A Radio 4 pundit said recently that all banks are bust. This is a controversial claim but he qualified it by saying that lenders only make money when they can lend more than they hold in capital, so they gear their capital investment by borrowing from other lenders.
The problem is that the banks don’t trust each other enough to lend to one another thanks to bad debt.
Recently, Swiss investment bank UBS unveiled a further $18bn of bond market write-downs on top of the $18bn it disclosed last year.
But if it can’t borrow enough to cover its existing liabilities, it will go bust. Just look at Northern Rock, which lent long and borrowed short and had to be saved by the government.
If lenders have inflows such as retail deposits from savings customers or borrowers repaying their loans, they’re holding onto the cash to repay some of their own debt if they can’t roll it over.
As LIBOR lending dries up, the knock-on effect is passed onto the mortgage market. Lenders manage their balance sheets by not doing much lending and restricting the amount of new mortgage business by increasing prices and tightening criteria. If they reach the limits of acceptable gearing according to their internal rules or regulation, they stop lending. We’ve already seen this happen on a number of occasions and more lenders are bound to follow suit.
I was in a meeting with a group of lenders recently discussing the size of the gross mortgage market this year.
There’s nothing unusual in this as market forecasting has always been a topic of conversation but one of the responses to the question of whether the market will be worth over or under £300bn in 2008 surprised me. One of the lenders said that the demand needed to hit the figure would exist but nobody could be sure about the supply.
The scary implication is that by the end of the year the size of the mortgage market will be determined by the amount of funding lenders can cobble together.
Consumer demand is still high for mortgages but unless trust returns to the money markets and lenders and investors start to lend to each other again, it will be difficult to satisfy it.
Sadly, restoring trust will be difficult. Even if central banks pump billions into the financial system, lenders might simply hang on to it. For the time being, the trust crunch is what we should worry about.