Judging by the US, the worst may be yet to come

You can always count on America to give the world a lead. Just as it kicked off the credit crisis, so it stays at the cutting edge as the crisis unfolds. So much the worse for the rest of us.

Phase I – the writedown of dodgy securities – is by no means over, but is no longer the big story. Phase II – the travails of ordinary commercial banks – is now well under way. And this, of course, is the mechanism whereby the credit crunch transmits itself to the real economy.

In the UK we may feel we know about this stuff already. After all, shares in the mortgage lender Bradford & Bingley are down some 90 per cent on a year ago.

But shares in IndyMac Bancorp, a lender of comparable ranking in the US, were down 99 per cent before the bank finally went under last Friday. As for the drama of Fannie Mae and Freddie Mac, that is in part a US speciality. But it also illustrates a wider issue.

To do their job of propping up the US mortgage market, the two agencies must borrow heavily from the capital markets. If – as looks to be the case – those markets become shut to them, they must instead sell assets, such as mortgage-backed securities.

In today’s markets, that would mean a fire sale. Other banks would then be obliged to mark to market and take further writedowns. And so the spiral winds on.

More generally, Lombard Street Research reports that total US bank credit in the 13 weeks to mid-June fell by an annualised 9 per cent. That is the worst since records began in 1973 – or, in effect, since the Great Depression – and compares with a 15 per cent rise as recently as March. So much for the Bear Stearns bail-out.

The pressure is therefore on the banks to recapitalise further. But providers of capital seem to be getting scarcer.

Part of the problem lies with US rules, whereby if you hold over 9.9 per cent of a bank you risk having to top up its capital should it fall below a given level.

The rules also hamper you from appointing directors – not an appealing prospect for an activist investor or private equity house. Hence recent moves to relax those rules – but how soon?

Similarly, the US Treasury is urging commercial banks to issue covered bonds, like their European counterparts. But there are snags. In the UK, for instance, analysts have argued that Bradford & Bingley will have difficulty maintaining its lending because of the extra capital needed to guarantee its covered bonds.

Despite all the alarm bells, though, the effects on the real economy are only just starting to show, even in the US. According to Morgan Stanley, US issuance of home equity loans actually accelerated in the 13 weeks to June 4. That, combined with the tax rebates to US households, presumably accounts for US consumer spending holding up so far.

But the latter factor is of course a one-off. And with consumer confidence at a 28-year low, the real downturn surely cannot be long postponed. After all, for lending to be sustained it is not enough for banks to advance the money. Ultimately, borrowers need to be confident in their ability to repay.

Granted, Morgan Stanley also estimates that real capital spending by US corporations rose by 5.7 per cent in the second quarter versus only 0.1 per cent in the first. That is frankly puzzling, and gives comfort to those hardy souls who argue the US downturn is the product of fevered Wall Street imaginations.

But corporate cash flows are under pressure, bonds markets are unaccommodating and bank lending is down. So how is this spending to be financed henceforth?

In the UK, the same sense of trouble postponed is if anything stronger. According to Leigh Goodwin of Fox-Pitt Kelton, UK defaults on both mortgages and commercial loans are still at the bottom of the cycle.

In mortgages, for instance, the default figure in this year’s first half was a negligible 1-2 basis points of book value. He expects this to rise to around 50bp – which, in the context of margins of 70-80bp, would wipe out most of the banks’ profit on mortgage business.

On the narrow question of bank valuations, one could argue all this is mainly in the price. Up to a point, no doubt.

But according to Absolute Strategy Research, the analysts’ consensus forecast is for a 10 per cent fall in European bank earnings next year, but a 23 per cent bounce the year after. For Europe, excluding the UK, the latter figure is 33 per cent.

Given the experience of past downturns, that is frankly unrealistic. We are in this for the long haul, and the US is showing the way.

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