Thought the worst was over for the credit crunch? Think again…

This has been a particularly grim week for the City. The total shambles over Bradford & Bingley's rights issue has ramifications far beyond one small indeed now very small mortgage lender. It has implications for the rest of the UK bank sector, the housing market, the economy and the reputation of the City itself. For anyone lulled into thinking the credit crunch was nearly over after a fairly uneventful May, this mess will have come as a nasty shock.

The buy-to-let specialist lender was all set to raise £300m from its shareholders in a deal that was fully underwritten by UBS and Citigroup, two of the biggest names in global finance. Yet, in the course of an extraordinary weekend, it emerged that trading at B&B had deteriorated sharply in April and that the underwriters were trying to wriggle out of their commitment to buy the new shares if existing investors refused to take up their rights. Then, late on Sunday night, B&B said that TPG, a Texan buyout group, would buy a 23% stake for £150m and that the rights issue would be scaled back to £250m, with the price dropped from 82p to 55p, underwritten by the same two banks.

No one I have spoken to can remember any other rights issue where underwriting banks have managed to escape from such a commitment. Investment banks get paid handsomely to take the risk that a group's share price falls sharply during the period between when a rights issue is announced and the new shares are offered. Occasionally, this bet goes sour. One UK merchant bank during the early 1990s ended up with a very large stake in a chemicals company after it was forced to buy a substantial amount of new shares in a rights issue. But usually, the banks make out like bandits.

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

It's still not clear why the banks were able to get off the hook. They could have cited "material adverse changes" in the market under the terms of the underwriting agreements, but I am told they did not do so. But the idea the banks were happy to honour their commitments is hard to square with the fact that emergency meetings took place at the end of last week involving the Treasury, Financial Services Authority and Bank of England; or that one of the banks involved took the bizarre step of hiring its own PR agency to put its side of the story over the weekend; or that B&B chairman Rod Kent dropped the issue price to 55p. Why do that if you already have the money in the bag at 82p?

There are three main points to take away. The first is that raising new capital in London just got harder. Cynics may claim that the era of "my word is my bond" ended in London a long time ago. But if doubts emerge about how much you can rely on a signed underwriting contract, we are in new territory. The market will wonder if the money is really in the bag when the rights issue is announced, creating uncertainty and making the exercise more costly and risky. That could be bad news for banks such as Barclays and Alliance & Leicester that have not raised fresh capital but might need to if conditions deteriorate.

The second point is what B&B's profit warning says about UK housing. B&B reported a sharp fall in the UK buy-to-let market in April, entirely at odds with its earlier predictions that the rental market would remain robust. This is a real blow to hopes that the UK can escape with only a minor housing correction. During the boom, buy-to-let investors were the crucial marginal investors who kept prices rising once first-time buyers were priced out of the market. With arrears among this group now rising and rental income for many falling below interest expense, forced selling is on the cards.

The third point is that the B&B profit warning is the first real sign of distress in the real economy from a UK bank. Everything we have seen to date the credit crunch, the writedowns, the rights issues reflects problems in the financial system before almost anyone has lost a job, or repossessions have really risen. The losses to date have been almost entirely the result of the collapse in the market prices of assets held on trading desks not the value of loans on their banking books. Nobody yet knows for sure what a deep recession would do to the banks. But what we do know is that more than half the mortgages in the UK have loan-to-value ratios of more than 80% and 30% have LTVs of 90%. If house prices fall 10%, all these homeowners will be faced with negative equity and no chance of getting a new mortgage.

A few brave investors are clearly ready to call the bottom of the banking downturn TPG among them. It is paying a discount to B&B's book value of more than 70%, which it must feel more than reflects any likely bad news. Two leading brokers also this week turned positive on Royal Bank of Scotland shares. But I prefer to take the advice of a leading hedge fund manager who told me he's still giving the banks a wide berth. There's just too much uncertainty around over the economy, the housing market and the true strength of bank balance sheets. To that we can add a new risk: whether and on what terms banks can raise fresh capital.

Simon Nixon is executive editor of Breakingviews.com.