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Rodrigo de Rato - Big issue is counter-party risk aversion
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Confronting the sub-prime ogre
17-07-2008
MADRID — Rodrigo de Rato, former Managing Director of the International Monetary Fund, has urged Washington to take the unprecedented step of brokering a solution between US sub-prime borrowers and their creditors. Resolving the US sub-prime crisis and housing slump is the only way to regain financial stability and to avert further threats to the global economy, he says.
Action is necessary to reverse the financial turmoil and to avoid placing the global economy at greater risk than warranted, de Rato told representatives of financial institutions at the ADB meeting in Madrid. de Rato, now a Senior Managing Director of investment bank Lazard, said the US Government could facilitate establishment of a debt exchange.
He believes US authorities have a role to play in providing incentives for both creditors and debtors, and in bringing the two parties together for debt workouts.
Homeowners want to hold on to their houses and would be willing to service mortgages within their financial capability, he said. Faced with defaults, lenders know that foreclosure is a costly and uncertain option, especially for mortgages with negative equity.
The US Government should offer incentives for borrowers and creditors to agree on a new level of debt, he said. And that new mortgage debt should be guaranteed by the Government — but at a face value substantially below the old mortgage and just above the amount creditors could recoup from foreclosure. "I don't know if the US Government will be willing to do this. If they do, it will be an extraordinary approach with clear fiscal costs," de Rato said.
The cause of the current turmoil — deterioration of the US sub-prime mortgage market and the housing markets — must be dealt with, he said. Otherwise, financial markets would continue to malfunction, with further sizable write-downs by financial firms. de Rato believes the time has come for such action, without which policymakers are unnecessarily prolonging the financial turmoil and placing the global economy at greater risk than warranted.
He does not agree with the proposition that private mortgage exposure should be shifted to the public book. "I am sure many emerging economies would be surprised if the US or the EU should now adapt a bail-out system that was denied to emerging countries when they had a financial crisis," he said. The US Government, must do more to avert a "tsunami-like wave” of sub-prime foreclosures.
“This is the only way to stem the tide, not only in the sub-prime segments of the US mortgage and housing markets, but in the global financial market.” The sub-prime crisis, which has now led to a collapse of the US housing market, is the trigger of the current financial turmoil. It is, therefore, most important to tackle the cause of the problem and to bring confidence back to the financial market, de Rato said.
Despite massive injections of liquidity by central banks, principally the US Federal Reserve and the Bank of England, the global credit market remains comatose. "We are living today in a market breakdown which has its roots in aggressive credit growth," he said.
The single biggest issue remains counter-party risk aversion, which has become acute and pervasive. Until it is resolved, the current turmoil cannot be overcome, de Rato warned.
Financial institutions are building up liquid-ity because of their fear that liquidity difficulties could escalate into solvency problems — they have already built up significant precautionary liquidity pools, some as much as 25 per cent of their balance sheets.
de Rato said non-financial corporations have been coping with the crisis by actively drawing down credit lines that were put in place earlier. Money market funds which used to supply funds to the term markets (from which financial institutions borrow internationally) have switched into the safest and most liquid securities, namely US Treasury securities. In the US, money market funds now have US$3.5 trillion under management.
de Rato said the term money market is one area where strain is acute. Risk aversion remains, even though central banks have injected liquidity into the market through short-run channels and new longer-term facilities.
In a series of measures, the Fed has made available half of its US$880 billion balance sheet to take in a wider range of non-Treasury securities as collateral, and to provide support to a wide range of financial institutions. de Rato said there must be other ways to break the logjam if the massive liquidity injection does not help. But, he has been heartened by a number of recent events which suggest that "things are turning positive, if only slightly".
"Of course, I am aware that, having experienced a few dawns over the past several months, we have to be extremely careful not to draw premature conclusions from prevailing market indicators," he said.
The watershed came in April through the actions of the US Federal Reserve and the Bank of England, said de Rato, The Feds instigated the bail-out of Bear Sterns, and the British central bank took action to establish a floor price on some assets. These two actions presented to the market the new strategy of the central banks —which showed a readiness to do whatever is necessary to avert a financial meltdown.
Their actions meant they are willing to put a floor to the crisis, and had helped resuscitate certain segments of the financial markets. Equity markets had recovered, and particularly the share prices of financial firms had gone up.
A number of major financial firms had been able to raise capital in the market rather than through private placements, and several banks had also been able to sell a significant part of their troubled or unwanted exposures. "Nobody can deny that these are all positive signs which the market has not seen since August," he said. |
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