The end of the world is nigh

For a solvent mortgage lender to require emergency government support on a huge scale suggests that all is not well in our financial markets. This understatement matches the gorgeously hubristic claim from ‘Chuck’ Prince of Citigroup, America’s largest bank, in July, that ‘as long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ But by November Prince was gone, victim of a multi-billion-dollar write-down relating to losses in the mortgage market. Perhaps he now dances with Stan O’Neal of Merrill Lynch, America’s biggest stockbroker, who also resigned in November after giant mortgage-related losses.

Countless institutions have been brought low, having invested in supposedly low-risk bonds cobbled together from mortgages on US property. Banks everywhere have managed to choke themselves on an alphabet soup of mortgage derivatives: CDOs, MBSs, CDSs, SIVs. For as long as US property prices rose, nobody bothered to look under the bonnet and see what was actually powering the enhanced returns available from repackaged sub-prime loans. It’s now painfully clear that too many lenders threw too much money at too many high-risk borrowers. What is not clear is how great the exposures are (analysts at Deutsche Bank suggest sub-prime mortgage losses could total $400 billion worldwide, but nobody really knows), nor on whose balance sheets and portfolios they sit. As a result, banks no longer trust their counterparties enough to lend to each other: the financial system has broken down. Wounded banks will offer more stringent terms to borrowers, individual and corporate.

With easy money now gone, big takeovers that were previously possible thanks to a surplus of credit on attractive terms will dry up. That removes a key pillar that has underpinned equity market valuations.