If Simon Wolfson, CEO of Next, gets it why doesn't the market ?? 22.04.2009

Author: David Whittaker Posted on: 22 April 2009

Alongside more encouraging employment statistics it appears that the problem of bad debts is not quite the catastrophe the markets were expecting. A key indicator of this is that defaults on mortgages are nothing like as high as the depressed prices of mortgage-backed securities would suggest.

Mortgage-backed securities are large pools of mortgages lumped together by banks and sold on to investors so that the banks can raise funds. In a given pool the best 93 per cent might be classed as triple AAA. Investors who buy these securities will only lose their money if more than 7 per cent of the total loan is not paid back. A 7 per cent loss would require many more than 7 per cent of borrowers to default, because the value of repossessed properties is likely to cover a significant portion of any unpaid loan.

Let's say the mortgage loans represent a not untypical 70 per cent of the value of the underlying property, even if the properties fall in value by half the bank will recover 71 per cent of the value of its loan. So, in this example, for the AAA bonds to incur any losses an astonishing 23 per cent would have to default - that's more than one in five. That is simply not happening; repossession rates are still well below 1 per cent.

Unlike the recession of the early 1990s interest rates have fallen, making defaults even less likely. Yet AAA mortgage-backed securities are trading at 93p in the pound: this price implies a default rate of more than 40 per cent.

The conclusion must be that mortgage-backed securities are now trading at way below reasonable value. In time, the smart money will take advantage of this and banks will see the market value of their assets increase. This will free up the banks to lend more money and, slowly but surely, the banking sector will come back to life.

The markets have in fact overly punished the banks for careless lending. The astonishing bounce in Barclays' shares (up by more than 200 per cent in a couple of months) is testament both to the remarkably strong and sensible leadership of that company and to the slow awakening of the markets to a world that is not quite as dangerous as the pundits have indicated.

So we can expect a slow but steady return to normality, an economy bruised but still breathing. Don't expect an overnight cure, we still have a difficult year ahead, but hopefully the foundations of a recovery are in place.

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Author: David Whittaker