Has subprime claimed its first 'near-prime' scalp?

Renewed concern over the credit markets led to a late-day fall on Wall Street yesterday that has since spread to Asia and Europe. John Stepek looks at why troubles in the subprime sector are starting to spread.

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The UK blue-chip index rebounded strongly yesterday, with the FTSE 100 closing around 150 points higher.

However, the rebound hasn't lasted at one point this morning, our Bloomberg monitor showed that every single blue chip, save one Shire Pharmaceutical was in the red, and the broader index had lost around 120 points.

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It was a late-day plunge in the US that ruined it all for the buy-on-the-dips' brigade. The Dow started yesterday's session in an upbeat mood, only to fall by 140 or so points by the end of the day.

The rising oil price was partly to blame. But the credit markets remain the biggest worry. The country's tenth biggest mortgage lender, American Home Mortgage, warned that it had missed margin calls from lenders. It could become the first big lender outside the subprime sector to go bankrupt.

It's unlikely to be the last

Meanwhile, the credit market turmoil has seen the plug pulled on yet another private equity sale. Owner 3i was auctioning NCP, which supplies traffic wardens to local councils, with the aim of raising at least £250m, says The Telegraph. But offers didn't reach the magic number, and the auction has been pulled. According to the paper, private equity sources' said they "were unable to get the adequate debt financing packages to reach the expected price tag."

The best way to understand all this is just to imagine it all as one giant housing market. As credit conditions have tightened, and banks get stricter with their lending criteria, buyers can no longer borrow as much money as the sellers want for their asset. It's the equivalent of slashing the salary multiple you're willing to lend. And if people can't borrow as much, it means they can't pay as much.

So either the market dries up as sellers sit on their homes or businesses and wait for a better time to sell. Or, if the seller has no choice, they have to slash their price to meet what buyers are willing and able to pay. The longer the deadlock goes on for, the more likely it is that the second scenario will occur.

But why has the lending machine dried up so sharply? Well, John Gapper summed all this up very well in the FT at the start of this week. Basically, banks have gone from simply lending money from their own reserves to being halfway houses for debt. In the old days, a bank gave you money, and that money then stayed on its books. You owed the bank, and the bank therefore had an added incentive to make sure you were able to pay the money back. The goal in this scenario is for the bank to get a return that it feels is proportionate to the amount of risk it's taking - just like any normal investor.

But in our brave new golden era of low interest rates and credit derivatives, the banks agree to give money to a business - such as a subprime mortgage lender, or a private equity house - to write subprime mortgages, or buy another company. They then parcel up the resulting debt and sell it onto the markets, clearing it off their books, and freeing up more capital to lend to the next person.

The ultimate goal in this scenario is to get the fees involved in securitising this debt and arranging the deals. The quality of the credit, or the rationality of the risk / reward equation does not come into it - after all, it's not the bank who'll take the hit if the lender defaults.

So the banks went from being lenders to being salespeople. They went from caring about the quality of the business, to being far more interested in the quantity.

The one snag was that in between lending the money and selling the debt to the markets, the debt sits on the banks' books. And of course, because business was so good, the pipeline was always full. But when credit markets got into a panic about the collapse in subprime, suddenly no one was interested in buying debt anymore.

So the banks have been left with their books stuffed with debt looking for a home. And the realisation that this debt may not have any home to go to, and may in fact end up residing permanently on the bank's books, means that the banks are no longer as keen to give any funding to back deals.

As Gapper says: "Instead of passing on risk quickly and profitably, they may have to live with it."

The trouble is, some of the companies they've backed include lenders like American Home Mortgage, which as we mentioned above, is now on the verge of bankruptcy. According to Marketwatch.com, Barclays, UBS, Bear Stearns and Bank of America provided a combined $9.7bn in loans to back the company's mortgage underwriting. Barclays apparently provided $1bn of that amount.

It'll be interesting to find out just how much of that it'll get back.

Turning to the wider markets

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In London, the FTSE 100 ended yesterday with strong gains, adding 154 points to close at 6,360 as miners and life insurers lent support. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 added 50 points to end the day at 5,751, whilst the Frankfurt DAX-30 was up 127 points to 7,584.

Across the Atlantic, signs of trouble at American Home Mortgage wiped out recent gains for the US market. The Dow Jones was down 146 points to close at 13,212 as all but four of its components ended the day in the red. The tech-havy Nasdaq was 37 points lower, closing at 2,546. And the S&P 500 was 18 points lower, at 1,455.

Wall Street weakness spread to Asian markets overnight, with the Nikkei down 377 points to 16,870 and the Hang Seng tumbling 717 points to as low as 22,467 today.

Crude oil had fallen to $77.95 this morning and Brent spot was down 37c to $77.45 in London.

The sell-off in Asian markets saw spot gold fall by nearly $3 to £661.40/oz this morning, whilst silver was down to $12.77. And platinum futures fell by their maximum daily limit of 100 yen on the Japanse exchange to 4,828 yen.

Turning to the foreign exchange markets, the pound was at 2.0229 against the dollar and 1.4814 against the euro this morning and the dollar was at 0.7321 against the euro and 117.81 against the Japanese yen.

And in London this morning, British Airways announced that it will face total fines of around £350m relating to price-fixing investigations by the US Department of Justice and UK Office of Fair Trading. The OFT is fining the air carrier £121.5m after it was revealed that BA employees had discussed the level of surcharges with Virgin Atlantic on at least six occasions. An investigation into whether the level of surcharges was actually fixed is ongoing. BA shares had fallen by as much as 3.2% in early trading.

And our two recommended articles for today...

Two ways to play the lithium boom

- It's already used in the rechargeable batteries that power our laptops and mobile phones, and could soon be even greater demand if the battery-powered car takes off. But lithium isn't the easiest of metals to invest in. For Martin Spring's pick of two of the best ways to gain exposure, see: Two ways to play the lithium boom

Are we heading for China.com?

- Asian equity markets - and China in particular - have outperformed during the global equity correction. As government efforts fail to cool the overheating economy, it looks like we could soon see some dizzying dotcom multiples. For more on the current situation in the Chinese equity markets, read: Are we heading for China.com?

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.

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.