Financial plumber must stem the panic

Financial plumber must stem the panic
By John Authers
Copyright The Financial Times Limited 2007
Published: August 10 2007 19:31 | Last updated: August 10 2007 19:31


When people start talking about infrastructure, the chances are that it has already gone badly wrong. We simply do not notice if everything is working smoothly.

For example, nobody much cares about computer servers, or about the pipes in their house, until they are confronted with an e-mail outage, or a flood in the kitchen.

At that point it is human nature to get very angry with the people responsible for that infrastructure, whether they be the know-it-all from the IT department, or the local plumber. These often innocent and hard-working people have to spend much of their lives being berated by amateurs who do not appreciate the work they have silently been doing.

The same applies to the financial infrastructure. You can build a good career in banking without ever understanding the intricacies of the interbank lending market, or asset-backed commercial paper, or the activities of the US mortgage finance agencies. If these markets function well, as with e-mail servers or pipes, you will not notice them.

If something goes wrong, however, the result is panic, and extreme anger directed at the regulators and central banks that guard the infrastructure. That has happened this month.

On Friday last week, Jim Cramer, the hedge fund manager and television pundit, created an instant YouTube classic on the CNBC business channel as he berated the Federal Reserve, the US central bank, and Ben Bernanke, its head, and told them to bail out the market.

“Bernanke is being an academic!” he screamed. “It is no time to be an academic . . . He has no idea how bad it is out there. He has no idea!

“My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! . . . The Fed is asleep!”

His outburst, with which many traders agreed, made compelling television. It also contributed to growing panic, as CNBC is ubiquitous background noise in trading rooms.

The week just ended has seen a huge rally, followed by another panic. The rally was sparked by optimism that the authorities would be there to bail out the market – through cheaper money from central banks and through permitting mortgage agencies to buy up “toxic” mortgage securities that nobody else wanted to buy.

The subsequent collapse came as central banks did indeed intervene, but traders realised that the problems with their infrastructure – the pipes of the financial system – were more severe than they had realised.

With basic infrastructure now called into question, this is without question the scariest market incident since stocks began their long recovery early in 2003. All cosy assumptions have suddenly been called into question.

This gives regulators a problem. Unlike plumbers, they have to contend with moral hazard – the risk that bailing out risk-takers now will encourage excessive risk-taking in the future. It is this “academic” theory that people like Mr Cramer dislike. But it is no less true for that. Central banks should only bail out traders who made bad bets if the financial infrastructure is truly in danger.

As long as the problems created by the US subprime mortgage debacle were restricted to difficulties raising the finance for leveraged buy-outs, they could rightly be regarded as nothing more than knocking the froth off the top of an overvalued market.

Bill Poole, the governor of the St Louis Fed, described by Mr Cramer as “shameful” during his outburst, said last month: “The punishment has been meted out to those who have done misdeeds and made bad judgments. We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.”

But now, the problems have reached the world’s very financial infrastructure. Thursday saw sharp rises in the rate at which banks will lend to each other, a critical flow of funds that creates “give” in the financial system. That prompted the European Central Bank’s historic intervention on Thursday, offering money (at the usual interest rates) to any bank that needed it.

But the problem also spread to the asset-backed commercial paper market – the business of raising short-term financing in return for bonds backed by collateral. This paper is normally regarded as very safe, and in the US its rates vary little from the benchmark Fed funds rate.

On Thursday, corporate paper yields – the rate borrowers would need to pay in order to get financing – suddenly rose to their highest in six years. Continuing the plumbing analogy, this was as though a second major pipe of the world financial system had sprung a leak.

With fear now rampant, the Fed itself intervened three times on Friday, offering funds to banks and saying it would accept mortgage bonds as collateral. This step is more extreme than first appears. The Fed used public money to take risk, in the form of high-quality, but stricken mortgage securities off banks’ hands – at least for the short term. That could create moral hazard. The intervention did calm the money market, but stock markets remained in a state of panic.

That panic remains the regulators’ greatest problem. The plumbing analogy is not perfect. If a homeowner is panicking, that does not make it any harder to fix a leak in the pipes. But if markets are panicking – and they are certainly doing so at present – then that in itself makes it harder, if not impossible, to fix the infrastructure of the financial system.

These are dangerous times indeed.

john.authers@ft.com