"It seems like the world is going under," said Mattias Westman of Prosperity Capital Management. America's S&P 500 index fell by 8.8% on Monday after Congress unexpectedly rejected the $700bn bail-out plan for US banks. Money markets remained gummed up early this week, threatening the supply of credit to economies even as central banks pumped yet more liquidity into the system. The interbank wholesale money market is not working, says Padhraic Garvey of ING bank. Three-month interbank loans in Europe climbed to a record as the banking crisis spread to the eurozone.
The pan-European DJ Stoxx 600 index plunged to January 2005 levels: not long after European politicians suggested there was no need for a Paulson-style bail-out in Europe, they are rushing around propping up banks across the continent. The governments of Belgium, Luxembourg and the Netherlands agreed an €11.2bn bail-out of banking and insurance group Fortis, one of the largest retail banks across the three countries, and took a 49% stake in the subsidiaries in their country. The shares had slumped amid losses on mortgage-backed securities and the acquisition of part of ABN Amro, which had stretched its balance sheet.
Hypo Real Estate Holding, a big German commercial property lender, received a €35bn lifeline from the government and private banks; seized-up capital markets also led to the partial nationalisation of Iceland's Glitnir. The Belgian-French local-government financing specialist Dexia's shares tanked after analysts said it would need a capital injection. Much of this will now be delivered by the Belgian and French governments. The money markets are frozen as banks don't trust each other, equity investors don't trust banks that look weak, and cash holders are taking no chances with commercial paper (short-term bank debt), says Edward Hadas on Breakingviews.com. "The mistrust is self-fulfilling, as banks without funding fall into spirals of terminal decline."
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There is plenty of scope for more misery in the European banking sector. Citigroup notes that many European banks have sizeable exposure to likely losses in the US as well as high credit-growth countries in eastern Europe. Indeed, according to a recent IMF estimate, European banks' aggregate exposure to US subprime mortgages is 73% as big as that of US banks. Moreover, in 2005-06, European banks as a whole had lower profits and interest margins than their US counterparts, but they have built greater leverage, says Citi. The average ratio of total assets to equity for the 12 biggest European banks is 35, compared with under 20 for the biggest US banks, notes The Wall Street Journal. Greater leverage means losses erode capital rapidly and hardly helps boost confidence when interbank markets are frozen, because banks mistrust each other.
The housing bubbles in Spain, Ireland and France have now burst, while corporate debt levels in Europe have risen sharply in recent years, notes Citigroup. In the second quarter of this year, 78% of credit ratings changes for European issuers were downgrades, the worst quarter since early 2003. High corporate debt also bodes ill for jobs and investment as firms retrench. As the economy slides, then, new arrears and defaults look set to "blow a hole" in balance sheets, as Sean O' Grady puts it in The Independent, leading to a further tightening of credit.
The latest macroeconomic data for the eurozone the economic confidence index is at a seven-year low suggest a recession may already have begun, notes The Economist. Despite all this, however, analysts still expect 12% earnings growth next year, so there is still scope for disappointment as earnings and the economy slide. As Andy Lynch of Schroder Investment management says, "there's more pain to come".
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