What will the collapse of the fourth-biggest investment in the US mean for the UK?

by Tom Sieber

Following an unprecedented 24 hours which witnessed the collapse of Lehman Brothers, the largest insurer in the US, AIG, teetering on the brink, the forced sale of Merrill Lynch and a huge dive in global markets Shares assesses the implications on this side of the Atlantic.

The FTSE 100 was down 3.9% on Monday (15 September) and down a further 2.9% as we went to press on Tuesday. Aftershocks from the economic earthquake on Wall Street could impact everything from trading volumes on the London Stock Exchange (LSE) through to the cash registers of high-end retailers and, although we could never have predicted the direction events have taken in the last few days, our call a week ago, to sell into short-term strength in the banking sector, has proved to be justified. Despite the dramatic falls since, we are not yet ready to change that view – given the level of uncertainty that remains.

In the short-term we would retreat to traditional defensive stocks like utilities and pharmaceuticals. There may also be some strength among airlines as the price of oil falls, while gold has benefited from Lehman’s collapse as investors treat the precious metal as a haven. It jumped from $750 to over $780 per ounce. As a miner highly leveraged to the gold price, Randgold Resources (RRS) jumped 6.6% to £20.25 intraday on Monday.

Shares says: Buy National Grid (NG.), GlaxoSmithKline (GSK) and Randgold Resources

Trading Buy easyJet (EZJ)

Banking

Although we expect the sector to remain under pressure the Financial Services Authority (FSA) has said there is minimal direct exposure among UK banks to Lehman Brothers.

Given that and the fact that none of them is comparable to Lehman or any of the US investment banks we believe it to be unlikely that any of the financial conglomerates on this side of the pond will collapse.

However, for banks with funding pressures the massive increases in London Inter-Bank Offer Rate (LIBOR), which is the wholesale cost of credit, are a real concern, prompting the Bank of England to inject £20 billion into short-term money markets. HBOS (HBOS), which needs to refinance as much as £110 billion worth of debt in the next three months, is down more than 50% on Friday’s (12 September) close.

For now our havens will continue to be Standard Chartered (STAN) and HSBC (HSBA) and we would avoid investing in the rest of the sector.

Barclays (BARC), is 14% off Friday’s close as the market reacted cautiously to reports it had sealed a deal for Lehman’s US broker-dealer operations.

Alex Potter, banking analyst at Collins Stewart, says the interest signals management’s unwillingness to deleverage the balance sheet and adds: ‘continued leverage at the firm to be a negative’.

Shares says: Hold Standard Chartered, HSBC

Avoid Barclays, Bradford & Bingley (BB.), HBOS, Lloyds TSB (LLOY), Royal Bank of Scotland (RBS)

General financials

Traders at Lehman Brothers were reportedly the largest source of business for the London Stock Exchange’s SETS order book, said to account for between 12% to 13% of all deals. The LSE declined to comment, although the bank’s collapse, while perhaps boosting volumes in the short term as volatility spikes, will be negative.

While Shares previously believed the LSE was undervalued, the loss of Lehman’s business (and, although of less importance, the loss of the Lehman collaboration on the new Baikal trading platform) means investors should take a more cautious stance. Equally hard hit will be inter-dealer brokers ICAP (IAP) and Tullet Prebon (TLPR) who also rely on investment bank trading volumes. But down 16.8% and 13% respectively these shares are factoring in potential revenue losses.

The follow on for asset managers will be a further reduction in assets under management, and possible downward earning revisions. Traditional long-only fund managers like New Star Asset Management (NSAM) and F&C Asset Management (FCAM) look most vulnerable.

Spread betting providers IG Group (IGG) and London Capital (LCG:AIM) faced two potential risks, one being that Lehman was a counterparty to their trades and the other being unsettled losing client bets on Lehman’s share price. London Capital says it has no counterparty risk to Lehman and that clients have sufficient funds to cover losses. IG, while unavailable to comment, told Investec analyst Daniel Havercroft it did not have counterparty risk to Lehman and no ‘material’ bad debts from client losses. IG and London Capital should therefore benefit from the increased volatility driving up trading volumes.

Shares says: Hold London Stock Exchange, ICAP, Tullett, IG and London Capital

Sell New Star Asset Management and F&C (SK)

Insurance

While AIG’s difficulties are company specific, sentiment towards the wider sector will certainly be negative in the short term. Not forgetting the fact that the ensuing turmoil in the investment markets will also put pressure on all insurance company’s investment returns. There could be a silver lining though. Firstly AIG has been a major operator in the global industry for years and is a key competitor to Lloyd’s. A less aggressive AIG could be a positive in that it limits competition both at home and abroad.

Companies worth holding on to on valuation grounds include Brit Insurance Holdings (BRE) and Lancashire Holdings (LRE:AIM). Counter-cyclical play Abbey Protection’s (ABB:AIM) emphasis on legal expenses insurance and tax protection should be defensive in an economic slowdown. While in the life insurance sector, changes in both demographics and the regulatory environment suggest the long-term future for Just Retirement (JR.:AIM) looks bright.

Shares says: Hold Brit Insurance Holdings, Lancashire Holdings, Abbey Protection, Just Retirement

Commercial property

The crash in commercial property is likely to be at the most extreme end of pricing forecasts in the key City and Canary Wharf financial areas. City rents are expected to fall by at least another 25% in the next two years.

So the near 20% rally in property shares since July is likely to prove a dead cat bounce. Shares in Songbird Estates (SBDB:AIM), the Canary Wharf developer, have dropped from a peak of 370p just over a year ago to 94p on Tuesday having rallied from 87p to 110p since July.

British Land’s (BLND) chart shows a similar pattern with the shares more than halving from £17.21 in early 2007 to 758p this week, having bounced from the July low of 619p. City property specialist Minerva (MNR) is the worst hit with a fall from 424p to 74p.

Re-letting the 14% of space in Canary Wharf occupied by Lehman, worth £300 million a year in rent, will take several years though there is a four-year rent guarantee from AIG which also occupies Songbird property in Canary Wharf.

Shares says: Sell Songbird Estates, Minerva and British Land (TD)