[NYTr] Hold tight, the central banks have no plan

[All the News That Doesn't Fit]

Two items on the increasing disarray in the international central
banking system sent by Riaz K Tayob to the activ-l list. No URLs
supplied, but both are from the UK's 

Financial Times
http://www.ft.com 

Hold tight, the central banks have no plan 

By Wolfgang Munchau

This has been the year when many deeply held beliefs have been 
challenged. One such belief was that central banks have the toolkit to 
sort out any conceivable economic or financial crisis. Last week?s 
co-ordinated liquidity action by five central banks taught us that this 
is not the case. The idea was that a co-ordinated response would 
reassure the markets, but it had the opposite effect. It turned out
that market participants are not infinitely stupid. They know by now
that this is not a liquidity crisis at its core. If it had been, it
would be over by now.

It is a fully fledged solvency crisis that has arisen because two giant 
and interlinked bubbles burst simultaneously ? one in property, one in 
credit ? leaving banks and investors on the brink of bankruptcy, some 
hanging on by their fingertips. Yet there is nothing the central banks 
are offering at this stage to alleviate a solvency crisis.

So the message from last week is that central banks have no game plan. 
Expect continued stress in financial markets for most of next year and 
possibly beyond. Expect also further declines in property prices in the 
US and the UK and spill-overs to the real economy.

As the European Central Bank correctly noted in last week?s financial 
stability report, the crisis is not going to be over until and unless 
there is a turnround in the property sector. But we are not going to
see this for quite some time, not even in the US where the property
market downturn began in 2006. In the UK, property prices have only
recently started to fall.

I looked at the Nationwide house price index for the UK, which goes
back to the early 1950s. After adjusting for inflation, the result is a
line with two interesting characteristics. The first is that there is a 
surprisingly stable linear trend, with only a moderate upward shift. 
Real prices go up over time but not by much, and any deviations from
the line are followed by a return to trend. The second is that past
bubbles were relatively symmetric ? both in extent and in time.

In the UK the latest upward movement has lasted 10 years and on my 
calculation prices started to rise above the trend line somewhere 
between 2000 and 2002. That would suggest that the downturn phase is 
going to last as long ? possibly longer since downward moves often 
undershoot the trend line. Unless there has been some structural shift, 
there is going to be one of the most serious housing downturns ever.

Homeowners and mortgage lenders are always clinging to the hope that 
there may have been a structural shift. But even then, it is not at all 
clear whether such a shift would necessarily raise the position or the 
slope of the trend line. For example, an increase in housing supply or 
some regulatory restriction on credit may well lower it.

In an environment in which central banks target a low rate of
inflation, the lion?s share of the adjustment will have to come from
falling nominal house prices. That was different in the 1970s, when
high inflation took care of the real price adjustment. But an 
inflation-targeting central bank cannot allow that to happen.

This raises the question of whether central banks, or governments, 
should consider raising their inflation targets. That would be a huge 
mistake, in my view, but I expect such a debate to hit us next year. 
Higher inflation would make it easier for indebted mortgage holders to 
cope with a multi-annual fall in real house prices.

Here is the basic arithmetic. Let us assume that the housing downturn
is going to last eight years. A 2 per cent annual inflation rate ? the 
target of many central banks today ? adds up to 17 per cent inflation 
for the entire period; and a 4 per cent annual rate adds up to 37 per 
cent. So if UK house prices have to fall 40 per cent in real terms ? 
which is not exaggerated given the extent of the bubble ? an annual 
inflation rate of about 4 per cent would take care of the problem. 
Nominal houses prices would then not have to fall. This is an
experiment I would dearly love to watch, though preferably from outer
space. A hypothetical increase in inflation targets would, I think,
turn the current episode of turmoil into an uncontrolled financial
crisis. Bonds would become the next asset class to crash and we could
also expect violent adjustments in global exchange rates.

I suspect that central banks would dearly love to choose the semi-soft 
option ? to allow a temporary overshoot in inflation targets and pray 
that people do not raise their inflation expectations. But that option 
has already been over-stretched, given that inflation expectations are 
already rising everywhere.

The bottom line is that inflation-targeting central banks will end up 
doing little more than swamp the financial markets with liquidity, and 
defend themselves against accusations that they had anything to do with 
this mess. 

Copyright The Financial Times Limited 2007

                            ***

[Sorry about the lack of proper punctuation in this one. -NYTr]

Financial Times - Dec 16, 2007

Out of the shadows: How banking?s secret system broke down

By Gillian Tett and Paul J Davies

When the New York markets open on Monday, all eyes will be on Wall 
Street?s banks. As the US Federal Reserve, in a bid to ease the 
liquidity crisis, holds a novel type of money market auction to inject 
some $20bn of funds into financial institutions, investors and 
policymakers will be watching closely to see how many large banks bid 
for how much cash ? and what that, in turn, indicates about their state 
of health.

Yet while investors are scrutinising some of the industry?s best-known 
names, a spectre will be silently haunting events: the state of the 
little-known, so-called ?shadow? banking system.

A plethora of opaque institutions and vehicles have sprung up in 
American and European markets this decade, and they have come to play an 
important role in providing credit across the financial system. Until 
the summer, structured investment vehicles (SIVs) and collateralised 
debt obligations (CDOs) attracted little attention outside specialist 
financial circles. Though often affiliated to major banks, they were not 
always fully recognised on balance sheets. These institutions, moreover, 
have never been part of the ?official? banking system: they are unable, 
for example, to participate in Monday?s Fed auction.

But as the credit crisis enters its fifth month, it has become clear 
that one of the key causes of the turmoil is that parts of this hidden 
world are imploding. This in turn is creating huge instability for 
?real? banks ? not least because regulators and bankers alike have been 
badly wrong-footed by the degree to which the two are entwined.

?What we are witnessing is essentially the breakdown of our modern-day 
banking system, a complex of leveraged lending [that is] so hard to 
understand,? Bill Gross, head of Pimco asset management group recently 
wrote. ?Colleagues call it the ?shadow banking system? because it has 
lain hidden for years, untouched by regulation yet free to magically and 
mystically create and then package subprime loans in [ways] that only 
Wall Street wizards could explain.?

By any standards, the activities of this shadow realm have become 
startling. Traditionally, the main source of credit in the financial 
world was the official banks, which typically forged business by making 
loans to companies or consumers. They retained this credit risk on their 
books, meaning that they were on the hook if loans turned sour.

However, in the past decade, this financial model has changed radically. 
On the one hand, banks have increasingly started to sell their credit 
risk to other investment groups, either via direct loan sales or by 
repackaging loans into bonds; at the same time, regulatory reforms have 
permitted the banks to reduce the amount of capital that they need to 
hold against the danger that borrowers default.

The net consequence is that the western financial system embraced what 
Paul Tucker, head of markets at the Bank of England, has described as 
the age of ?vehicular finance?. This system has given banks huge 
incentives to pass on their loans to new vehicles, either by creating 
these themselves or by sponsoring outside fund managers to run them.

The role of such entities in creating credit has increased vastly in the 
past three years. For example, the asset-backed commercial paper market, 
which supplies the lion?s share of funding to SIVs and conduits in the 
form of cheap, short-term cash, saw a step-change in growth at the end 
of 2004. The volumes of such paper in issue had fluctuated between 
$600bn and $700bn for at least four years; at the market?s peak this 
summer they stood at almost $1,200bn.

?The shadow banking world has expanded at an amazing rate,? says Bob 
Janjuah, credit analyst at Royal Bank of Scotland, who estimates that 
these shadow banks could have accounted for half of all net new credit 
creation in the past two years in the US.

Because these vehicles typically borrow heavily to finance their 
activities, they have also been a key reason why leverage ? or debt 
levels ? across the financial world has risen so fast without 
regulators, or ordinary investors, being fully aware of this boom.

The involvement of hedge funds, themselves highly geared, as providers 
of the equity at the foundations of this system illustrates why shadow 
banking can have such an outsized impact on the supply of credit. 
Satyajit Das, an author and derivatives industry expert, cites an 
example where just $10m of real, unlevered hedge fund money supports an 
$850m mortgage-backed deal. This means $1 of real money is being used to 
create $85 of mortgage lending ? credit creation far beyond the wildest 
dreams of high-street bankers.

Since SIVs and CDOs have never been in the business of gathering 
deposits from customers, their significance to the economic and 
financial system has not been widely recognised by regulators and 
policymakers. However, the huge expansion of the SIV and conduit 
industries in particular was fuelled by short-term debt bought by 
so-called money-market funds. Retail investors, schools, hospitals and 
pension funds have placed billions of dollars in such funds, yet none of 
this system comes under bank regulations.

The problem now is that the business model behind parts of this shadow 
banking world looks increasingly shaky, particularly among the SIVs. 
There is huge concern in the US that some of these money-market funds 
might not return all the money people have entrusted to them. ?You have 
a whole pool of investors who have been putting their money into SIVs 
thinking that they were as safe, or even safer, than real banks,? says 
the head of investment banking at one big financial institution.

The role of regulators in this world was to a great degree replaced by 
the credit rating agencies, which awarded high, ultra-safe ratings to 
the debt issued by SIVs and other vehicles on the basis of historical 
analysis of the probabilities of defaults and losses across the shadow 
banking system.

However, this year?s credit turmoil has brought ratings downgrades to 
many of these instruments. ?It?s clear that we can no longer solely rely 
on an investment?s credit rating when making management decisions,? says 
Alex Fink, chief financial officer of a state fund in Florida that was 
recently forced to freeze withdrawals after investors pulled out $13bn 
amid concerns over its exposure to securities backed by subprime 
mortgages. The securities had held top-notch ratings.

But it is not just in Florida or even the US where such pain has been 
felt ? money-market funds run by BNP Paribas and Axa of France were 
among the first to freeze withdrawals back in August. It is a process 
that some regulators, such as Axel Weber, the Bundesbank president, 
liken to an old-fashioned ?bank run? ? albeit one that is now happening 
in the shadow bank sector rather than at visible high-street names.

The result of this is that the shadow banking sector is now shrinking at 
an even faster rate than it grew. The SIV sector has seen assets fall in 
value by as much as $150bn from a peak of more than $400bn, while the 
asset-backed commercial paper market itself is almost $400bn off its 
peak in July.

T he almost inevitable demise of the SIV is unlikely to trouble many 
regulators in the long term, but in the short term it leaves 
policymakers and bankers with a big problem.

Precisely because the sector has been so widely ignored in recent years, 
there has been relatively little debate about who might be responsible 
if it ever ran into problems. After all, SIVs ? like other parts of the 
?vehicular finance? world ? do not have any right to call on central 
banks as lenders of last resort, since they are not part of the official 
banking system.

Most of these vehicles, and the shadow banking sector as a whole, is 
supported by back-up liquidity lines with ?real? banks ? promises to 
lend money that bankers never imagined they would have to deliver on. 
Only now are these private-sector ?lenders of last resort? being fully 
tested, as can be seen in the moves by HSBC and Citigroup, among others, 
to take tens of billions of dollars of lending back on to their balance 
sheets. Such rescues are taking place in spite of banks? continued 
protestations that they have no legal responsibility to act.

This illustrates the huge level of uncertainty about exactly what banks 
will do and when ? uncertainty that is compounded by the opaque nature 
of the vehicles themselves. For investors, regulators and central 
bankers ? let alone for politicians ? it is impossible to predict how 
this process will play out.

?As 2007 comes to a close, banks are having to deal with an expansion of 
their balance sheets, via an unwinding of SIV assets or retention of 
loans that banks are currently unable to sell,? says David Brickman, 
analyst at Lehman Brothers.

T his uncertainty has sparked money markets tensions ? prompting the 
Fed?s action on Monday. But it is also creating concern about whether 
banks will soon cut their lending to the real economy ? thus hurting 
growth.

Some investment bankers insist that the outlook is not so dire. After 
all, while the subprime mortgage-linked world has seized up ? in Europe 
as much as the US ? activity in other parts of corporate lending remains 
relatively robust. Indeed, investment vehicles linked to corporate debt, 
such as collateralised loan obligations (CLOs), remain a bright spot in 
the broader securitisation markets.

But central bankers are clearly concerned. The BoE?s Mr Tucker referred 
in a speech last week to a series of recent papers by the US economists 
Adrian Tobias and Hyun Shin, which argue that the credit cycle will be 
amplified by the kind of balance-sheet management employed by the shadow 
banking sector and modern banks themselves. ?When the music stops, the 
process [of credit expansion] can be reversed as falls in asset values, 
leverage and liquidity feed on each other,? said Mr Tucker.

One thing that is clear is that regulators are facing mounting pressure 
to change their attitude towards these ?shadow? banks. Hector Sants, 
chief executive of the UK?s financial watchdog, said last week that 
regulators? ability to monitor the financial system had been hampered by 
banks? use of ?opaque? off-balance sheet financing and that this ?needs 
to be addressed?.

There is also growing debate about whether a system that relies so 
heavily on non-bank lenders should also have some kind of ?buyer of last 
resort? to stand behind the markets, much as central banks do for the 
banking system.

?Lending has become disintermediated to the extent that in many sectors 
the majority of lending is done not by banks but by investors. So if 
there is a run on the markets through the evaporations of liquidity, who 
is there to step in and provide that liquidity?? asks Alexander 
Batchvarov, head of structured product research at Merrill Lynch. 
?Previously we saw a similar situation with the collapse of LTCM. Today 
it is structured finance. Tomorrow it will be something else. Maybe we 
can study this crisis and come up with some form of structure that in 
future can perform that liquidity-providing, buyer-of-last-resort role.?

In some ways, the co-ordinated actions of the central banks in coming 
days are already supplying funds for this ? but on a very modest scale 
given the size of the problem. Consequently, in the months ahead 
regulators and financiers will face mounting pressure to make the system 
of ?vehicular finance? less complex and opaque. One result of the 2007 
credit shock, in other words, is that the shadow banks will become less 
shadowy in the future.

As Pimco?s Mr Gross notes: ?Investors should anticipate that the 
shadow?s successor will be a more conservative, less risk-oriented 
banking system.?

Copyright The Financial Times Limited 2007