Investment Management Blog - Montague Capital

UK bank shares returned to the front of the stage yesterday but for the usual, wrong reasons.  The market decided to have another attack of the “glooms” over the approaching completion date for banks’ rights issues.  Bradford and Bingley, HBOS and RBS all fell as traders speculated over how much of their issues would remain “stuck” with the underwriters.  For issues that were supposedly priced to succeed, this is a disappointing mentality for the market to display.  Not that it has been helped by statistical evidence that institutions, who were supposed to be lining up to mark these events as the nadir of the sector’s share price performance, have instead been busily shorting the shares instead.  Such behaviour makes some sense of Barclays’ decision to try to tough things out rather than put itself under the spotlight and invite additional unwanted criticism of how it conducts its own affairs.  Not that this stopped its shares from being clobbered too.

But why should the institutions bet that these issues do indeed mark the bottom when even sector insiders can find little good to say about their own immediate prospects?  HBOS’ CEO Andy Hornby told a conference in Edinburgh yesterday that he thinks it will be at least another 18 months before the wholesale money market unblocks and offers a chance for things to return to what used to pass for normal.  He offered no hope that the Council of Mortgage Lenders’ forecast of a halving of new mortgage lending this year is wrong.  But in saying that his own bank is well prepared going into the forthcoming downturn (yes, he did say there is a downturn coming) he spoiled things slightly by claiming that the average HBOS loan-to-value ratio is low at only 44%.  What does “average” mean?  The devil is in the detail here and the time profile of that loan book is all-important.  Consider the overall size of that loan book and how house prices have moved in recent years.  It quickly becomes apparent that the rump of mortgages taken out many years ago at far lower prices will have been contaminated by the high loan-to-value ratio (and high nominal amounts too) pursuit of market share as the UK housing market approached the top of the bubble in the last couple of years.  That is where the potential for damage still exists and where rights issues even of the size announced so far may prove insufficient.  It is alarming that Mr. Hornby immediately covered his back by qualifying his predictions with the caveat that they were only valid for as long as UK unemployment does not pick up.  “Here’s an alternative, gloomier scenario I prepared back in May 2008.”

News of a report by Moody’s on banks’ capacity to cope with a downturn will be a mixed blessing.  Still struggling to find the bolt for the stable door after the old nag has long since disappeared over the horizon, Moody’s latest stress tests suggest that the banking sector could absorb a 25% fall in UK house prices without needing to raise additional capital.  A 50% fall would be another matter.  Give traders numbers like this to play with and they often don’t stop to think but just act.  After yesterday’s Nationwide house prices survey, “analysts” were quick to move their forecasts for UK house prices lower still.  The risk is that such pessimism becomes self-fulfilling, but trying to deny reality and attempt to restore confidence by cutting interest rates is not sensible when inflation has at last come onto the authorities’ and politicians’ to-do lists.  Because there is a subtle feedback mechanism now at work whose importance was increased by the introduction of the Special Liquidity Scheme.  It is this that HSBC’s CEO may have had at the back of his mind when he called for a consideration of higher interest rates earlier this week.  If inflationary expectations pick up, the bond market will weaken and with it the value of much of the collateral being put up banks for emergency cash under the SLS.  At which point the Bank of England will demand more collateral, so making it yet harder for banks to provide money to final customers.  Not a nice thought, but no point denying it just because it isn’t nice.  Another reason why controlling inflation really does matter.