Saturday, August 18, 2007

We need more than a US rate cut to resolve the crisis

We need more than a US rate cut to resolve the crisis
By John Plender
Copyright The Financial Times Limited 2007
Published: August 18 2007 03:00 | Last updated: August 18 2007 03:00

So the Federal Reserve has done its stuff. After injecting billions into the markets in recent days the US central bank yesterday gave in to the clamour from hard-pressed, though not necessarily deserving, financial folk to cut its primary discount rate. Equities thus perked up after a week of extreme volatility and, at times, panic. Is a crisis that has spread insidiously from the credit markets, to equities and currency markets, now at an end?

The case advanced by optimists is that global equities worldwide are now reasonably priced by historic standards. Corporate sector profits are at an all-time high and global economic growth is robust. According to Hank Paulson, US treasury secretary and former head of Goldman Sachs, the financial turmoil of recent weeks "will extract a penalty on the growth rate". But he does not expect a recession. As for the subprime mortgage market, the proximate cause of all the trouble, it is too small, argue the optimists, to inflict serious damage on the financial system. Credit spreads, meantime, have widened, but not to a degree that points to a financial meltdown.

The trouble with this cheery view is that the crisis is about much more than the subprime mortgage market. There has been a systemic deterioration in credit quality as a result of financial innovation. Banks now routinely sell their loans, which are then packaged into all manner of complex products designed to satisfy investors' demand for income at a time when yields on virtually all investments have fallen to very low levels. When loans can be rapidly ejected from bank balance sheets in this way, bankers have little incentive to worry about the creditworthiness of borrowers.

Worse, many of these innovative products such as collateralised debt and loan obligations are hard to understand, difficult to value and infrequently traded. They also have high economic leverage, meaning that a small investment outlay buys a very large exposure to market swings. Investors have relied heavily on the credit rating agencies in assessing the inherent risks.

All these potential problems surfaced spectacularly in July when two hedge funds run by Bear Stearns, a Wall Street investment bank, turned out to have lost a fortune in subprime mortgages. This raised the question of whether billions of dollars-worth of other mortgages around the system in other highly leveraged funds were similarly mispriced. Investors suddenly realised, as Bill Gross of the bond fund manager Pimco recently pointed out, that if Moody's and Standard and Poor's had done such a lousy job of rating subprime debt, how could the market be sure that the same mistakes were not being made with all the other innovative products?

Confidence has ebbed and risk appetite diminished across the credit markets this month to the point where central bank intervention was required to address a seizure in short-term money markets whereby banks became reluctant to lend to each other overnight. In this and other parts of the market, credit is simply not on offer, so the relatively modest increase in credit spreads sends a misleading signal about market conditions.

The best reason for thinking that the crisis remains unresolved is that an unprecedented de-leveraging process is under way in the financial system after an unprecedented credit bubble. When markets overshoot on the way up, they usually overshoot on the way down. And because many of the newer financial products are not required to be marked to their market value in a timely way, bad news is likely to continue to drip out over time. The new volatility in markets is also causing self-feeding value destruction as widely used but flawed risk management models cause forced selling as everyone seeks to reduce risk exposure simultaneously.

All this matters for the real economy. For if an economy is robust but unsoundly financed, it will not stay robust for long, as the Asian crisis of 1997-1998 showed. And economies are hostage to markets as never before, especially in the English-speaking countries where the extent of home and equity ownership tends to be higher.

The risk is that in a solvency crisis where real money has been lost in equities and property, overborrowed households draw in their horns and save more. Against such a background, interest rate cuts can be powerless to boost an economy.

While corporate balance sheets are in good shape there is still a potential problem with pension fund deficits, since lower interest rates may require lower discount rates to be applied to liabilities, which causes those liabilities to increase. Falls in equity prices then exacerbate the deficit. This does not help boardroom confidence, when credit is scarce. Nor does the impact of falling equity prices on executives' options and long-term incentive plans.

Whether this points to a US recession, and a consequent problem for the global economy, it is too early to say. But it will take more than yesterday's interest rate cut to keep this fragile financial show on the road.


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