Interesting...

The Fed did not panic


Posted by Ambrose Evans-Pritchard on 23 Jan 2008 at 17:39


Let us scotch one foolish and dangerous notion already gaining acceptance. Those who accuse the Fed of acting out of panic in slashing rates 75 basis points on Wednesday do not grasp the seriousness of the situation.


The move was imperative to prevent a grave financial crisis spiralling into disaster. The threat of a melt-down in the $2.4 trillion market for US municipal bonds had suddenly moved from possible to imminent. No monetary authority could ignore such risks.


As skittish markets showed today, more will undoubtedly be required, and soon. But at least the US authorities are facing up to the predicament that they created in the first place by fixing the price of credit artificially low for year after year, and failing to regulate banks, derivatives, and structured credit with a minimum of common sense.


“Central banks have lost control,” said George Soros to the chastened elites in Davos today, so humbled from the hubris of last year.


Not yet, perhaps, but the banks have certainly come a little too close to losing control. Both the European Central Bank and the Bank of England may yet do so, trapped by their inflation orthodoxies and mandates.


The trigger for the Fed action was the move on Friday by Fitch to strip the US monoline insurer AMBAC of its `AAA’ rating, with the mounting risk that the rating agencies would soon downgrade its bigger peer, MBIA.


Why does it matter? Because they have guaranteed a large part of that $2.4 trillion bond market.


If they lose their AAA ratings, all the bonds that they have insured will lose their ratings pari passu. This would force a large number of pension funds and institutions under strict investment rules to sell their bonds, setting off a cascade of sales with no obvious buyers in sight.


The effect could easily have been – and may still be – a second lethal leg to the credit crisis, with vast losses. This could all too quickly lead to a run of bank failures.


Do not be fooled by the fall in three-month dollar LIBOR rates. These had not fully returned to normal last week. They reflected the drastic change in expected interest rates, as priced by the futures markets.


The contracts were already pricing in huge rate cuts within three months. Adjusted for this, LIBOR had not really eased.


No doubt the Fed had a mix of fears. The “financial accelerator” was moving into a very ugly mode. The ABX index measuring subprime debt – and used as a benchmark for bank write-offs – had begun to plunge again, nearing 13 cents on the dollar for some BBB debt and 26 cents for A grade.


Even the AAAs were down as low as 60 cents for some vintages. S&P last week raised the expected default level on 2006 subprime debt from 14pc to 19pc. Citicorps said it was raising loss reserves on auto debt and credit cards. The noose was tightening fast.


If there was any doubt about the gravity of this crisis, it ended on Monday when the entire universe of global equities went into free-fall, with German stocks off 8pc and Japan’s Nikkei suffering the worst two-day fall in seventeen years.


The Fed action is not to everybody’s taste. Stephen Roach, the head of Morgan Stanley Asia, was blue in the face from righteous wrath in Davos today.


“Policy-makers are reaching back to the same play book that created this mess in the first place. They’re saying we are there to clean up after bubbles burst first rather than to prevent them. It’s a dangerous, reckless and irresponsible way to run the world’s largest economy.’’


“We have a market-friendly Fed injecting a lot of liquidity in the system which will set us up for another bubble economy. Excessive monetary accommodation just takes us from bubble to bubble to bubble.”


I have much sympathy for this view. The Fed has been “asymmetric” for much of the last fifteen years, standing back as asset prices overheat but then interviewing to prevent a proper liquidation to purge the excesses. Indeed, I would go futher, blaming them for actively stoking those bubbles in the first place.


But the time for tough-love is when the economy is humming along a little too fast, not when it is in the midst of a grave crisis. Calvinist monetary discipline at this point would wreak havoc, and possibly endanger the political stability of several countries (in Europe, if not in the US).


The best we can hope to do is right the ship slowly, and turn a blind eye to moral hazard for now. It is not pretty. It means a lot of pin-stripe villains and leverage louts in the City will escape their condign punishment.


But as Fed governor Frederic Mishkin put it recently, we cannot chastise whole societies to keep the moralists content.


Yes the banks will soon be able to play the carry trade again, borrowing short to lend long. It cleanses the balance sheets.


Money rains like manna from Heaven. Profits loom again and the new cycle starts.

That will be the moment for society to settle its scores with the credit clowns. Not now.


http://blogs.telegraph.co.uk/business/ambrosevanspritchard/december07/thefeddidnotpanic.htm