Thursday, September 06, 2007

"Solutions" to the market crisis

You may not guess it from the buoyant state of the Sensex but international markets are still gripped by fear and uncertainty. There are some who believe that the most obvious solution- interest rate cuts effected by central banks- will not suffice, although central banks, and especially the Fed, have been careful in using this instrument.

I see two other solutions being tossed around:

  • Fiscal intervention, that is, government bail-outs of distressed institutions, not just banks. This is based on the premise that interest rate cuts will not be adequate. In the US, the government-backed agencies such as Fannie Mae have been asked to step in to save mortgage institutions.

  • A rescue of distressed institutions by private banks and investments a la the rescue of the hedge fund LTCM in 1998. An article in FT proposes the creation of something akin to an asset reconstruction corporation for various credit instruments for which there is no market at present.

What do we make of these solutions? First, I don't believe that the situation is so bad that fiscal intervention will be widely required. As for private institutions doing a rescue act, don't forget that LTCM was rescued under "moral suasion" exercised by the Fed, it wasn't entirely voluntary. For banks to do so now, they would have to be convinced that this is a profitable exercise. As the FT article makes clear, there is a problem in making this determination: it's very hard to put a fair price on many of the distressed credit assets.

I don't see private banks, accountable to shareholders, undertaking this task. The first order of business, really, is for all concerned parties, to come clean on their distressed exposures. Only then can central banks get a fix on the magnitude of the problem. Central banks must make liquidity available. Some banks may have to be bailed out.

That's about it. For the rest, we should wait for some of the panic to subside- and like grief, it will over time. Then, private parties will swoop on attractively valued distressed assets and the clean-up will begin. There is enough capital sloshing around to do this job. Governments are not required to do this. And private firms need not be mandated to do so.

As you can see, I'm rather more optimistic about the resolution of the present uncertainty than many others.

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