I was on holiday in the New Forest last week, copping the atrocious weather but missing the storm in the City. The sun has, thankfully, returned again to London, literally, if not metaphorically. Hopefully it means the worst is over for those parts of central England that were flooded. That's unlikely to be true for the markets, where there is a clear sense that we're now into a new season and there is sure to be more bad weather to come. But as bankers and investors survey the damage, I sense a prevailing mood of guarded optimism that the markets can come through this deluge.
The main reasons for cautious optimism are, firstly, that the problems in the credit markets are so far focused on one area: US housing. Clearly, there was a vast bubble in US house prices fuelled by reckless lending to people who should have never been given mortgages. Now, thanks to rising interest rates and falling prices, these homeowners are going bust, leaving banks and hedge funds that hold the mortgage debt nursing huge losses.
But so far, there is little evidence of any financial distress outside the US housing market. While all credit markets have been caught up in the turmoil the leveraged loan market vital to private-equity deals has all but closed the real economy is strong and companies are servicing their debts. That could change, not least if the losses on US mortgages proved far greater than expected. Ben Bernanke, the US Fed chairman, predicted losses could reach $100bn; a lot, but something the financial system should absorb without choking off the supply of money to the global economy.
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Of course, much depends on who bears those losses. The danger is that, if it is all in the hands of highly leveraged hedge funds, they will have to dump investments at firesale prices, either to meet margin calls from investment banks who lent them money, or to meet redemptions from investors. That could see the US housing market turmoil spill into other asset classes, like corporate bonds and leveraged loans, leading to a new cycle of losses, margin calls and redemptions and creating the dreaded "contagion" that investors fear most.
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It was these fears that led to last week's sell off. But so far, they remain just that fears. According to one bank boss the fall was largely sentiment-driven, led by investment bank proprietary trading desks. There's little evidence so far of forced selling or hedge funds "puking their positions", as he delicately put it.
In fact, last week had two encouraging straws in the wind for investors. First was the news that a string of German banks had been hit by US subprime mortgage losses. Shares in IKB Bank fell 20% in a day after it admitted it had been burned. That's actually good news, as it shows the risks from US mortgages were indeed widely diversified, as credit-market bulls claimed. The more of these losses that are in the hands of banks and insurance companies the better, since they don't need to worry about margin calls or investor redemptions, and so can better absorb the pain.
Second was US hedge fund Citadel's decision to buy up Solow Capital, a rival which had halved in value due to its subprime exposure. Not only was Solow spared an ugly firesale of assets, which might have created further panic, but Citadel demonstrated that liquidity is still available. Of course, there aren't many funds as powerful that could step in and rescue a stricken rival. But others are also starting to wonder if the sell-off has now gone far enough. One prescient UK hedge-fund manager, who made a fortune betting against the subprime market earlier this year, says he is now beginning to see value in the market. No one wants to be complacent, and there are bound to be further squalls to come, but this is not yet a perfect storm.
Ushering in the City vote
With her outspoken attack on Heathrow this week, Kitty Ussher, the new City minister, underlined the Government's determination to win over the City vote. No one who has spent any time in the Square Mile will be under any illusion about the level of anger among business people at our national airport's squalor. But Ussher was of course partly being disingenuous. Terminal Five would have been built years ago if not for the eight-year planning process. And most of the delays and frustrations stem from absurd new safety regulations imposed by the Government, not Heathrow's owner BAA.
Still BAA is an easy target, particularly as the highly leveraged subsidiary of Spain's Ferrovial. That's the advantage of an open market. When things go wrong, you can blame the foreigners. But don't expect the Spanish to lose any sleep over all the bad publicity. London's three airports are a regulated monopoly, so BAA is under no pressure to improve things. Meanwhile, the political pressure can only strengthen its hand with the regulator at its next review. The Spanish can laugh all the way to the bank, while their customers remain stuck in a queue.
Simon Nixon is executive editor of Breakingviews.com
