June 25, 2008 | posted by Michael Baxter in Banking |

Investors understand it.

In times like these, asset prices can fall too low.    Shares in some mortgage lenders have fallen off the edge of a cliff.  It is not just Bradford and Bingley that is suffering.  Shares in buy-to-let specialist Paragon have fallen by 90 per cent; there’s Kensington Mortgages, which specialised in the UK equivalent of subprime lending, and was sold on the cheap; and a host of other lenders.  There’s also an awful lot of mortgage-based securities sitting on bank balance sheets – security they don’t want.

In times like these, it seems as if there is no hope for mortgage lenders operating at the subprime and buy-to-let end of the market.    

But investors understand that when bubbles burst, valuations fall too low.  Markets always overcorrect.   Recovery occurs, eventually. The assets no one wants today, will have value again.  

That is why Clive Cowdery’s plan for Bradford and Bingley is so bold.   He sees the swoop he is planning, in conjunction with fellow B&B shareholders Standard Life, Legal & General Investment Management, M&G and Insight (a part of HBOS), as a stepping stone.  A stepping stone to build up a new empire, created when price was cheap.

It is a philosophy that often runs close to the heart of a dedicated investor.     That is why shares in B&B soared yesterday.  They know a good idea when they see one.

It is not that the deal the bank put together with private equity company TPG wasn’t a good deal in the circumstances.     B&B had to move fast. If it hadn’t, well – the mind boggles, but we could easily have seen another Northern Rock movement. 

On face value though, the deal on offer from Cowdery and chums wins hands down over the TPG option.   It is pumping in more money at a higher share price, and involves the possibility of creating a new financial empire too boot.  Talk is, even Alliance and Leicester could come into the fold, eventually. 

The danger is this.  Supposing TPG lose patience, walk away, and the Cowdery deal falls through.  

Cowdery is an unknown quantity.  Sure, he made a packet with a similar venture in the insurance business, but there are crucial differences.  There is a difference between investing in closed insurance schemes that are cheap, and putting a management team in place to run a consortium of active banks and other lenders.

B&B is a bank.  Above all else, banks can not, must not, fail. 

The Cowdery plan offers a ray of hope for shareholders that they will eventually see their shares return to the values seen a year or so ago, and then maybe go up even further.

But, it is a high-risk strategy for B&B to pursue this policy.

So what they have to do then is keep TPG warm.  Make lots of noises about how they have no interest in the Cowdery plan, appear to give only very reluctant due diligence materials to Cowdery and hope he can come up with a cast iron, risk free plan before it has no choice but to accept the TPG offer.

Remember how quickly Northern Rock went down.  It is like that with banks. Crisis can erupt overnight.   For that reason it is a race against time, and the clock is ticking fast.

The irony, though, is that while it would be more risky to go down the Cowdery route, it is nothing compared to the risk it took lending out mortgages at the height of the market.

The perversity of bull and bear markets is this.  When, during a bubble phase, valuations are too high, banks and investors often pile in.   When the bubble bursts, and valuations become too low, banks and investors often retrench.  

At a time when assets are too expensive they think it is less risky to speculate.  When asset are cheap, speculation is seen as risky.

It will be like that with the housing market.  When houses were too expensive, it was easy to get 100 per cent mortgages, or even higher loan-to-asset values.    Should house prices fall to a sustainable level – say they fall 25 per cent – bringing average price in line with the level the IMF says is about right, chances are banks will be scared to provide any kind of mortgage of more than say 85 per cent of a property’s value.

This is why we have economic cycles.  And this is why prices will probably fall too low – overshoot on the way down.    And is why fortunes are often made in times like these.