can become financially secure again, and able to lend again, then the same will inevitably apply to lenders here in Britain.

If Mr Varley really believes the crunch is past its worst, he's got a few more nasty shocks on the way. As Capital Economics tells it: "12 months into the credit crunch, the worst still lies ahead".

Published in Economics | More articles by David Stevenson

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