How did the banks get in this mess?

Property prices in the US got out of control. Once borrowers began to struggle, prices crashed. It is too easy in the US to "hand in the keys" and walk away from property debt.

Lots of US mortgage-backed securities cycled round the banking system and European banks got hurt too. The property bubble has now burst in several countries. Financial stocks and shares have suffered greatly.

Confidence in banks had all but evaporated until governments acted decisively. Banks "borrow short and lend long" - they rely on confidence. The problem was most acute for those that borrowed from other banks - that is what caught out Northern Rock and Bradford & Bingley.

Recessions have popped up all over the globe. To the extent that their impact is now going to be worse than expected, non-financial stocks and shares also fell in value.

Are banks now safe?

Banks need to be both solvent and liquid - governments are helping on both fronts. Solvent means have a healthy margin of assets over liabilities. Liquid means having enough cash to meet immediate demands from depositors. Governments are taking shares in banks where necessary to build up a large margin of solvency, and then they are prepared to take further steps to improve liquidity. This should enable banks to start lending again - otherwise the dangers for property markets and businesses large and small are immense.

Retail depositors in the UK can also take considerable comfort from the way our government has intervened so far. They even stepped in to protect  retail deposits with Icesave - but non-retail depositors will need to see how things turn out. (The Barings experience proved pretty good for depositors, although they had to wait for their money.)

Aren't all savings guaranteed though?

The government is reluctant to issue guarantees, but there is a Financial Services Compensation Scheme (FSCS) that protects private individuals, and even small businesses in some cases. For bank and building society deposits, the limit has just been raised to £50,000 - and you can double that if you have a joint account.

For savings with life insurers and friendly societies (such as MPFS), the protection is unlimited - but only covers 90% of the value. It is worth noting that liquidity (ready cash) is not an issue for such firms - they do not lend and most of their investments can be cashed in within days. Also their solvency rules are well tested - historically, only 2 tiny firms have failed (in 1980 & 1993).

How are with-profits funds affected?

The investments in such funds are usually well spread. Some closed funds have sold all their shares. Other funds, even well-capitalised ones like MPFS, have reduced their commitment to shares in recent months. Only government bonds have performed well in the credit crunch, so investment returns in 2008 are bound to be disappointing. But direct investment in shares or unit trusts will have been far worse!

At MPFS, we have been through this before - the previous bear market bottoming out early in 2003. It has not stopped us delivering long-term value to our members - but it does emphasise the need to regard investments as long-term commitments. We still pay final bonuses on lump sum investments when they are cashed in. A With-Profit Bond cashed in after 10 years currently returns a profit of nearly 70% including the final bonus (basic rate tax paid by us). That is equivalent to an annualised net return of over 5% per annum compounded.

Stuart Bell
Chief Executive
October 2008

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