Why the crisis got worse

Financial Express, 10 October 2008

Why are global asset prices in doldrums even though the US has approved the $700 billion purchase of housing related securities proposed by Paulson?

The crisis began as a problem for housing finance companies. But securitised home loans and derivatives thereof are all over the financial system. Once US house prices had dropped sharply, many financial firms were in trouble. But nobody knew which ones were healthy and which ones were the walking dead.

The big financial firms started mistrusting each other. This led to trouble on the `money market'. The money market in the West is something that we in India cannot imagine. It is a giant market where borrowing and lending through short-dated bonds takes place, including both government bonds and corporate bonds. For over 25 years, it has worked flawlessly. However, the market design of this market requires large financial firms trusting each other. Once that trust was lost, it closed shop.

Many business plans were predicated on continuous access to the money market. When the money market choked up in August 2007, financial firms which required continuous access to the money market, such as the big American investment banks, got into trouble.

At this stage, the crisis consisted of two problems. First, there was illiquidity because of the lack of a money market. Second, many firms were insolvent. For a while, governments tried dealing with one firm at a time. After Northern Rock, Bear Stearns, Lehman and AIG, they realised that the problem could not be solved in this fashion. A deeper attack was required.

Government initiative in solving the problem is justified. Once a financial panic starts, only government intervention can solve it. Once trust is lost, only governments, with the power to print money and pay off debt through future taxes, can offer credible financial guarantees, and get the financial sector to work again.

An ideal big government effort at resolving these problems would involve three elements. It would involve stemming the bleeding of housing-related securities that are available at fire sale prices and are very illiquid. It would involve a government induced and policy supported mechanism for financial firms to raise fresh equity capital, going beyond the hundreds of billions of dollars that financial firms have raised by themselves. And, I think it would have to involve some mechanism through which the top 20 financial firms would get a detailed look at each others internals, so that they can start trusting each other and the money market can sputter to life.

The Paulson plan which has obtained support from lawmakers in the US is explicit about the first element: the US government will buy something like $700 billion of housing-related securities. This is a step in the right direction. But the other two problems remain : financial firms are low on equity capital and don't trust each other. We continue to live without a money market.

Last week, the crisis has taken a new and more dangerous turn. Once again, with the benefit of hindsight this appears obvious, but it was not anticipated. The logic is simple and brutal. If big banks cannot trust each other, why should depositors trust them? Runs on banks appeared imminent.

Bank runs are peculiar. If there is even a small chance that you might lose your money when a bank goes down, it is efficient to run to an ATM to withdraw your money. But once it is clear that the bank is not going to go down, nobody wants to withdraw money.

An incipient run on banks in Ireland was stopped by the government unconditionally guaranteeing all deposits of all banks there. This led to two major problems. Deposits of banks of other countries started fleeing to countries with generous guarantees, thus destabilising other banks, and tempting other countries to do similarly.

The second problem lies in small countries where the fiscal depth of the government is inadequate when compared with the size of banks. Switzerland, Iceland, Singapore, etc. are large financial systems housed in small countries. When they have banks which are too big to fail, those banks are often too big to save.

This, then, is a brief sense of where we are in the crisis, and why the market has reacted adversely despite approval for Paulson's $700 billion plan. That plan is necessary but not sufficient.

One of the most promising elements of a policy response has come from the UK on Tuesday. This involves three elements: liquidity injection to compensate for the collapse of the money market, guarantees for medium-term financing of banks, and equity injections into eight banks. Key design features of this package, and the magnitudes of resources involved, appear to have improvements compared with the American efforts. If this leads to a revival of the money market in London, this would mark a major step forward in resolving the crisis.

Back up to Ajay Shah's 2008 media page
Back up to Ajay Shah's home page