How the US banking crisis will strangle the mortgage market

The US government may have deemed Fannie and Freddie too big to fail, but as far as the rest of the banking system goes, it's every man for himself. And there are plenty more banks that won't be so lucky.

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Why Mervyn King deserves a bigger pay rise

US mortgage giants Fannie Mae and Freddie Mac have been deemed too big to fail.

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But investors are only too aware that not every bank or lender is in the same lucky position. The Federal Reserve didn't step in to save IndyMac, a Californian lender which was taken over by the Federal Deposit Insurance Corporation (roughly the equivalent of our Financial Services Compensation Scheme) at the end of last week.

That's focused attention on which regional bank could be next to fail, which in turn sent US banking stocks tumbling yesterday. But don't let the name 'regional banks' fool you. We're talking about some of the biggest banks in the US.

The reality is that regardless of how much money the US government pumps into Freddie and Fannie, the US financial system is in big trouble - and the sooner they face up to it, the better

Not all banks are as lucky as Fannie Mae and Freddie Mac

The US government has shown that Fannie Mae and Freddie Mac are definitely too big to fail. They'll do whatever they can to prop up the mechanisms that keep the US mortgage market going.

However, it's every man for themselves when it comes to the rest of the banking system. Californian lender IndyMac, which collapsed on Friday, was one of the biggest banks to ever go under in US history. It could, says the FT, end up being the most costly to clear up as well. The FDIC might have to shell out from $4bn to $8bn of the $53bn it has set aside to compensate depositors. That's a lot of money to be shelling out at the start of a crisis which is very likely to claim more banks.

The bank went under after depositors pulled out $1.3bn "in a matter of days", according to regulators. The timing was partly down to one Senator Charles Schumer warning the FDIC that IndyMac was in trouble that triggered the run. But the real problem was that IndyMac was heavily into Alt-A lending. Alt-A are basically self-certification mortgages. They're not deemed sub-prime, but because you're relying on the honesty of the applicant, they might as well be. As bad debts soared and house prices plunged, it was only a matter of time before IndyMac ran into trouble.

The good news is that the US is better set up for banking collapses than we are. After all, more than 1,000 institutions failed during the Savings & Loan crisis of the late 1980s and 1990s. According to the FT there are nowhere near that many banks in that kind of trouble just now but then, it's early days yet.

What all this means for the US housing market

The real problem is the impact that all of this is going to have on the US housing market. As the FT says, "With US banks licking their wounds [Fannie and Freddie] are critical providers of new credit." But it's hard to see how they can do this, given that the main aim for these two should now be to improve the state of their balance sheets, "reducing the US government's role in supporting the housing market." The way to heal their balance sheets is to cut back on taking on more liabilities, not keep providing cash for fresh mortgages.

In the meantime, as Lex puts it, "housing markets will suffocate for lack of the oxygen that is credit", while "financial assets will continue to sag for want of any real appetite for risk."

Meanwhile, in the UK, the markets were too excited by a fresh bout of takeover fever to worry too much about regional American banks. Alliance & Leicester agreed a bid from Abbey owner, Spain's Banco Santander (you can read my colleague David Stevenson's take on this here: Why A&L holders should cash in on the bid), sending other banking stocks up in a display of wishful thinking.

But any relief will be temporary. Our housing market is going the way of America's fast. The Royal Institution of Chartered Surveyors reported that in June the number of surveyors seeing prices fall slipped back a little bit. The balance reporting falling prices was 88% compared to 92% in May.

Don't break out the champagne yet though. The ratio of completed sales to stocks of unsold property fell from 19.4% in May to 18.2%. In other words, sales are falling while stocks are rising. So much for demand outstripping supply.

But even as house prices keep falling and people become more and more worried about recession, pressure to keep interest rates right where they are keeps building. Producer price inflation (the prices charged by manufacturers) hit double-digits for the first time in more than 20 years in June. The cost of goods leaving factories was up 10% year-on-year in June, from 9.3% growth in May.

And we hear this morning that consumer price inflation has clocked in at 3.8% for June. That's some way above the 2% target, and also above the letter-writing threshold of 3%.

Why Mervyn King deserves a bigger pay rise

Who'd want to be Bank of England governor now? Mervyn King could certainly be forgiven for wanting a hefty pay rise to continue with the job. But in a depressingly rare display of integrity from a public figure, Mr King has in fact knocked back a 30%-odd pay rise of £100,000 for himself this year. The salary hike (which comes as he starts his second five-year term as governor) was recommended by an external review panel, so he could easily have hidden behind that and taken the rise. But instead he took an increase of just 2.5% on his 2007/08 salary of £289,551.

Sure, he's not exactly in the poor house, but it's refreshing to see an authority figure actually trying to set an example by his actions. He clearly feels that he can't tell people to exercise restraint in negotiating their pay, while not doing so himself.

Good on him. Those bloated, snout-in-the-trough MPs, who recently voted against all public opinion and common sense to keep their 'John Lewis' list and easily-fiddled system of expenses and allowances, would do well to take note.

Turning to the wider markets

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UK shares bounced off a 2.5 year low as the FTSE 100 index recovered 39 points in a 0.7% pick-up to 5300. News that Alliance & Leicester, up 53% on the day, had agreed a £1.3bn takeover bid with Spanish banking giant Santander helped the mood, as fellow lender Bradford & Bingley gained 12% and Lloyds TSB 2.5%, though RBS lost 1.5% on concern it might pull out of the sale of its insurance arm. Media stocks were also in the limelight, with ITV soaring 12% on hopes that Endemol would bid. Yell surged 15%, but Thomson Reuters fell 3% to a 16-month low on City slowdown fears.

European markets also rallied, with the German Xetra Dax up 0.8% to 6,200 and the French CAC 40 adding 1% to 4,143.

But despite the Fannie and Freddie bailout, US stocks declined overnight, with regional banks taking a hammering. The Dow Jones Industrial Average shed 45 points, 0.4%, to 11,055, while the wider S&P 500 slid 0.9% to 1,228. The tech-heavy Nasdaq Composite fared even worse with a 1.2% drop to 2,213.

Overnight the Japanese market had a tough time, with the Nikkei 225 down 256 points to 12,755, while in Hong Kong the Hang Seng slumped over 4% to 21,092.

Brent spot was trading this morning at $144, while spot gold was at $975. Silver was trading at $19.15 and Platinum was at $2014.

In the forex markets this morning, sterling was trading against the US dollar at 2.0017 and against the euro at 1.2539. The dollar was trading at 0.6265 against the euro and 105.59 against the Japanese yen.

And this morning, fashion group Burberry has reported a 22% rise in sales for its fiscal first quarter, boosted by luxury goods sales and new store openings. Sales rose to £211m in the three months to June, from £167m the year before, beating analysts' forecasts.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.