Last year saw a huge swing in the banking sector as the dreaded credit crunch took hold and lenders tightened their belts considerably. Northern Rock et al suffered, but what is the future for share prices in the troubled sector?
With banking still feeling sub-prime shockwaves, IG Index analyst Anthony Grech looks at the effects the subsequent credit crunch is having on banks and the financial sector.
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Why are banks suffering?
The collapse of the sub-prime mortgage market in the US sent waves of concern across the global economy, with billions written off some of the world's largest banks with links to the sub-prime sector. These write-downs severely slashed banks' earnings, with Bloomberg estimating some $146 billion was lost or marked down in the sector in 2007.
The sub-prime market, the key to the credit problems of the last few months, consists of individuals with poor credit ratings who are offered mortgages and loans with higher interest repayments, in order to compensate for the increased level of risk.
During 2002 to 2004, interest rates in the US were historically low, meaning people with lower credit ratings were able to take out sub-prime mortgages with lenders happy to simply raise the interest repayments. However, the debt began to pile up while the Fed's interest rates continued to rise. By the end of 2004, interest rates in the US and UK began to pinch sub-prime lenders while borrowers increasingly defaulted on their payments, with tens of thousands of properties being repossessed.
Meanwhile, the banking sector had also been busy repackaging the income from the sub-prime mortgages into complex asset-back securities (ABS), which became highly unwieldy as defaults on payments increased and the funding tailed off. Banks tried to sell the ABS products off quickly, causing their value to tumble.
Using complicated computer-based models, the banks had to re-calculate their losses, raising concerns over the accuracy of the results and causing billions to be written off.
And as a result, during the period from 30 January 2007 until 30 January 2008, the share price of some of the world's largest banks plummeted. Merrill Lynch fell by 40% from $92.76 to $56.09 while US banking giant Citigroup's shares halved from $54.27 to $27.88. HSBC Holdings (-19%), Morgan Stanley (-40%), Bear Sterns (-46%) and UBS (-32%) shares were also badly hit over this 12-month period.
What is the future for banking markets?
With concern over the huge losses inevitably affecting share prices, most spiralled down as investors sold their shares in the banking sector. Recently, HSBC, the UK's largest bank, announced an £8.7 billion loss due to the sub-prime effect, with share prices falling almost 20% over the year ended 30 January 2008.
'The outlook for the rest of 2008 is uncertain,' announced HSBC chairman Stephen Green. 'The economic slowdown and the credit outlook in the US may well get worse before they get better.' [1]
However, there was already optimism for the market back in December 2007, William De Vijlder, chief investments officer at Fortis Investments, claimed that banking shares were on the brink of recovery. Mr De Vijlder said: 'Despite what the market currently anticipates, we think that financial stocks could start to bounce back even though the US housing slump continues.' [2]
The general consensus is that further write-downs are to be expected in 2008, which will in turn affect share prices. However, some experts suggest that banking sector shares are starting to fall close to their fair values from a fundamental analysis perspective, which could mean they support – acting as a potential wall to the current downside.
Following your judgements in the market
Whatever your views, there are options available to take advantage of the situation. Speculators who believe the market will continue to fall, with share prices dropping, could go short, backing their theory that further market uncertainty and continuing write-offs will further expunge banks' earnings, sending share prices down.
However, traders could also feel that the market has hit its lowest, meaning they will place long positions in the hope that share prices will recover as the economy battles the continuing credit crunch.
Take a more in-depth view on the banking sector with our specialist report from IG Index analyst Anthony Grech, available to all clients. Apply for an account and get set up in minutes.
[1] Source: BBC (3 March 2008) 'HSBC in $17bn credit crisis loss'
[2] Source: Reuters News (7 December 2007) 'Banking shares poised to recover – Fortis'
The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.
Updated: 5 March 2008