Markets fear banks have $1 trillion in toxic debt

by Sean O’Grady, The Independent - Nov 6, 2007

A new phase in the credit crunch, one of “$1 trillion losses” seems to be dawning. The crisis at Citigroup and renewed doubts about some of the world’s leading banks disquieted stock markets on both sides of the Atlantic yesterday, with the fractious mood set to continue.

The FTSE 100 fell 69.2 to 6,461.4, with Alliance & Leicester (down 4 per cent) and Barclays (off 3 per cent, to a two-year low) singled out for punishment. In New York, Citigroup, down 4.9 per cent to multi-year lows, weighed on the Dow Jones index, which fell 51.7, or 0.4 per cent, to 13,543.4. Merrill Lynch, Goldman Sachs and Lehman Brothers also dropped on speculation they face more writedowns on top of the $40bn (£19bn) announced in the past four months.

Bill Gross, the chief investment officer of Pacific Investment Management, said US mortgage delinquencies and defaults would rise in 2008. “There are $1 trillion worth of sub-primes, Alt-As [self-certified] and basically garbage loans,” he said, adding that he expects some $250bn in defaults. “We’ve only begun to see the pain from rising mortgage payments,” he added. Brian Gendreau, an investment strategist at ING, commented: “Financials are 20 per cent of the S&P 500 and if that sector doesn’t do well all bets are off. People just don’t know what’s on the balance sheets.”

The banks remain unwilling to lend to each other, preferring to rebuild their balance sheets and “hoard liquidity” to buttress themselves against any shocks from repatriating off-balance-sheet losses from their special investment vehicles (SIVs). However, this tightening up has led to a vicious circle. Making credit tougher has exacerbated the problems of struggling mortgage holders in America; default rates then rise and make the banks even more exposed to losses as credit agencies downgrade their assets. This seems to be what happened at Citigroup. The admission that it was unable to assure investors that a potential $11bn write-down for sub-prime mortgages would not grow has led to this fresh fit of extreme nervousness. Huge write-downs by Merrill Lynch ($7.9bn) and UBS ($3.4bn) have not helped.

Samir Shah at Landsbanki Securities said: “People thought most of the bad news had been priced in. It seems we’re entering a second phase of the credit squeeze. We’re going back to a place where liquidity is drying up and volatility is increasing.”

Barclays has seen its shares savaged. “There is a concern about the extent of the debts among the banks generally and who will be left holding the debt,” Richard Hunter, of Hargreaves Lansdown, said. “There’s a read-across to Barclays Capital. People are concerned about the exposure it has.” Profit growth at its subsidiary was “strong”, the bank declared last month, though it offered no comment yesterday.

Alliance & Leicester also suffered from vague rumours that it had turned to the Bank of England for emergency funding. An A&L spokesman offered this reassurance: “Each week in recent months, including last week, Alliance & Leicester has successfully raised the funds it requires. We have also continued our share buy-back programme.”

The Chancellor, Alistair Darling, also pleaded for calm. “We are experiencing an unparalleled period of financial uncertainty caused by the problems in the US housing market,” he said. “I believe that we can get through that. Many banks in this country have very strong balance sheets after years of making very good profits.”

Meanwhile, on the continent, newspaper reports named two German banks – WestLB and a small specialised bank for professional people – as possible next victims of the crisis.