Jeremy Warner's Outlook: Credit markets begin to show the cracks

Northern Rock's profits warning; O'Leary flies off the handle - again
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The Independent Online

Every time the financial markets convince themselves that somehow or other they have managed to absorb the meltdown in US sub-prime mortgages without mishap, something comes along to suggest that perhaps they haven't.

The latest such reminder is in the travails at Bear Stearns, the Wall Street investment bank which has been forced to put up $3.2bn of its own money to bail out two hedge funds up to their necks in mortgage-backed securities. Ever since, there has been a renewed flight from risk, with credit markets now showing distinct signs of putting up the shutters.

Yet the underlying cause of all this nervousness is not so much the sub-prime crisis itself as rising interest rates. It is higher interest rates that have caused the sub-prime market to go belly-up, and it is also higher interest rates that instruct the growing outbreak of risk-aversion among investors. For the time being, it is impossible to predict how all this might play out in equity markets. It is also too early to declare a full-scale credit crunch under way.

Interest rates are rising because of strong economic growth the world over, and the inflationary pressures that this growth is beginning to inflict on economies. In itself, strong growth ought to be good for corporate profits, but obviously not if it prompts rates to go so high that they bring the growth cycle to an end.

Already, higher rates are causing pain in the mortgage market. Anecdotal evidence is that they may also be starting to take the froth out of the leveraged buyout market. The holiday season hasn't begun, but it might well have done to judge by the calm that is descending on the mergers and acquisitions scene.

Appetite for the mega-deals being talked of only a few months back seems to be fast disappearing. It might come back, but probably not this side of the summer break.

There is also said to be indigestion in getting the financing away for some of the mega-deals already announced. For instance, bankers to CVC in its bid for the Spanish tobacco company Altadis have agreed to carry the debt on their own books for an extended period because of unsettled credit markets.

Some of the biggest private equity players are adopting a wait-and-see approach before they venture out further. Arcelor Mittal was forced to postpone a €1.5bn bond sale last night because of growing problems in the credit markets.

As with soaraway house prices, it is cheap and easy credit which has fed the buyout boom. As the liquidity is removed, these booms are bound to subside. The transformation in the world economy brought about by rapid development in China and India has allowed a period of very low inflation. This has kept interest rates low in the developed world, which in turn has encouraged very strong growth in asset prices and a possibly quite dangerous appetite for risk.

These trends may now be coming to an end. Already, with interest rates not at particularly high levels by historic standards, the tightening has been enough to prompt a crisis in the US mortgage market. We can only guess at what similar turmoil might break out elsewhere in the financial system if rates rise much further.

The hope has to be that central bankers are able to restrict the tightening to a pinch which takes the froth out of the financial system without poleaxing the economy. In central banking speak, it is about removing the punch bowl before the party gets too drunken. It's not going to be easy given the period of exuberance we have just lived through. They may already have left it too late.

What's more, central bankers no longer have as firm a grip on the tiller as they used to. Market-determined interest rates are these days a law unto themselves. Equity markets will remain volatile until we get a clearer idea of whether policymakers have pulled off the trick.

Northern Rock's profits warning

One British mortgage lender apparently caught on the hop by higher interest rates is the previously faultless Northern Rock. The profit warning flagged yesterday by Adam Applegarth, the chief executive, hardly fits into the same category of catastrophe we've seen in large elements of the US mortgage market.

Attributable profits this year are now expected to rise by "just" 15 per cent, against previous expectations of 17 per cent. Yet the setback may be a harbinger of more serious problems to come in the British mortgage market.

There have also been some key mistakes by this one-time blue-eyed boy of the sector. About a third of the revenue shortfall detailed yesterday is down to the fact that the company was unhedged on new mortgage lending against the possibility that rates would rise above 5.5 per cent.

Mr Applegarth has moved to address the problem by reducing the two-and-a-half month lag between a new mortgage being awarded, and completion, when the mortgage is financed. It is nevertheless odd that Northern Rock should have left its business model so exposed to the possibility that rates would rise further than expected.

Fundamentally, Northern Rock remains an excellent business with decent growth prospects in a mortgage market where customer switching between providers is now the norm. Yet that is not much comfort to the borrower.

The bigger picture is that an awful lot of mortgage holders, forced to refinance into higher interest rate deals, face steep increases in monthly repayments over the next year. The highly competitive nature of the market provides something of a cushion, but it can only take off the rougher edges of rising interest rates. It cannot make mortgage-holders immune to their consequences.

The squeeze on disposable incomes brought about by tightening credit conditions is only just beginning to bite. For many, it is going to feel ugly.

O'Leary flies off the handle - again

So what's old motor-mouth ranting on about this time? Oh dear, Neelie Kroes, the EU Competition Commissioner, seems to have blocked Ryanair from buying its Irish rival Aer Lingus.

This is about the most unsurprising decision the EU has ever taken - combined, the two carriers would have dominated flights in and out of Dublin with more than 80 per cent of passenger traffic - yet it has again had Michael O'Leary, the Ryanair chief executive, foaming at the mouth with righteous indignation.

It's all a political fix, he screams. What an outrage. The only people to oppose Ryanair's ambitions were Aer Lingus itself, he fumed. In fact, it was the other way around. The only person who actually supported Ryanair's attempt to take over its main competitor was its own chief executive.

Mr O'Leary is on firmer ground when he points out other potentially anti-competitive airline mergers within Europe have been approved. Indeed, his is only the second takeover to be blocked by Ms Kroes and the first such airline merger. Yet it is hard to argue she had no cause and even harder to see how the threatened appeal could succeed.

It is completely irrelevant that Ryanair and Aer Lingus combined would have only 5 per cent of the total European air travel market; its grip on Ireland would be all-embracing. Mr O'Leary's case was perhaps always a hopeless one, yet he scarcely helped his chances by keeping up a more or less constant barrage of insults against the officials examining it.

This sort of rhetoric might be helpful when directed against rivals and airport operators in the battle for passengers, but it is most unwise when dealing with regulators. Who was yesterday's tirade directed at? Consumers couldn't give a stuff about Mr O'Leary's empire-building. Their only concern is about being flown from here to there at the cheapest possible price, an aspiration unlikely to be furthered by the reduction in competition proposed.

Mr O'Leary once said there would come a time when Ryanair would get too big for a "gobshite" like himself. The Aer Lingus tilt seems to have proved him right.