We are in need of swift and far-reaching actions

Sir, Lawrence Summers in "Wake up to the dangers of a deepening crisis" November 25 mentions that there needs to be a comprehensive approach taken to maintaining demand in the housing market to the maximum extent possible…[and] to assure that there is a continuing flow of reasonably priced loans to credit worthy home purchasers." 

This sounds right though let us hope that with it he does not refer to a need for maintaining the prices of the houses. The more intense the market is allowed to work the shorter the adjustment period and that should really be the primary goal. This subprime bad tooth needs to be pulled out very fast if we are to avoid much worse complications.

The other thing we need to do fast is to start to comprehend the real significance of systemic errors in a globalized environment. What brought us here and what could have happened if this subprime mess had had two more years of build-up before exploiting? Let us shiver at the idea and start doing something about it. Please reign in our bank regulators and their commissars the credit rating agencies. Without them, this would not have occurred.

Give the banks some time to adjust

Sir currently when financial assets like the bonds collateralized with subprime mortgages suffer a downgrading by the credit rating agencies, a bank, according to the minimum capital requirements, has to come up with new capital in the case he did not have more capital than needed. When downgradings become epidemic, as currently is the case, this might force such a scramble for bank capital that it could make matters worse.

Again, many downgradings are really not about the assets turning sour but more about discovering that they always were and so really the capital should have been there from the very start, and if so why the rush to now fix it all immediately if the rushing might turn into panic?

In this respect I would suggest that our bank regulators start thinking about giving the banks some time to adjust their capital base, for instance by giving them at least one year to come up with more capital for any asset that is suffering epidemic downgradings.

Why should bank regulators be so lenient? Well for a starter they were the ones who got us into this mess with their minimum capital requirements adjusted to risk invention and with their appointment of the credit rating agencies as their financial commissars.

Let us beware of upgrading the storm to a hurricane

Sir Gillian Tett reflects well our uncertainties when asking “Is the storm over?” October 4. Now, even if its over, in order to take stock of the damages we will have to wait for quite some time since the costs of any financial crisis are: the actual direct losses existing at the outbreak of the crisis; the losses and costs derived from mismanaging the crisis, for instance injecting too much liquidity and running up inflation; and 3 the long-term losses to the economy resulting from the financial regulatory puritanism that tends to follow in the wake of a crisis and that stops thousands of growth opportunities from being financed. I have hypothesized that each of these individual costs represents approximately a third of the total cost but actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest.

I mention the above since as we have not yet heard a word from Basle about some flexibility on the minimum capital requirements they imposed on the banks, by perhaps temporarily bringing down the base line from 8% to 7.5%, we should fret about the consequences of the surge in demand for bank capital from having to put assets back on their books and that if not accommodated could upgrade this storm to hurricane.

Regulators, please make the financial flows free to flow again

Sir, when Saskia Scholtes reports that “Moody’s alters its subprime rating model” September 25, we get a glimpse on what is the inherent weakness of any rating system that does its rating from the desk. It is not that the borrowers were subprime that caused the current difficulties since there clearly are many prime mortgages to subprime borrowers, it was that some of those shady operators that always exist in any market exploited the Achilles heel opportunity provided by the credit agencies themselves when they assigned prime ratings to very sub-primely awarded mortgage loans. Anyone should have been able to tell those mortgages were lose-lose propositions if only they have left their desk for just a second to go and have a look.

The above describes perfectly the systemic risks or even the moral hazard that can and will arise from empowering any agent in the market too much and there is no way on earth you can really correct that, and much less so if you insist on doing the ratings by monitoring real life from afar.

I do appreciate the credit ratings efforts and that we should be able to benefit much from their services, but this can only occur if the market is also totally free from not having to use them. Regulators please make the financial flows free again.

It’s a Baron Münchhausen moment for the US

Sir Martin Wolf in “The policy challenge of rescuing the world economy”, September 12 writes that “Prof Martin Feldstein of Harvard University pointed to a 3.4 per cent year-on-decline in US house prices” and “Prof Robert Shiller of Yale argued that the US house prices might ultimately fall by as much as 50 per cent”. Although oversimplified a division would yield that the recession carries a 15 years potential and since this is clearly unacceptable by all standards, one of the main real challenges is how to get out of the current conditions as fast as possible. Wolf mentions the need for the Chinese authorities to expand their domestic demand so that the burden of external adjustment does not fall unfairly on Europe and though he is right on his European concerns I am not that sure that Chinese domestic demand expansion would really be so helpful at this particular time for the US since China’s demand elasticity towards commodities and mid-range industrial products could be higher than the elasticity to the products offered by the US.

This looks in fact much more like what I would call a Münchhausen moment for the US, and by which I refer to that Baron’s legendary escaping from a swamp by pulling himself up by his own hair. If there was ever a moment to hurriedly correct other weaknesses in the US economy; like for instance by tort reform, health sector reforms, more strict supervisions on how much intellectual property right’s originated monopolies are exploited and the introduction of a tax on petrol consumption and that would help to take away pressures from fiscal and trade deficits while at the same time sending a better long term signal to the US economy, this is it.

But a share is still (mostly) a share… it’s attractive

Sir, John Plender in “There can be no return to ´normality´ of a freakish bubble” August 30, mentions that “in the midst of all this, many investors are baffled that equity markets have not been seriously damaged”. The explanation for this should be quite clear though, in this freakish market, at least for the time being, a share is still mostly a share, and you can see its value quoted daily, so when you compare it to all those fancy investments where your advisors is currently asking for more time to figure out what it could be worth, give and take 20%, no wonder a share looks attractive.

It is not about to little or too much but about the right or the wrong regulation

Sir, Barney Frank, the chairman of the House Financial Services Committee says in “A (sub)prime argument for more regulation” August 20, that “the subprime crisis demonstrates the serious negative economic and social consequences that result from too little regulation”. He is wrong. The question should not be about too little or too much regulation but about the right or the wrong regulation. At this moment there should be no doubt that what leveraged the very local subprime mortgages problem into what seems to be a global crisis, was having empowered the credit rating agencies to explicitly or implicitly impose so much of their criteria on the markets, and that was ordered by the regulators.

I am not against credit rating agencies. Of course I will use them. But please unshackle the markets from having to use them.

Please unshackle the markets

Sir, in a “Shake-out could help the markets” August 14 you make it clear that Central Banks should offer liquidity but not rate cuts and I fully agree, as you, based on the evidence we have seen. Central Banks are there to be there when needed but always with ever more demanding conditions and rates.

What they could also do is to suspend, until further notice, hopefully forever, that so much of the market in its investment allocations, has to heed the criteria of the credit rating agencies. Now is the time to unshackle the market and allow it to better find its own way out of the mess.

I wonder if also the Central Banks should not give a second look at those minimum capital requirements that the Basel banking regulating community has imposed on the commercial banks. I mean from yesterday to today it is not like the banks have become more risky, it is more that they are discovering how risky they really were, and so the Central Banks should perhaps help to ease that tragic moment of realization.

Where the buck really needs to reach

Sir, David Hale in “The Credit crunch and the quandary of the Fed” August 14, is just another one in the long line of commenter on the current financial turmoil that refuse to apportion responsibilities where they should go. For instance when he says that “the rating agencies facilitated the boom by giving high credit scores to securities with loans of dubious quality” the facilitated is by all means an understatement since they in fact have a great responsibility for that boom. Mind you, not that the “buck” should stop with the credit rating agencies. In the first line of responsibility, without any doubt, are those regulators that instructed and even in some cases ordered the market participants to stop thinking for themselves and heed the expert opinion of the credit rating agencies.

If we don’t realize all this and furiously back-peddle from our current setup, if we survive this turmoil, we will not do so the next time around. There is just too much systemic risk fabrication going around.

This time though ignorance was mostly fabricated

Sir John Kay in “The same old folly starts a new spiral of risk” August 14 recounts a story from the files of Lloyd’s to make a case for how “people who knows a little of what they are doing pass risks to people who knows less” and so therefore risks tend not to spread but to concentrate setting us up for an explosion. I agree that we might or should have already learned our lessons from that but in the current turmoil there are in fact two new elements that give a fresh perspective on financial history. The first, the most ironic, seems to be that it was in fact those most knowledgeable participants that with their excessive arrogance fabricated with their sophisticated financial models their own ignorance and second, more tragic, that the market was not allowed to apply its own and perhaps even more wise ignorance, but was instructed, by the regulators, to follow the advice of the experts, the credit rating agencies. The concentration of risks under such circumstances could prove to be even much more explosive.

In the stupid/intelligent, coward/valiant chart where will history plot today’s investors?

Sir it is clear what Saskia Scholtes is driving at in “Fear rather that fundamentals is driving trading” August 11, but as she readily admits that it can become self-fulfilling, we should never forget that fear can easily morph into a fundamental. You can fear finding a bear in the woods but if it appears you’d better treat it as a real fundamental or you pay for it. Now how you handle that fundamental and avoid panicking well that is a totally different matter which brings us to a graph where on the axis we plot from stupid to intelligent and on the y axis from coward to valiant, and then sit back and wait for history to plot us…on a minute by minute basis.

We need to attach a warning message to the credit ratings.

Sir Andrew Ward reports August 10 that President George W. Bush has said there was a “proper role for government” in enhancing financial literacy as “we had a lot of really hardworking Americans sign up for loans and the truth of the matter is they probably didn’t fully understand what they were signing up for”.

Mr Bush might have a point but from what we currently see those most in need of a financial literacy course seem to be all the investors struggling to make head and tails out of credit rating grades or financial models that really do not mean what they say.

Of course it also cannot only be a question about the reading but also about the writing. For a starter, as a minimum role for the government, I would suggest they start by making obligatory, whenever credit ratings are disclosed the inclusion of a “Warning, following these ratings blindly is dangerous to the financial well being of your portfolio.”