When greed gave way to fear: how debt deals left the financial world in turmoil

Anthony Bolton, the fund management supremo at Fidelity, is widely regarded as one of the wisest heads in the City. So when he says there is no need to have a seizure over the current state of the markets, investors should be reassured.

"My advice to small investors is not to panic," Mr Bolton says.

He adds that he has taken a "cautious approach" to equity markets since earlier this year and is on the record as saying that too many fund managers of every hue have been blind to the dangers of debt-based financial products.

"Maybe some people did not truly understand what they were buying into," he argues.

But despite a recovery in the value of shares on Friday, we are by no means out of the woods yet. "The markets are going to be difficult for the next few weeks," Mr Bolton says.

The current share price crash has caught traders and economists completely cold, with £60bn wiped off the value of shares in London alone on Thursday. So how did we reach this point?

The origins of the slump lie in the US, where banks have been handing out hundreds of billions of dollars in "sub-prime" mortgages to borrowers with poor credit histories. What has that got to do with falls in the FTSE? Well, major financial institutions on both sides of the Atlantic, as well as hedge funds, have been buying debt in the US sub-prime mortgage market. As defaults increase, this type of debt becomes less valuable. Shares in banks and other financial institutions have fallen as they are forced to write off the value of their investment.

But hedge funds are to blame for the FTSE slump as well. Banks lend to hedge funds on the basis that they can recall loans if debt rises above a specified proportion of the total fund. As shares have fallen, the banks are calling in the loans, forcing hedge funds to sell equities to cover the repayment and thus triggering further falls in share prices. And as fears grow about the state of the US economy, in particular the declining spending power of the American consumer, a whole range of companies that do business with the US are hit. It is a vicious circle – a perfect storm of anxiety – that has caused some extreme movements in global markets.

The credit agencies, such as Standard & Poor's and Moody's, are now subject to a European Commission inquiry to find out why they did not pick up on what was happening earlier. The agencies are supposed to determine how risky each financial product is, and give them a rating as a guide to investors. Many of the funds and types of debt product that are now coming under severe pressure were given top ratings by credit agencies.

Anyhow, as the recriminations start to fly, traders and economists are desperately trying to work out if there are further falls in markets to come. Although a 0.5 per cent cut by the US Federal Reserve to the rate at which it lends money to banks trigged a 205.3 point surge in the FTSE on Friday afternoon, the future is still uncertain.

The main problem in coming to any conclusion is the uncomfortable fact that no one knows just how exposed UK financial institutions are to the US sub-prime market and its derivative debt products. And so far no bank is coughing up the information. The Financial Services Authority has told UK institutions to rapidly tot up their losses and announce them to the market in order to inject some transparency into the situation. However, given the complex and interlocking nature of the investments in question, the answers may remain obscured for some time yet.

Yesterday the FSA refused to confirm it was pressuring banks to come clean about the scale of their losses. However, a spokesman said: "As you would expect, the FSA is carefully monitoring developments in the financial markets and, in the normal course of business, has had discussions with other relevant authorities about current market conditions.

"By and large, the relatively benign economic conditions of recent times have left the major financial institutions we supervise well capitalised, but we are in constant dialogue with them to ensure that they are vigilant with regard to the risks inherent in tighter and more volatile markets."

Robert Talbut, chief investment officer at Royal London Asset Management, says: "We still don't know how bad the problem is. There have been no clear confessions from institutions."

Richard Batty, global investment strategist at Standard Life, says: "What problems are out there will only reveal themselves in the medium term."

Mr Bolton echoes his comments: "What is happening now is a result of what ripples we can see on the surface. We do not yet know what problems lie beneath the surface."

The rapid drying-up of liquidity in financial markets may have dire consequences for private equity groups. Several takeover bids, including that of the J Sainsbury supermarket chain by Delta Two, the Qatari-backed buyout fund, may now be under threat from banks no longer willing to risk lending billions of pounds for highly leveraged deals.

So far, the crash in global share prices has been seen as purely a financial market crisis, removed from "real world" economic strength. Company profits remain at record levels, and there are a significant number of FTSE 100 companies paying a dividend to shareholders of over 5 per cent at current prices. Companies are also trading in line with historic earning multiples and do not look particularly expensive. Several commentators have gone as far as to say that now is the perfect opportunity for investors to fill their boots with cheap shares.

But that advice might be misplaced. Mr Bolton says: "First, there is the US consumer. I can't see how any of this is good for them. And second, if people change their attitude towards investment risk, then that will have an adverse impact on economic activity. A risk-adverse climate does have an effect on the real world. People are saying that everything economically is great now, but we need to be looking at the situation six months down the line."

He adds ominously: "We are leaving behind an environment of greed and entering an environment of fear."

Britain's economy feels the shock waves from panic across the Atlantic

Property

The question mark already hanging over the future of the UK's housing market has grown substantially larger as a result of events taking place across the Atlantic. There are even fears that the UK market could follow its US counterpart into decline.

The current panic in the US stock market caused by the crisis in the sub-prime mortgage market looks set to have a negative impact on the more aggressive end of UK mortgage lending. According to Simon Rubinsohn, the chief economist at the Royal Institution of Chartered Surveyors, the likely impact of the US crisis in the first instance is an increasingly cautious mortgage market, with lenders ceasing to offer high multiples of salaries to mortgage applicants. This could squeeze the housing market in the short term.

But Mr Rubinsohn believes that the panic in the US equity market could conversely benefit UK house prices in the medium term. He said: "People looking at their pension pot who might just about have forgotten about the dot-com bubble, and who were thinking of dipping their toe into the equity market, may now be tempted to forget about stocks and buy to let instead."

Retail

News from American shopping malls is that the crisis in the sub-prime mortgage market and the subsequent drop in share values have already hit consumer spending. Stores are reporting sharp falls in revenues towards the end of each calendar month as some shoppers struggle to repay their debts.

With US chains such as Wal-Mart already feeling the squeeze, retailers in Britain are asking themselves how long it will be before high streets over here start to feel the heat. Malcolm Pinkerton, the British Retail Consortium's business information analyst, says: "If the lending market in the UK becomes less competitive, customers already affected by mortgage costs and the high cost of living will have less to spend in the shops. Retail spending is fuelled by credit and the net effect is likely to be reduced revenues for retailers."

The British Retail Consortium has already reported that higher borrowing costs and heavy rain pushed retail sales growth in the UK for July down to its lowest level in seven months. There are fears among retailers that falling stock prices and a tightening of lending criteria will accelerate what is already a downward trend.

Manufacturing

While manufacturers earlier this month were welcoming the sharp dip in inflation to 0.1 per cent below the Bank of England's 2 per cent target, there is new concern from industry about dollar weakness resulting from the recent financial turmoil.

The relief represented by a freeze on UK rates would count for little if there were to be a significant economic slowdown in the US, forcing the Federal Reserve to cut rates and weaken the dollar further.

"If it's just a small currency movement on its own, we would expect the impact on manufacturers to be fairly limited," says Steve Radley, chief economist at the Engineering Employers Federation, which represents manufacturers.

But, says Mr Radley, if the current financial crisis led to a US economic slowdown that in turn led to an appreciation of the pound against the dollar, then "manufacturers would have a double hit" of reduced demand for their products and a squeeze on prices.

Another problem with the current volatility of stock markets will be a difficulty for publicly quoted manufacturing companies in raising cash through equity fundraisings to expand their businesses.

Pensions

The disastrous state of the US sub-prime mortgage market could, it is feared, have long-term negative effects on the retirement plans of workers in some of Britain's leading companies by reducing the value of the equity-based funds that service their pensions.

Last week saw firm evidence that British pension schemes are already beginning to bear the brunt of the US stock market crisis. Leading UK actuary Lane Clark & Peacock (LCP) reported that the UK pension schemes of the FTSE 100 companies had £18bn wiped off their assets by the end of July, with a further £9bn being lost last Thursday alone. LCP estimated that the FTSE 100 pension schemes had a combined deficit of £15bn by the close of play on Thursday.

Ken Willis, the head of corporate investment consultancy at LCP, said: "In my view, it is crucial that the companies who sponsor pension funds understand the investment risks they are running."

However, UK pension holders should not panic at the news and should bear in mind that their pension funds were in deficit at Christmas, then moved into surplus before going into deficit again. They could change once more just as quickly.

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