Central banks are underwriting the credit risk with public money but without any level of transparency.
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. Debauching the regulatory apparatus is a step along the same road. Current problems in credit markets are attributable, in part, to failures on the part of central banks and regulators.
Central bankers fuelled the liquidity bubble through excessive monetary growth and low interest rates. The "Greenspan Put" repeatedly bailed out banks and investors from poor decisions or irrational exuberance underwriting excessive risk taking. Asset price bubbles rolled merrily along; waves of risk mis-pricing moving through different markets. The current credit crisis has its origins in the Fed's interest rate cuts of the early 2000s that helped engineer the housing bubble. This enabled the markets and economy to recover from the Internet bubble.
Bank regulators have presided over substantive changes in financial institution balance sheets and risks. The balance sheets of large banks and investment banks now hold high levels of risky and illiquid assets, such as private-equity investments, bridge loans, hedge funds investments, distressed debt and exotic derivatives. Derivative transactions with and loans to hedge funds through their prime broking operations are substantial. Assets and exposures in "arbitrage" conduit vehicles and hedge funds outside regulated bank balance sheets have increased. A recent OECD analysis1 shows that while major banks have increased capital and reduced reliance on short-term funding, the risks have increased faster.
Regulators have been uncritically accepting of financial innovation. The benefit of dispersion of risk through the final system has become the accepted orthodoxy. The risks of a diffuse, opaque, globally inter-linked, highly leveraged financial system have largely been ignored. Belatedly, in its 2007 annual report, the Bank of International Settlements (BIS) admitted that "our understanding of economic processes may be even less today than it was in the past."
As recent events show, the risk transfer is largely cosmetic. In excess of $300 billion of risk in the form of Asset backed Commercial paper (ABS CP) -- short-term IOUs secured against high grade (AAA/AA-rated) securities including CDOs (Collateralised Debt Obligations) -- has returned to bank balance sheets as ABS CP investors have gone on a buyer's strike. The total amount of risk that may revert to bank balance sheets is not known -- estimates range as high as $1,000 billion. Weaker banks have been forced to forage down the back of the sofa for any loose change to add to their dwindling liquidity to meet these commitments. This has led to sharp rises in inter-bank lending and borrowing rates as well as general shortage of funds, especially for riskier borrowers.
Central banks have reverted to type in dealing with the crisis. There is no difference between a run on a bank and the shutdown of access to funding from the capital markets. US mortgage lenders faced old-fashioned runs. Northern Rock found itself requiring central bank support. The Chancellor of the UK Exchequer was forced to effectively guarantee the UK system of bank deposits to restore confidence
Central banks pumped money into the system. The Fed has cut the fed funds and discount rates. Current expectations are for deep interest rate cuts despite higher inflation.
In further regulatory debauchery, the Fed recently allowed banks to pledge ABS CP as well as highly rated asset-backed securities, corporate bonds and mortgage-backed instruments as collateral for funding at the discount window. Funding has been extended from overnight to 30 days. Other central banks have followed suit.
Traditionally, only government securities are eligible for discounting. A fundamental principal of the discount window is that it is designed to provide short-term liquidity against instruments of unimpeachable credit quality. The regulatory spin is that this is "temporary" "in the light of market conditions" and "recognises innovation in the market".
There are profound practical and policy issues in this development. What price will the central banks attribute to these riskier securities? What is the level of the advance that the central bank will offer and how will this be adjusted as market values of the underlying collateral change? There are unconfirmed suggestions that central banks are placing a value of 85 per cent on AAA CDO securities. Given that there is significant uncertainty about the value of securities and even how they should be valued, the entry of central banks into this debate is curious.
There is also the question of what happens if the bank cannot redeem the borrowing at the end of 30 days and the value of the securities is below the level of the amount advance. This is precisely the problem confronting lenders who have lent against these securities. Central banks appear to have entered the field of prime broking, perhaps tempted by the profitability.
The moves have attracted remarkably little scrutiny or comment. In widening the eligible assets, central banks are effectively underwriting the credit risk and the liquidity of the financial system with public money, but without any transparent political debate.
In other cases of "déjà vu all over again", US mortgage agencies, such as Fannie Mae (Federal National Mortgage Association), are buying mortgages to support liquidity as they have done in past crises. The assets and guarantees of these institutions are huge and supported by limited stockholders' equity. Financial prudence would suggest that the scope for liquidity creation by this route is likely to be difficult.
Despite the above actions, credit markets have not recovered. Long-term dollar bond rates have gone up reflecting inflationary fears putting pressure on the important long-term fixed rate mortgage rates in the US. Despite the continued optimism of equity markets and emerging markets (where the bubble has rolled into), the problems in the credit markets seem some way from resolution.
Central banks and regulators bear a serious responsibility for safeguarding the functioning and integrity of financial systems. At the moment they are being exposed like the Wizard of Oz -- old desperate men (they are mainly men) behind the curtain running from one lever to another in a desperate attempt to maintain illusions.
The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
