Tuesday, September 30, 2008

Important to curb destructive power of deleveraging - FT

The consequences of the remarkable events and policy developments that have led to the creation of the $700bn banking bail-out plan are by no means over. The far reaching implications of the crisis for the banking industry, capital markets, the role of government in the economy, and confidence in US dollar debt will be with us for a long time. The most urgent issue is how to contain the destructive power of deleveraging. Financial stability must be restored to avoid a harsh economic downturn that would amplify the credit crisis. Moreover, policy must provide for orderly financing flows, especially of debt rollovers, the absence of which has forced up money market and private lending rates in spite of copious liquidity provision. The Emergency Economic Stabilisation Act 2008 (EESA), as the bail-out plan is now called, marks an important precedent for the US. It acknowledges the need for extensive government intervention in dealing with the financial crisis by deploying the government's balance sheet to absorb part of the contraction in private sector credit. The enormous fiscal consequences will have to be managed later. The good news is that the act could relieve some liquidity and capital constraints for participating banks, and it might have some indirect effects in moderating home price deflation and foreclosures. The key issue is the pricing of the assets to be bought. The reverse auction system and the ethics of paying premium prices suggest that prices paid will be on the low, but not firesale, side. In a limited gesture, the government is entitled to receive warrants from participating banks, and the Securities and Exchange Commission will have the authority to suspend mark-to-market accounting, where deemed appropriate. Against this, there is no explicit provision for homeowner debt relief to help manage household deleveraging. The larger objection to the EESA is that, because it sees the financial crisis through a mortgage prism only, it does not go far enough. Mortgages are only one, albeit significant, source of deleveraging. Most systemic banking crises have been resolved via state-backed re-capitalisation in some form, and the EESA will make a modest contribution at best. Mortgages and mortgage-backed securities account for about $23,000bn of the $48,000bn of total debt owed by the financial and non-financial private sectors. The focus only on the mortgage sector misses the point that debt destruction and asset deflation are generic. The shrinkage of balance sheets is occurring equally in banks and in the non-financial sector. Full crisis management must provide, therefore, for the re-capitalisation of the banking system by the state in exchange for equity participation that could be sold back at a later date. This could be bolstered by a more robust change in accounting standards, so that some types of losses could be absorbed over time and reported in the income statement, rather than appear in immediate capital destruction. How much capital do US banks need? Using a loan loss rate of about 5 per cent (roughly 3 per cent historically), a top-down estimate suggests there may be about $2,000 to $2,500bn of mark-to-market losses in the economy. Assuming a 50 per cent recovery rate and allowing for the $300bn or so of capital raised since August 2007, the banking system may now be undercapitalised by about $700bn. It might have been better to use the EESA authority for this purpose, rather than to buy bad assets. Not all of this needs to be provided by the state, because the EESA, dividend suspensions, a steep yield curve, and earnings over the next few years should all help. Re-capitalisation, however, is needed now, and only the government can make it happen. It would help to limit the more destructive aspects of deleveraging, strengthening capital to asset ratios, without intensifying the pace of asset sales. It would contribute to rebuilding confidence in money markets, institutions and instruments. The economic cycle will have to run its course, but the urgent priority is to rebuild financial stability through the containment of deleveraging. The EESA will help but it will not defuse the crisis alone. The writer is senior economic adviser, UBS Investment Bank, and author of The Age of Ageing, (John Wiley & Sons, October 2008)

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