Saturday, March 15, 2008

Financial system must tap the taxpayer

(Krishna Guha in the FT) The notion that the US could suffer the kind of deep and protracted recession that plagued Japan in the 1990s no longer looks as far-fetched as it did a month or two ago.

House prices are in free-fall, spreading losses through the universe of mortgage-backed securities and making it very difficult for financial markets to stabilise. The labour market is cracking, with three consecutive months of job losses in the private sector. Consumer sentiment has soured and spending is faltering.

Financial markets have taken another lurch downward – triggering emergency responses, including Thursday’s rescue of Bear Stearns, the Federal Reserve’s $436bn liquidity support package and proposals in Congress for $300bn in housing loan guarantees.

A “financial accelerator” is taking hold as banks react to losses and falls in the value of collateral backing loans by pulling back on their capital at risk, intensifying the credit crunch and aggravating the economic downturn. The pull-back in credit lines is transmitting distress from the banking sector to hedge funds – which are being forced to reduce leverage and sell assets into markets at firesale prices to meet margin calls in a classic case of financial contagion. As hedge funds cut leverage they are amplifying the effect of the contraction in bank balance sheets on the economy. This “great unwinding” is putting enormous stress on the financial system, including the market for mortgages guaranteed by Fannie Mae and Freddie Mac. Mortgage rates are much higher now than they were when the Fed resorted to emergency interest rate cuts in January.

The Fed cannot halt this negative spiral through monetary policy, even if it can mitigate its severity. Interest rate cuts have been largely offset by the rise in risk spreads. And there are limits to how much further rates can be cut amid concerns about inflation.

The good news is that as long as inflation pressures remain, the US cannot get stuck in an outright debt-deflation trap as Japan did in the 1990s. Indeed, the more inflation, the less nominal house prices will have to fall to deliver a required change in real house prices. But asset prices could still fall far enough to generate a vicious contraction in credit – at a time when wealth is declining and inflation is eating away at real income growth. That could be a recipe for a severe contraction in demand.

Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.

What needs to be done? There is no silver bullet. Whatever happens, house prices will have to fall further to reach a fundamental equilibrium. But the key challenge now is to stop the financial accelerator in its tracks. That means one thing above all: additional capital for the financial system to stop the process of balance sheet contraction. That capital can come from one of two places – the private sector or the public sector.

By far the best solution would be for banks and Fannie Mae and Freddie Mac to raise large amounts of new private capital quickly – allowing them to treat estimated losses as sunk costs and start expanding their balance sheets again. There is more than enough private capital (and foreign sovereign capital) available. But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.

Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets. Meanwhile, their cost of capital is very expensive. It may be in their shareholders’ interest to hunker down, preserve capital and ride out the storm rather than raise expensive new capital to provide additional cover for losses that may never fully materialise.

If this is the case, the new capital will have to come from somewhere else: the public sector and ultimately the taxpayer, as the International Monetary Fund pointed out this week. The public sector could provide capital to the private financial system – for instance, by purchasing preference shares on terms more favourable than those available in the market. Or it could deploy its own balance sheet directly: intervening either in the mortgage securities market or the housing market itself.

This could be done through the Fed (which took a half-step in this direction by offering to swap $200bn of mortgage securities for Treasuries) or the government, either on balance sheet or through a special purpose vehicle. There would be severe costs either way. Public money for the banks would bail out existing shareholders. Direct intervention would require the public sector to set a price for mortgage securities and/or houses themselves. Either would foster moral hazard and expose the taxpayer to large potential losses.

But the costs of not providing public funds could be greater. Japan showed that incremental policy initiatives may not work. Rising inflation risk signals the dangers of addressing the problem through ever greater macroeconomic stimulus rather than – albeit large-scale – microeconomic intervention.

For those who oppose the use of public money, time is running out to prove that the private sector can recapitalise and calm the credit crunch without taxpayer funds – the best solution. Meanwhile, advocates of public intervention must determine how much money is needed and how to employ it to greatest effect.

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