The problem of a lack of available funding remains. While the extension of the Special Liquidity Scheme offers a brief respite, and should help tide firms over a potentially difficult year-end period, the lack of funding coming into the system remains the vital issue for the authorities to address.
Forming a clear view on where events might take us next is highly challenging amid such high octane volatility. The markets have seen developments and decisions made that few would have believed possible just a few months ago.
The US authorities have exercised difficult judgments in deciding which firms to leave to the mercy of the market. In cases where there was overwhelming systemic risk, the US taxpayer had stepped in, with mortgage giants Freddie Mac and Fannie Mae taken into temporary ownership and acquiring an 80% stake in the world's biggest insurer AIG. Elsewhere the strategy has been to leave solutions to the market. Investment bank Lehman Brothers was allowed to fail without a bail out, while Merrill Lynch sought safe haven with Bank of America. The continued volatility in the markets suggests participants do not fully understand under what circumstances the authorities will intervene.
In the UK the authorities clearly do not want to see a deposit taker fail. To date the private sector has formed its own solutions with Santander taking over Alliance & Leicester, Nationwide absorbing fellow building societies Derbyshire and Cheshire, and Lloyds TSB acquiring HBOS.
The fundamental market problem remains an actual or perceived shortage of available funding. The extension of the Special Liquidity Scheme through to the end of next January is certainly welcome and will provide some headroom for getting through what could have been a difficult end-of-year period. But the SLS only addresses the issue of liquidity, not the root cause of an ongoing lack of funding.
Mervyn King has made palpably clear his objection to the Bank of England going any further in injecting funds into the system, but the extension of the SLS is something of a U-turn. The deadline for Sir James Crosby to submit his final recommendations on funding is the end of this month. In the current highly charged environment one would expect the government to respond positively and take appropriate action in as short a time frame as possible.
Housing and the economy
The news out of the housing and mortgage markets over the last month has been much as expected. House prices are falling, turnover is low and remortgaging activity has weakened. On a positive note, several lenders have reduced rates on low LTV fixed-rate products, in response to lower rate expectations going forward. Nevertheless, the lack of funding and the low level of mortgage approvals means that the coming months are likely to see activity continuing to weaken.
At the same time the wider economy clearly taken a turn for the worse and we have almost certainly entered into recession. The labour market is weakening and unemployment starting to rise. The decision to increase the zero stamp duty threshold to £175,000 is helpful but will not kick start the market in itself. The MPC noted in the minutes of its last meeting that the package of measures will not have a significant impact on the wider economic outlook.
Economic weakness will bear down on inflation next year. Once the recent spike in utility and food prices drops out of the annual comparison, the weakening in demand should become the dominant force. The Bank of England is understandably concerned about the high current level of inflation feeding through into a sustained increase via pay increases as well as higher import prices due to the weakening in sterling. But the weaker the labour market is, the less likely this is to happen. Consequently, the MPC may well reduce rates quite sharply next year and the odds have shortened for a cut as soon as November.
From a wider perspective, as HBOS chief executive Andy Hornby said in a recent interview with the BBC, the downturn still has some way to run and the first step on the road to recovery in confidence in the global system will be when US house prices start to stabilise.