Don't think that it is just the US that has to worry about systemic risk. The Europeans have their own problems and the weaker financial institutions are getting absolutely killed in European trading right now. Royal Bank of Scotland (RBS) is down nearly 13%. But HBOS is the top loser in the UK, down almost 25%.
Are we about to see bankruptcies over in Europe as well?
Given the inter-connectedness of the global financial system, it is not difficult to understand that selling pressures are hitting the European markets as they hit Asia in overnight trading. However, it is in the UK where things are the diciest. The UK has seen a double-digit decline in home prices and its property market is potentially more inflated than the US market, and therefore has further to fall.
This means that the companies most exposed to falling property prices are in the firing line right now. Number one on that list is HBOS. The company, which is the result of a merger between Bank of Scotland and the Halifax, formerly the UK's largest mortgage lender, is heavily exposed to property prices and is now experiencing increased selling pressure as a result.
HBOS is more reliant than any other major UK bank on borrowing in the wholesale markets for its funding, and could face higher financing costs as a result of Lehman's collapse, which is likely to increase problems with interbank lending, analysts said.
Just in April, I was openly wondering why HBOS had not been pressured by the markets.
Looking through old e-mails, I read an article from the FT in 2006 that surfaced claiming that HBOS (Halifax Bank of Scotland)were poised and ready to go offer loans for 125% of value. That's right, HBOS thought it a good idea to cover 95% of the house price and loan another 30% over appraised value unsecured as a personal loan.
Now that the UK has joined the housing bust, one must ask where are the massive write-offs that have to be sitting on HBOS' books? Why aren't they looking to do another rights issue like RBS? I fully expect some pretty horrific things coming from HBOS as the housing crisis heats up in Britain.
Now the case is exactly reversed: I wonder if market pressure will be the HBOS's downfall.
RBS is the second big bank to come under pressure as they too have taken riskier assets onto their balance sheet and have had a difficult time raising capital to shore that balance sheet up. With the equity and capital raising markets closed, RBS's options are effectively limited.
The question remains what the response by the Bank of England will be. The BoE and the European Central Bank seem less likely to bail out failing institutions than the Fed, although Northern Rock was eventually bailed out by the BoE and is now a British taxpayer liability. It must be worrying for the likes of HBOS to know that even the Fed let Lehman Brothers fail.
In the end, the question for HBOS and RBS will be liquidity and not solvency over the near term. Last Tuesday I said the following on solvency:
When it comes to solvency it is usually an issue of cash flow and not profitability. An institution can be perfectly profitable and become insolvent, just as an unprofitable institution like General Motors (with over $50 billion negative equity - see their Q2 2008 balance sheet) can continue as a going concern.
One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.
This will be the issue for mortgage lenders in the UK going forward. Northern Rock collapsed because of its heavy dependence on the wholesale market. As HBOS and RBS fight for their survival, the same issues are at hand. Whether HBOS and RBS remain going concerns depends heavily on the measures they and the UK monetary and regulatory authorities take to bolster a jittery market.
Let's see how this process unfolds.
See also: Credit Crisis Timeline for a full list of writedowns by institution and a timeline of the credit crunch.