Credit Crunch Trading
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Trading Features / Strategies from Simon Denham of Capital Spreads.
Credit Crunch Trading – Part 1 of 3
The news has seemed so unremittingly bad that sometimes you have to step back and wonder ‘are we just getting too negative’ for our own good. Yes ‘the sub-prime’ problems leading onto the ‘credit crunch’ problems giving rise to ‘growth’ worries blah, blah, blah are real issues but how big and how important.
The entire issue started with some unusual waiving of the normal criteria for awarding mortgages in the poor credit segment of the US consumer sector. But how big is this sector and how did, what appears to be a small percentage of overall lending, have such a major impact on banks many of which, on the face of it, are not really in the American mortgage lending arena. For some readers it may seem very strange that banks are now forced to issue large swathes of new capital at knockdown prices over such a relatively small issue. The problem is that banks make their money in the margins. If a bank lends you money at 6% this does not mean that they have made 6%. The bank itself must borrow the money from somewhere else (at say 4.5%) and it then makes a profit of the difference. If the bank is good at its job it will make this margin many times over but will always have the capital risk on the money it lends as it must always be able to repay the money it borrows. On this basis it can be seen that a relatively small level of bad debt can quickly get a bank into trouble (as a 100% loss on a loan takes up quite a few 1.5%’s) and goes a long way to explain why banks seem to always trade on very attractive returns to investors. Even in boom times major banks will seldom get over 12 to 13 times earnings because the big investors know that a slowdown may only just be around the corner.
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The US is suffering because house prices became a get rich quick route in a country that has one major product in abundance ‘Land’. In the UK (although there are a few 100% plus mortgages) most loans are well covered and the value of the asset, the house, will almost certainly cover most of the debt anyway. So the risk to the bank is just the interest. In the States, with so much available building land, the potential for wild swings in house valuations is that much greater. If the lenders are handed back the keys on too many properties, that are worth just 75 to 80% of the initial loan, then crisis waits in the wings.
This is why the employment numbers in the States are being watched with such trepidation. A further weakening in job prospects will cause more bad loans and more banking crisis, so the Fed is abandoning, for the time being, the battle with inflation in favour of the rather more pressing issue of growth and stability. It is a dangerous game and one that, if played incorrectly, could have very dire consequences.
For Part 1 of the Credit Crunch - Trading, click here
For Part 2 of the Credit Crunch - Markets, click here
For Part 3 of the Credit Crunch - Finance, click here
The above comments do not constitute investment advice and neither Capital Spreads nor Clean Financial accept any responsibility for any use that may be made of them.
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Risk Warning: Spread betting carries a high level of risk to your capital. You may lose more than your initial investment. It may not be suitable for all investors. Only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved and seek independent financial advice where necessary.
Article provided / approved by Capital Spreads which is a trading name of London Capital Group Ltd which is authorised and regulated by the Financial Services Authority (FSA), FSA Register number 182110.
'Credit Crunch Trading' edited by DB, updated 16-Feb-08
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