Bill Totten's Weblog

Wednesday, August 29, 2007

Yes, there's every reason to worry

By the standards of the second half of the 20th century, we are in the midst of a panic as serious as any which preceded it

by Alex Brummer

New Statesman (August 27 2007)

One has come to think of the Frankfurt-based European Central Bank as a master of inaction, looking upon distressed financial institutions with lofty disdain. So it has been astonishing to see how the burgher bankers of Frankfurt have weighed into the money markets with literally hundreds of billions of euros in assistance.

The ECB has not been alone. In New York the Federal Reserve has also been hyperactive, swamping the markets with cash in a titanic effort to prevent short-term interest rates from rising. From Sydney to Tokyo, there has been similar behaviour. The only notable exception to this generous behaviour has been the Bank of England - which, for a central bank that prides itself on being a good global citizen, is curious.

What the other central banks have been doing is following the classic advice to monetary authorities when faced with a financial crisis: you make sure that the capital markets do not dry up, by supplying them with pots of cash to ensure that interest rates do not soar. The fear is that if they climb too far the banks will stop lending to their business customers, consumers will be unable to obtain credit or mortgages, output will plummet and the jobless rate will soar.

By the standards of the second half of the 20th century, we are in the middle of a panic every bit as serious as, if not worse than, those that preceded it. These include the 1987 stock market crash, the bursting of the Japanese bubble in 1991 and the east Asian crisis of 1997, followed by implosion of the Russian rouble in August 1998 and the collapse and $3.6 billion rescue of Long-Term Capital Management, a US hedge fund, a month later.

In the past decade there has been a credit explosion unmatched in human history. In Britain, at the personal level, it is to be seen in the GBP 1.3 trillion overhang of credit and mortgage debt. That is why shares in some of our biggest mortgage suppliers have come under such selling pressure. The global debt mountain is many times bigger than this, with GBP 500 billion raised for corporate buyouts alone. In addition there is a little-understood world - of unregulated, highly geared hedge funds - where the scale of potential loss is unknown.

The gross unfairness in all this is that whereas the domestic consumer has no choice but to keep debt payments up to date, or face insolvency or repossession, the big financial institutions are regarded in many countries as too big to fail. The flood of money placed by the central banks in the money markets is intended to give them time to unwind transactions with the minimum of pain. The likelihood is that the federal government will eventually bail out America's mortgage lenders by propping up semi-official lenders such as Fannie Mae.

Amid all this frenzied activity, the Bank of England has so far trodden a very different path. Under the governorship of Mervyn King, it has developed a framework for assisting financial institutions that seeks to avoid rewarding those hedge funds and banks that have acted foolishly. Instead of flooding the London wholesale markets with cash, it is being miserly. It has told the 57 or so banks that have registered with it that they can indeed borrow extra money - but only at a crippling rate of one per cent above the current bank rate of 5.75 per cent. In other words, those banks that have behaved foolishly will pay penal rates.

King has made clear that he does not believe in "no-cost" bailouts for the financial sinners, arguing that this creates what is known in financial circles as "moral hazard": if you make life easier for those banks that have lent to badly run hedge funds, or put their cash into poorly designed private equity buyouts, you encourage others to take the same ridiculous risks. It was this thinking that for years stopped the Group of Seven richest countries from forgiving the debts of Africa's poorest nations. That was until they recognised that it was the people of Africa who were starving, not the government officials in armoured Mercedes.

This is the flaw in the Bank of England's approach. By refusing to acknowledge the building difficulties in Britain's money markets, it risks punishing ordinary borrowers, investors and depositors, rather than the financial institutions that have failed to behave responsibly.

So far, the Old Lady of Threadneedle Street's tough love has not caused fundamental problems. This is partly because our big international banks, such as Barclays and HSBC, have access to ECB, Fed and other central bank money through their foreign subsidiaries. Nevertheless, its policy has provoked cries of anguish from some players in the London money market.

The betting must be that, should push come to shove - and an international rescue operation for a major institution be mounted - the King will find it hard to remain on the sidelines.


Alex Brummer is City editor of the Daily Mail

Bill Totten


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