Ending the affair?
The recent bail-out of Bear Stearns, the US investment bank, brought to a close a remarkably frenetic episode in financial markets. The Bear Stearns rescue raises some really big questions. Until now it was possible to argue that, whereas the UK...
The recent bail-out of Bear Stearns, the US investment bank, brought to a close a remarkably frenetic episode in financial markets. The Bear Stearns rescue raises some really big questions. Until now it was possible to argue that, whereas the UK authorities had got things wrong, the US authorities had got things very right.
Northern Rock's collapse apparently stemmed from the Bank of England's failure to inject liquidity and its unwillingness to cut interest rates. It also stemmed from the Financial Services Authority's inability to find a buyer and the government's failure to provide a bail-out in times of distress. In contrast, the Federal Reserve did inject liquidity. It did cut interest rates. And the US does have bail-out options, not least deposit guarantees and the Federal Home Loan Banks.
While not all of these factors are directly relevant to the Bear Stearns situation, it seems that monetary easing, liquidity injections and the rest are in no way guarantees of financial stability.
This is a powerful - and worrying - conclusion. A few years ago, investors thought interest rate cuts worked. Back then, the Federal Reserve was typically rewarded for taking decisive action. During the dark days of 2001, for example, when the US equity market was in freefall and the economy was in recession, the dollar rallied, helped along by the sheer aggression of the Fed's monetary easing. The message was simple: The economy might have broken down but the Federal Reserve knew how to fix it.
Today, that optimism has gone, to be replaced by a growing sense of scepticism. The Fed's latest rescue efforts have fallen on deaf ears. The dollar's value is plunging against virtually all the major currencies. Oil prices touched $110 per barrel, gold has hit $1,000/oz, while the yen temporarily jumped through the ¥100 level against the dollar. The yen's strength is particularly astonishing.
So what is to be done? It is important, first of all, to recognise that there is no quick-fix solution. We are witnessing a breakdown in trust within the financial system on a scale that does not lend itself to easy answers.
Certainly, the policy initiatives announced so far have not worked terribly well. In some cases, this is hardly surprising. The US Treasury Secretary recently called for banks to raise more capital. But if this means a fire sale of assets or a rights issue this is hardly going to provide additional stability. Moreover, if the banks went down this route, their shareholders would presumably not be terribly happy.
The best that can be hoped for is an injection of foreign public money, through the activities of sovereign wealth funds, but this approach contains its own controversies. It is now time for some revolutionary initiatives. Three policy options may be considered.
First, there has to be an immediate review - and possible suspension - of fair value accounting. This now-ubiquitous technique could be described as the tyranny of mark-to-market.
If, for example, a bank made a loan yesterday at 5 per cent yet the loan could be made today at 10 per cent, this is recorded as a loss. Mark-to-market measures the value of assets according to current market conditions, not according to the longer-term aims of borrowers and lenders. In the short-term, mark-to-market may lead to huge losses, which in turn contribute to the fire-sale of assets. It is a potential source of huge instability.
Second, central banks (and the governments which back them) need to do more than simply lend cash and liquid assets to the private sector. The Fed's announcement that it was prepared to lend Treasuries to a limited number of primary dealers in exchange for a wider range of collateral, including AAA-rated mortgage-backed securities, was seen by some as a magic bullet. It is no such thing. Ultimately, the authorities need to deal with the ongoing collapse in demand for an ever-widening range of financial assets and the obvious way to do that is to become buyers of last resort. This is, of course, highly controversial because it means that taxpayers will have to clear up the mess left behind by others. Better, though, to clear up a mess than be faced with a meltdown...
Third, it is time to think about so-called "helicopter money". While most people understandably worry primarily about the US housing market, the real threat to economic security is now coming from the financial system. If this does not function, central bank rate cuts will not have much of an impact. Over the last few months, as banks increasingly have been forced to cut back on their lending, the power of the central banks has steadily waned.
Helicopter money bypasses the banking system. The government issues bonds directly to the central bank and the cash that is created can be placed directly in the pockets of households and companies through a series of tax cuts. The recipients, in turn, are then able to spend more easily, freed from the liquidity constraint imposed upon them by the banking system.
This is all controversial stuff. Accounting conventions are called into question. Taxpayers have to cough up. And the independence of central banks is at least temporarily undermined via helicopter money. However, stressful times call for radical measures.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Northern Rock's collapse apparently stemmed from the Bank of England's failure to inject liquidity and its unwillingness to cut interest rates. It also stemmed from the Financial Services Authority's inability to find a buyer and the government's failure to provide a bail-out in times of distress. In contrast, the Federal Reserve did inject liquidity. It did cut interest rates. And the US does have bail-out options, not least deposit guarantees and the Federal Home Loan Banks.
While not all of these factors are directly relevant to the Bear Stearns situation, it seems that monetary easing, liquidity injections and the rest are in no way guarantees of financial stability.
This is a powerful - and worrying - conclusion. A few years ago, investors thought interest rate cuts worked. Back then, the Federal Reserve was typically rewarded for taking decisive action. During the dark days of 2001, for example, when the US equity market was in freefall and the economy was in recession, the dollar rallied, helped along by the sheer aggression of the Fed's monetary easing. The message was simple: The economy might have broken down but the Federal Reserve knew how to fix it.
Today, that optimism has gone, to be replaced by a growing sense of scepticism. The Fed's latest rescue efforts have fallen on deaf ears. The dollar's value is plunging against virtually all the major currencies. Oil prices touched $110 per barrel, gold has hit $1,000/oz, while the yen temporarily jumped through the ¥100 level against the dollar. The yen's strength is particularly astonishing.
So what is to be done? It is important, first of all, to recognise that there is no quick-fix solution. We are witnessing a breakdown in trust within the financial system on a scale that does not lend itself to easy answers.
Certainly, the policy initiatives announced so far have not worked terribly well. In some cases, this is hardly surprising. The US Treasury Secretary recently called for banks to raise more capital. But if this means a fire sale of assets or a rights issue this is hardly going to provide additional stability. Moreover, if the banks went down this route, their shareholders would presumably not be terribly happy.
The best that can be hoped for is an injection of foreign public money, through the activities of sovereign wealth funds, but this approach contains its own controversies. It is now time for some revolutionary initiatives. Three policy options may be considered.
First, there has to be an immediate review - and possible suspension - of fair value accounting. This now-ubiquitous technique could be described as the tyranny of mark-to-market.
If, for example, a bank made a loan yesterday at 5 per cent yet the loan could be made today at 10 per cent, this is recorded as a loss. Mark-to-market measures the value of assets according to current market conditions, not according to the longer-term aims of borrowers and lenders. In the short-term, mark-to-market may lead to huge losses, which in turn contribute to the fire-sale of assets. It is a potential source of huge instability.
Second, central banks (and the governments which back them) need to do more than simply lend cash and liquid assets to the private sector. The Fed's announcement that it was prepared to lend Treasuries to a limited number of primary dealers in exchange for a wider range of collateral, including AAA-rated mortgage-backed securities, was seen by some as a magic bullet. It is no such thing. Ultimately, the authorities need to deal with the ongoing collapse in demand for an ever-widening range of financial assets and the obvious way to do that is to become buyers of last resort. This is, of course, highly controversial because it means that taxpayers will have to clear up the mess left behind by others. Better, though, to clear up a mess than be faced with a meltdown...
Third, it is time to think about so-called "helicopter money". While most people understandably worry primarily about the US housing market, the real threat to economic security is now coming from the financial system. If this does not function, central bank rate cuts will not have much of an impact. Over the last few months, as banks increasingly have been forced to cut back on their lending, the power of the central banks has steadily waned.
Helicopter money bypasses the banking system. The government issues bonds directly to the central bank and the cash that is created can be placed directly in the pockets of households and companies through a series of tax cuts. The recipients, in turn, are then able to spend more easily, freed from the liquidity constraint imposed upon them by the banking system.
This is all controversial stuff. Accounting conventions are called into question. Taxpayers have to cough up. And the independence of central banks is at least temporarily undermined via helicopter money. However, stressful times call for radical measures.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.