Heading for a crash?

The queues at Northern Rock branches around the country were a graphic reminder of how dependent modern economies are on a sound and stable banking system, writes Michael Jackson.

Assurances have been provided by Northern Rock, which says it’s agreed new guarantee arrangements with the Bank of England and HM Treasury, bringing enhanced protection for customers during the current instability in the financial markets. Unquestionably, the central bank acted quickly and decisively to restore investor confidence. But are we really past the worst?

Northern Rock, of course, landed itself in trouble by borrowing large amounts of money from other banks to provide money to its homebuyers. Such a strategy has proven unsustainable after the sub-prime meltdown in the US, where mortgage loans were given to people with dubious credit histories and the banks packaged and sold on the debt.

It’s hit major financial institutions and hedge funds, which are no longer able to sell on this dodgy debt and are facing much bleaker balance sheets.

Burst bubbles
There’s also a recognition that the private equity industry’s ability to do mega-deals using debt multiples as high as eight to nine times earnings before interest, tax, depreciation and amortisation (EBITDA) is almost certainly dead. This in turn may well affect quoted and unquoted equity prices (downwards!) as private equity has been responsible for some 40 per cent of deals in the past three years.

Another factor is that acquisitions fuelled by the availability of vast funds at very favourable rates are likely to slow down as the ‘credit crunch’ starts to bite. A knock-on effect is that lawyers, investment banks and accountants will be less busy. So if you have a large exposure to these sectors, be warned.

But you might say, so what? I run a growing company and the effect of esoteric financial instruments, which have made some back-office financial engineers very rich, is of no concern to me.

Why should you care about highly leveraged acquisitions drying up? They simply cost greedy private equity executives their bloated interest payments taxed at only ten per cent – or at 18 per cent now that Chancellor Alistair Darling has trimmed off some of the fat.

Not-so-hot property
But you may be wrong. Market confidence is such a vital thing that if this starts to erode, then it could hinder us all. Let’s take the housing market. There’s no doubt this has been affected, with the possible exception of central London property. Falling house prices have a massive impact on the feel-good factor of many people and may prove the biggest bombshell to hit economic growth.

It may be too soon to discuss the ‘R’ word now, but even a slowdown means less capital expenditure and fewer employment opportunities.

And it doesn’t stop there. Property is one of the key assets many people use to secure debt for both personal and company use. Declining asset values are very bad news anyway, but particularly when you are using them to secure a business or personal loan. So, reduced asset value and poorer economic prospects add up to pain for everyone, not just the super-rich.

Now, you may be saying what a horrid pessimist I am, but there are some early indicators. For one, fine wine prices are down 30 per cent from their peak.

Signs of trouble
Shares in small companies are some 20 per cent down and although the FTSE 100 is still powering ahead, this is partly driven by large cross-border deals and not representative of stock markets as a whole.

We do not know what is happening with the US housing market, but if things got a whole lot worse the US economy could well slow down significantly over the next six months as consumer spending dries up - not good news.

However, it is an ill wind that blows no good at all. The spectre of rampant inflation is less apparent now. With oil at $80 (£39.20) per barrel and record prices for commodities such as copper and lead, a slowdown could provide a welcome easing of prices. Let’s hope so.

Worse, though, is if prices continue to soar while growth remains sluggish, or enters negative territory. Anyone remember the recession between 1990 and 1992? It must send a chill down any Tory MP’s spine even to think about it. But Prime Minister Gordon Brown may have a similar situation if things go the wrong way.