In the middle of a turbulent river crossing

Since the long brewing US sub-prime crisis broke into the public space in August 2007, it was more than clear that a major financial crisis would come to pass, with many casualties and much collateral damage. That things did not immediately lurch into chaos was largely due to the intervention by the world’s major central bankers – the European Central Bank (ECB), the US Federal Reserve and the Bank of Japan. There were three sets of problems.

First, the financial sector – investment funds, banks and brokerages were chock-a-block with Collateralised Debt Obligations (CDO) – complex structured notes based on warehoused pools of sub-prime residential mortgages. The CDO market had developed very fast and was extremely liquid. As doubts about them began to surface this liquidity vanished overnight, threatening the entire financial sector with the kind of seizure your car would have if all the engine oil were to suddenly drain away. So, central banks devised methods to provide liquidity support to the banking system by accepting much of CDO (and related) assets as collateral. Rather surprisingly, it was the ECB, not the US Fed that had by far the larger liquidity programme.

Second, there was the underlying problem of millions of individual mortgages, a large proportion of which had a high likelihood of defaulting. Two inter-related factors push the process of default forward. One, where the home-owner lacks the money to meet the mortgage payments; two, as home prices fall, the debt can come to exceed the value of the home, acting as a disincentive for the mortgage to be paid, even if the home owner has the money. As more and more loans default, homes were re-possessed and brought to sale – causing prices to crash even further. What the authorities do in this circumstance is a product of legal and commercial culture and of ideology. In the US, the practice has been for excesses (as sub-prime lending had become) to be corrected by “bust” and there is disinclination to do otherwise. Statements from the White House and the US Fed in September 2007 (and later), however seemed to suggest that financial assistance would be forthcoming towards refinancing sub-prime loans selected on the basis of the willingness of the home owners to service the debt. Not one, but two federal schemes were launched, but produced nary a mouse. At the end, people are creatures of habit – elephants don’t waltz.

Between September and December 2007, financial markets went through several cycles of panic followed by relief. By basically choosing to sit on their hands during this period of four months, the US authorities cast the mould for what unfolded in 2008. The underlying problem of crashing home prices and rising delinquency expectedly got worse. The sharp increase in risk premium and the disinclination of those who had cash to lend made the illiquidity problem ever worse. Adding to the problem, the US Fed’s discount lending facility was restricted to banks, leaving brokerages like Bear Stearns out in the cold. The Fed chose the interest rate instrument slashing the policy rate by 200 basis point (bps) between January and now. It has cut the discount rate (at which it lends to banks) by 225 bps.

The objective was to reduce the interest rate of mortgage loans due for re-set and to lower the borrowing cost of banks. And pray that this would offset the negative effect of declining home prices. The problem is that in metropolitan areas with the highest concentration of sub-prime loans, home prices fell by 20% and more in the year to December 2007 and the price erosion continues. The Fed’s interest rates cuts may not be able to catch up with crashing home prices.

But the preference for the interest rate instrument has opened the door to other problems – namely inflation. The headline CPI inflation rate continues to be well above 4% and it won’t come down just because the Fed hopes it will. The financial markets are reflecting much higher inflationary expectations as is reflected from the steepening of the yield curve with longer maturities staying high even as the Fed cuts short term rates. As swap rate spreads rise. Fixed mortgage rates and yield on corporate bonds have remained virtually at July 2007 levels.

There is unease about the turn that US monetary policy has taken, for the Fed has blown all of its dry powder and has seemingly nothing left to combat inflation if its prayer – “(we) expect inflation to moderate in coming quarters, reflecting a projected levelling out of energy and other commodity prices” – is not answered by a benevolent Providence. Will the Fed’s rate cuts reduce delinquency and foreclosures, which were up 60% in Jan and Feb 2008? May be, may be not. The problem is that even if it does help, the situation would hold only as long as the Fed kept its rates low. The Fed has thus locked itself into a situation, where the benefits are dubious, but moving away will amount to disowning the cuts made so far. For if inflation remains at current levels, it is unlikely that the Fed can continue without reversing the rate cuts that it has made.

It is clear that the ECB which has provided much larger refinance facilities, but not cuts its rates, has shown the better judgement. The proximate problem was intra-financial sector illiquidity and a readily accessible repo (or discount) window was what was needed. If you are going to have a policy response to deal directly with the difficulties of stressed borrowers, use a direct instrument (such as partial refinancing or subvention) and not an indirect tool like interest rates that have many other ramifications.

It is no longer sub-prime woes per se that is rocking the world’s financial markets. Markets in both the US and outside are unable to quite decide on what to make of the odour coming out of Washington. It smells like incompetence, but that is hardly what one would expect from the storied US monetary and financial institutions and of proven individuals like Treasury Secretary Paulson. The thought is thus born that maybe we don’t know the whole story – there is plenty more (of bad things) to come.

It is this uncertainty that has caught up innocent bystanders (if one may use the term) like the municipal bond market, conforming mortgage backed securities and other assets with no link to sub-prime loans. The recent debacle of Carlyle Capital involved Agency Debt, which used to be treated almost-as-good as US government paper.

To use the analogy of a river crossing this is the point where you can no longer feel the bottom of the river, which is scary, but actually you are about halfway across. Many analysts, including this columnist, saw the sub-prime engendered crisis lasting out through the first half of 2008 and there is as of yet no reason to believe otherwise. However, the choices that the US Fed has made were not predictable – the educated guess was that it would not put interest rates to such an unprofitable use. The outcome is that the inflationary outlook has been made much worse. So, even as the financial sector stabilises in the second half of 2008, the recovery will be slower thanks to the higher levels of inflation that everybody will have to combat.

(The author is Economic Advisor, ICRA)

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Published in Mail Today, Friday, 21 Mar. 2008