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Economics
Worrying Aspect of Recent Bank Mergers
September 25, 2008
Clifford Bennett, Chief Economist, Sonray Capital Markets

There is a worrying aspect to the recent seemingly framed “rescue” bank mergers in that they tend to contain a significant concentration of exposure to the still declining property market. Several cases, from Westpac and St George, to Lloyds and HBOS,involve the payment of a premium to current stock values of the take-over target.

This suggests the purchasing bank believes it is worth paying a premium to increase its exposure to the mortgage market. The thinking can only be that the property market is bottoming and therefore the increased exposure is an averaging down process in terms of overall exposure and the price of that exposure. This is a very dangerous game which runs the risk of extending the current crisis perhaps for another one to two years. What happens when like Westpac you have become the largest holder of home loans in a declining home value market. It is a clever idea if you are correct and close to the bottom, but it could seriously harm the purchasing bank a year or so from now if home values continue to decline as they have in the US and are in the UK. For an organisation such as Bank of America, increased exposure to the US mortgage market is fraught with danger.

The most likely scenario for the US property market is further decline. Several measures of home values in the US have prices down by 15% to 17% and still falling.

Given the property market was already to say the least vulnerable, the current headline grabbing financial contagion can hardly be seen as having anything else than a further downward impact on home prices. The US authorities “conservatorship” actions regarding Fannie Mae, Freddie Mac, and now AIG, contain within the agreement and commitment to a steady unwinding of exposures, in other words the sale of mortgage paper and or related property.

The implications for the entire financial industry is further downward pressure on mortgage related CDOs and perhaps other CDOs as well. This will be occurring as all and any financial institution in the world looks to reduce their own exposures.

For the man or woman in the street, there is no doubt as to the risk they now face in regard to their own property and any investment properties they may have. The depth and degree of media coverage is likely to lead smaller more nimble participants in the property market to bring forward any sales they were already considering.

This process is likely to weigh heavily on home prices in the short term. With institutional property unwinding likely to be significant in the months ahead, there may be little if any let up in the current downward price pressure. As previously mentioned the expectation here.

is that the US property market will decline a further 10% to perhaps 15% into the early part of 2009. This will spill over to a lesser degree to the UK, and again to a lesser degree to Australia, but it will spill over.

With that degree of devaluation further significant pain lay ahead for any bank with a large exposure to that market, regardless of any recent improvement in the average price of that exposure via merger. The paying of premiums may be difficult to justify with the passage of time.

Current seeming rescues may be an unnecessary increase and concentration of risk.

Clifford Bennett, Chief Economist, Sonray Capital Markets.

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