Investors must not let euphoria go to their heads

by Tom Sieber

Despite a sharp rally in UK banking stocks it would be a mistake to see the multi-billion dollar bailout of US mortgage institutions Freddie Mac and Fannie Mae as a ‘buy’ signal. Investors should instead sell into this strength.

Share prices in the sector had cratered last week after both the European Central Bank (ECB) and the Bank of England revealed funding is unlikely to be as freely available as it has been. The ECB decided to crack down on what its president, Jean-Claude Trichet, termed ‘abuse’ of the bank’s additional lending facilities, and the ECB will begin to demand more collateral in 2009.

Such worries were then swept aside after US Treasury Secretary Henry Paulson announced a plan to effectively nationalise Fannie and Freddie, which guarantee around half of all US mortgage lending. From Friday’s close to midday on Tuesday, Barclays (BARC) gained 16.9%, Royal Bank of Scotland (RBS) 17.3%, and HBOS (HBOS) 17.8%. Even relative laggards such as HSBC (HSBA) Standard Chartered (STAN) and Lloyds TSB (LLOY) chipped in gains of 8.3%, 10% and 13% respectively.

Yet this barely takes banking stocks back to where they were a month ago. As Sandy Chen of Panmure Gordon (PMG:AIM) explains, the action has had little impact on liquidity and has yet to lower mortgage rates on either side of the pond, two of the stated aims of taking Freddie Mac and Fannie Mae into public ownership. He says: ‘All the fundamental drivers for the credit crunch are still very much in place, and we do not see the US bailout of Fannie Mae and Freddie Mac changing that.’

To emphasise the point, the three-month London Interbank Offered Rate (LIBOR), a key indicator of lending between banks, has barely changed since the US plan was announced and stands at 5.7%, still way above the Bank of England’s 5.0% base rate. This suggests banks have not suddenly become more willing to lend to each other and credit markets by implication remain clogged.

Paulson’s plan is also unlikely to significantly impact UK house prices, with the chief executive of the Nationwide Building Society this week predicting a turnaround will not be forthcoming until 2010 at the earliest and that prices have at least another 25% to fall. On that basis significant headwinds remain for the UK’s biggest mortgage lender, HBOS, in particular.

Shares says: With more negative macro-economic news in the offing this rally should be short-lived.

Hold HSBC, Royal Bank of Scotland, Standard Chartered

Sell Barclays, HBOS, Lloyds TSB.