The credit crunch returns with a vengeance

For a moment there, it seemed as though everyone had forgotten about the credit crunch. But then a broker downgrade for banking giant Citigroup sent markets into a full-blown panic yesterday.

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: Sign up for Money Morning

Remember the credit crunch?

I only ask, because for a moment there, it seemed like everyone had forgotten about it. Stocks were soaring, and investors were even getting excited about the financial sector again, in the vain belief that investment banks had "kitchen sinked" their results - getting all the bad news out in the open.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But Merrill Lynch's results last week rattled Wall Street, with the bank announcing a $7.9bn write-down for the third quarter, far larger than expected.

And now that fear has turned into full-blown panic as the Street has realised that maybe the other banks are still storing up little nasties for this quarter

The panic was partly driven by a broker note on Citigroup. Meredith Whitney at CIBC questioned the strength of the group's balance sheet, leading to worries that the bank may have to cut its dividend to shore up its capital ratios.

Meanwhile, the analysts at Merrill Lynch were getting stuck into rival UBS, arguing that it would have to make an additional $8bn write-down this quarter.

On top of this, in Europe, little progress has been seen since the credit crisis began, according to Standard & Poor's. The pipeline of leveraged loan deals waiting to be sold onto the credit markets has shrunk to 75bn euros, from - wait for it - 76bn euros when the crisis began in August.

Many commentators have compared this blockage in the credit markets to a cow moving through a python. But frankly, it looks like the python's constipated.

And as the stock markets were diving, oil managed to poke its head above the $96 a barrel mark, while sterling climbed to more than $2.08 on the dollar.

Why the sudden fear that it's not all over? Well, the critical problem is that despite all the write-downs, still no one really knows what all this mortgage-backed debt is worth. All anyone really knows is that as the uncertainty spreads, and credit tightens, and the US housing market continues to deteriorate, the outlook for the value of mortgage-backed debt is only getting worse.

Peter Warburton of Halkin Services sent out an interesting graph yesterday. It shows an index tracking the price of the most senior tranche (the best quality) of mortgage-backed debt, which launched with a value of 100 in January this year. "Despite the outbreak of subprime mortgage problems in February, this tranche was thought to be impervious."

The graph shows that the index stayed level at 100, until mid-July, when it slid to below 90, around the credit crunch. It picked up again to around 95, and stayed there for most of September, but in late-October, has fallen off a cliff, to less than 80, after Standard & Poor's and Moody's downgraded thousands of these securities.

Why's this? Well, when Merrill Lynch wrote down its "AAA-rated super-senior exposures" - among the safest' such debt - by an average of 29%, it made people realise that maybe the other banks had some "catching up - or catching down - to do."

As Warburton points out, "if the July wobble provoked a 10% equity market correction in the following weeks, should we not expect a repeat performance?"

This isn't the only problem. Markets are becoming increasingly worried that the companies which insure bonds might be vulnerable if a host of CDOs collapse. As Lex in the FT puts it: "This is scary because, bluntly, what hurts Ambac and MBIA [two of the biggest bond insurers] hurts the rest of the credit market. So many transactions depend on the guarantee these two provide." So if the bond insurers see their credit ratings downgraded, that would have a knock-on effect to many other products in the market. "This panic has contagion' written all over it."

Regular MoneyWeek columnist James Ferguson is broadly bullish on stocks. But even so, he has already told subscribers to his investment email, Model Investor, that he expects another correction of 20% or so in the US equity market, probably just before the US goes into recession. With many pundits suggesting that US GDP could actually shrink this quarter, the timing could be absolutely right for this to be the big one.

We'll soon see, I'm sure.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email

In London, the FTSE 100 index of leading shares plunged 135 points into the red yesterday, ending the day at 6,586. Banking stocks including Barclays and Northern Rock were the day's biggest losers after CIBC downgraded US financial giant Citigroup. For a full market report, see: London market close

Elsewhere in Europe, shares also closed substantially lower. The Paris CAC-40 was down 117 points at 5,730, and the DAX-30 had lost 138 points to end the day at 7,880.

On Wall Street, the Dow Jones tumbled by 362 points to close at 13,567. Citigroup fell by nearly 7% and fellow financials were also weaker. The tech-heavy Nasdaq was off 64 points, at 2,794. And the S&P 500 was down 40 points 1,508.

Asian stocks also felt the fallout from yesterday's rout today. The Japanese Nikkei fell 352 points to end the day at 16,517. And in Hong Kong, the Hang Seng was down 1,024 points at 30,468.

Crude futures rose above the $96 mark in New York yesterday but had fallen back to $93.46 this morning. In London, Brent spot was at $90.56.

Spot gold climbed as high as $799.30 yesterday as the crude oil price soared, before falling as low as $784.10. However, bargain-hunting saw the price rise backup to $789.90.Silver had fallen to $14.10 this morning.

Turning to the currency markets, the pound had fallen back to 2.0838 from yesterday's 26-year high of 2.0851.The pound was also trading at 1.4398 against the euro. And the dollar was at 0.6907 against the euro and 114.669 against the Japanese yen.

And in London this morning, British Airways registered its biggest fall in two months after announcing a below-expectations rise in first-half profit. Net income rose 52% to £478m, below analysts' estimates of £492m. The air carrier also cut forecasts for the full year as the weaker dollar is set to hurt US revenue.

Finally, our recommended articles for today...

Why gold still looks cheap

- After years of neglect, the dollar price of gold is hitting 28-year highs. Yet when you consider that the 'real' price of gold was as high as $5000 back in the early 80s thanks to massive growth in the money supply, then it has the potential to climb much further. For an alternative perspective on inflation and what it means for the gold price from the Mises Institute, click here: Why gold still looks cheap

Investing in water: how to cash in on blue gold

- The bad news is that global water shortages can only get worse. The good news is that by investing in the right firms, you can cash in on rising demand. Tim Bennett reveals eight ways to surf this wave of profits in this MoneyWeek article, just available to non-subscribers: Investing in water: how to cash in on blue gold

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.