UK Banking Sector and Housing Market Reverting to Below the Mean
Economics / Credit Crisis 2009 Jan 27, 2009 - 07:31 AM GMTBy: MoneyWeek
Banks have money - they just don't want to give it to most people - The job losses are stacking up across the world. According to The Times , about 70,000 jobs went globally yesterday. Most of the cuts were in the US - construction equipment maker Caterpillar is cutting 20,000 jobs, while mobile phone operator Sprint Nextel is cutting 8,000 posts.
In Britain , steel maker Corus is cutting 2,500 staff, while ING and Philips, both of which have operations in the UK , are cutting thousands of staff worldwide.
If companies aren't making as much money, they have to lay people off. But unfortunately, as more people lose their jobs, the less money there is to go round, and the more bad debts that will build up.
No wonder banks don't want to lend...
Careless lending has left banks very vulnerable
The banking crisis came about because banks had overstretched themselves. They loaned out more money than it was realistically possible for the economy to pay back. That left them very vulnerable when defaults started showing up in the dodgiest loans – the US subprime market .
Lending clammed up. Governments tried to come to the rescue, and are still trying. Interest rates have been slashed, money is being printed, and central banks are crossing their fingers and praying for inflation to magic all the bad borrowing away.
But all that careless lending led to careless investment too. Businesses and jobs were created that relied entirely on the continued existence of large quantities of borrowed money to fund them. Now those companies and jobs are disappearing along with the borrowed money.
Banks are becoming choosy about who they're lending to
So while the recession may have kicked off with the banking crisis, it's now taken on a life of its own and moved into the next phase. I've heard quite a bit of anecdotal evidence that the idea that banks aren't willing to lend isn't strictly true. People with successful businesses who don't need the money are apparently being pestered to take loans. And if you look at the mortgage market , you can get lower rates than ever before – as long as you have a big chunk of equity in your house.
It's more accurate to say that banks don't want to lend money to as many companies or individuals as they used to, because suddenly the outlook for those businesses (and home buyers) is pretty bleak. In other words, banks are doing exactly what they always do in recessions.
Would you lend money to an estate agency today? Or a theme restaurant? Or a florist, say? I doubt it. All of these businesses rely on a forgiving economic environment where people are willing to spend. But people are not willing to spend – in large part because they're worried about the future.
Here's what banks do. They borrow money at one rate, then lend it at another. The rate they lend at needs to be higher than the rate they borrow at, or else they don't make any money. And the people they lend to need to be able to pay them back, or else they don't make any money.
In a world where everyone is lending money to anyone, you can't charge very much for loans, even to people who would normally be seen as poor credit risks, because there's always someone round the corner willing to undercut you.
But when there's less competition, you can raise your prices, and you can be more picky about who you lend to. And that's what's happening now.
Property pundits in particular are describing the banks as “mean” and blaming them for the drop-off in property prices. But banks are only to blame in so much as they allowed so much careless lending in the first place. Property prices only rose as far as they did because credit conditions were ridiculously lax. What's happening now is a ‘reversion to the mean' – we're returning to normality after an abnormal period of rampant credit growth.
Why you should still avoid buying bank stocks
The trouble is that just as things tend to overshoot when everyone gets too greedy, they also undershoot when the greed turns to fear. So in terms of house prices, economic growth, and unemployment, we're looking at things getting a lot worse before they start to get better.
This partly explains the whole scepticism towards banks at the moment. Some of them might be OK for now. But if you don't know just how much worse things are going to get, it's impossible to predict how much damage is still to be inflicted on their balance sheets. That's why I'd keep avoiding the banking sector for the time being – despite the more than 70% rebound in Barclays' ( LON:BARC ) share price yesterday.
By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .
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