Monday, March 17, 2008

Time to renew the financial toolbox

(FT) If subprime mortgage defaults were a nasty cough, and trouble at hedge funds and minor European banks were the start of a fever, the near collapse of Bear Stearns marks the onset of chest pains. Where before the diagnosis was influenza, pneumonia is now a possibility. But a doctor would not panic – and nor should the public authorities with generalised bail-outs. They should mount a programme of action to treat the disease, slow its progress and encourage the patient.

The credit squeeze can continue and can get worse: vulnerability abounds and contagion could yet spread further. Equity markets are valued well above their long-run averages relative to cyclically adjusted earnings and the replacement cost of their assets. The US housing market and those in other countries remain expensive relative to earnings and rents. And in addition to leveraged hedge funds, brokers and structured vehicles that could be forced to sell assets quickly, there are institutions with lending facilities that must be renewed in 2008 and 2009.

More financial failures are a racing certainty. But a sustained bear market in equities and other assets is also possible, as is a further fall in the dollar, as indeed is a crisis in a minor market such as Iceland. When market falls are disorderly they tend to overshoot and prices end up well below their fair value.

The extent of the damage, however, will depend on how far financial weakness damages the real economy, and how far real economy damage feeds back into financial weakness. In contrast to previous financial crises, the world’s real economy headed into this one in decent shape. But a deep real recession, brought on by lack of access to credit, would mean lower profits, more personal and corporate bankruptcies, and consequent pain for a range of financial securities.

Central banks and governments can prevent all this, if they are willing to pay the price, by taking some or all of the problem assets on to the public balance sheet. That could be done through outright purchases of asset-backed bonds, cheap loans to the banking system, or government equity injections into banks. The US Federal Reserve has already begun to do this with its special lending facilities and rescue of Bear.

But there is a cost to this kind of support. By socialising some of the risk in the financial system it makes losses everybody’s problem, not just an issue for hedge funds and banks, while if intervention halts a necessary adjustment in the price of risk, it simply stores up trouble for the future. It may become necessary to use the public balance sheet, but for now it should remain a last resort, to mitigate systemic risks such as bank failures.

What central banks and governments do need to do is get ahead of events, head off problems before they begin and impart a sense of confidence to the markets: something that they have not managed since the credit squeeze began. That need not mean wholesale bail-outs but it does mean a programme of concerted, co-ordinated action.

Part one should be reassurance that it is safe to trade with systemically important banks. The Fed’s action with Bear Stearns – organising a rescue that prevents its failure but almost totally wipes out shareholders – is a wise one. The Fed should broadcast the message that it will help other troubled banks but only on similar terms.

Part two is setting appropriate monetary policy to support the real economy. Having all but promised a 75 basis point rate cut this week, by failing to indicate otherwise, the Fed is now obliged to deliver it. To do otherwise would be destabilising.

Part three is some action to slow the fall in the dollar, which risks becoming a disorderly flight, and pushing up longer-term US interest rates in the process. Fixing the dollar would be undesirable even were it possible but sharp, co-ordinated intervention could make selling the US currency less of a one-way bet.

Part four should be to refill the toolbox. The credit squeeze has been marked by ad hoc policies: the Fed had to invent a new facility so that it could lend to Bear Stearns, for example, because it is a broker-dealer rather than a commercial bank. One contingency that is especially pressing in Europe is to decide who would address the failure of a cross-border bank – something that is entirely unclear.

Part five is to show some urgency in dealing with the policy problems revealed by the crisis: the role of mark-to-market accounting and the pro-cyclical effects of the Basel II capital requirements, for example. Though all of these rules have been adopted for good reason, some are having perverse consequences and it may even be necessary to suspend parts of them for a time. The disease need not be fatal but it does need aggressive treatment.

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