It began with US sub-prime mortgage lending, but, like a rock thrown into the middle of the pond, the impact is progress-ively rippling out to affect all areas of the structured credit markets. The latest casualties include the $3trillion "covered bond" market, where conditions have become so dire that European bankers have agreed to shut up shop and suspend trading until next week.
In another worrying sign that the credit crisis is still gaining force rather than subsiding as hoped, questions are now being raised over the future of so-called "monolines", another previously obscure area of the debt markets which is said to insure some $2.3trillion of structured and US public finance credit. Two mutually owned French banks, Caisse d'Epargne and Banque Populaire, were forced yesterday to provide $1.5bn of rescue finance to one of these bond insurers, CIFG, after credit rating agencies threatened to strip the organisation of its triple-A rating.
The monoline most exposed to collateralised debt obligations, ACA, has already been placed on negative credit watch by Standard & Poor's. Outright downgrades are threatened on a number of others. As ever, the credit rating agencies, bless them, seem to be somewhat behind the curve in recognising the challenges faced by organisations previously rated as safe as houses.
Both covered bonds and monolines are part of the panoply of structures which in recent years have enabled bankers to spread, securitise and fund credit risk, thereby making it more freely available. The worry for the wider economy is that if these structures are now breaking down, possibly irredeemably so, then the supply of credit is also going to shrink dramatically.
Monolines, most of them Bermuda-based and therefore outside the orbit of frontline banking regulation, provide bond insurance, so that even when the underlying security defaults, principle and interest is paid when due. The availability of credit insurance of this sort has encouraged banks to write more loans, confident in the knowledge that they can sell on the ones already made on a fully insured basis.
Yet if the insurer cannot pay, then the credit risk comes bouncing back. And if the monolines are all about to be downgraded then, a bit like Northern Rock, they will struggle to find the counterparties willing to sign up to the other side of the contract. Funding for the insurance provided will dry up.
If any of them fail, the effect would probably be profound, but even if they don't they are surely going to have a good deal less appetite to insure than they did. If there is no longer an insurance wrapper to go with the debt, there will be less securitisation, less risk sharing, less credit, and so on. And if they fail, making the insurance worthless, then the write-offs so far seen on sub-prime mortgage lending are going to look like only the tip of the iceberg.
The covered bond market doesn't technically securitise credit risk, but many of the same points could be made about the more difficult circumstances it now finds itself in. With a covered bond, the mortgage asset remains on the bank's balance sheet, but if the bank fails, the security reverts to the bondholder.
Covered bonds have by this means become one of the biggest conduits for mortgage funding in Europe. If that funding mechanism is now going the same way as the commercial paper market, that's again less money to finance house purchases. Bank-ers reckon that by closing the market for a while, they will underpin confidence and stabilise prices. More likely is that it will have the opposite effect, causing prices to slump further once the market reopens.
However these issues play out, the credit crunch plainly has a lot further to run yet, with plenty of potential for further damage. The inclusion of monolines and covered bonds in the cocktail of challenges facing credit markets helps explain why bank shares have fallen as far as they have.
These falls are plainly not justified by the sort of write-offs we have seen to date on sub-prime and leveraged finance. Yet they possibly would be if the structures which have allowed the credit boom of recent years and thereby fed the growth in banking profits are about to disappear or be significantly scaled back.
It's also worth remembering that a bank doesn't have to write down an insured loan even when the loan is turning sour. Yet if the insurer goes bust, then all bets are off. The bottom line is that an economy starved of credit is unlikely to grow by very much. Interest-rate cutting by central bankers may, by providing cheaper funds, allow banks to stay in profit, and thereby prevent wider systemic damage. Yet paradoxically, it might not help the real economy in circumstances where credit markets are of their own accord tightening. All very worrying.
Nationwide's mutual success story
Graham Beale, the chief exec-utive of Nationwide, has become like a dog with two tails. "Yes, we've had queues outside our branches, too", he says excitedly, "only with us they are queuing to put their money in, not take it out". After years of having to live with the description of "dull and boring", it's all of a sudden cool to be a secure, risk-free, mutually owned building society.
Thanks to the travails of Northern Rock, Nationwide's inflow of new retail deposits nearly doubled in the half year to the end of September. With more than 70 per cent of the mortgage book funded from retail deposits – more than any other UK mortgage lender – everything else seems to be fine and dandy too. The conventional building society model seems ready made to weather the present turbulence.
Mr Beale explains his success thus. With a mutual, you only have your customers to answer to. With a plc such as Northern Rock, the primary duty of care is to shareholders. Investors also expect plcs to take risks to generate better returns.
There is none of that pressure in a mutual, which is run solely for the benefit of the customer and the staff. Nationwide doesn't have to take on risky loans. The quality of its loan book is as a consequence second to none, while its funding is the most conservative in the industry. It also has very little exposure to the dodgy international credit which is causing such mayhem elsewhere in the banking system.
Mutual ownership was thought to be pretty much dead as a corporate model. Lack of access to capital markets, it was said, would ultimately doom it to stagnation, decline and eventual irrelevance. Look who's laughing now.
Third runway prepares for take-off
In agreeing to consult on a third runway and sixth terminal at Heathrow, ministers have bowed to market reality, which is that there is little, if any, demand for more capacity at Stansted, previously the Government's preferred solution, but oodles of it for the expansion of Heathrow, which despite its problems with standards of service is still where the premium traveller likes to fly from.
To deny Heathrow more cap-acity risked eroding its place as a world-class airport, and damaging British competitiveness accordingly. Yet there is still one more thing that needs to be done to safeguard Heathrow's future – force its separation from the rest of BAA. As a collective owner of airports, BAA fudges its priorities between them and can therefore never be properly motivated to make Heathrow stand head and shoulders above the rest in terms of service and investment.
Willie Walsh, chief executive of British Airways, promises to drop his campaign for separation now that BAA has swung full square behind the idea of a third runway at Heathrow. The Competition Commission, which is examining the issue, should be less magnanimous.