Banks should form a bail-out vehicle to ease the credit crisis

Banks should form a bail-out vehicle to ease the credit crisis

http://www.ft.com/cms/s/0/9cfe08ee-5c10-11dc-bc97-0000779fd2ac.html

By Cambiz Alikhani

Published: September 6 2007 03:00 | Last updated: September 6 2007 03:00

Over the past few months a modern day pyramid scheme of colossal proportions has begun to unwind. The sheer scale of it is clogging up the arteries of the financial system and has led to major disequilibrium within global credit markets.

Markets face a credit crunch that continues to manifest itself in the money markets and this can have pronounced effects on the real economy as the lending system becomes dysfunctional. This credit crunch could be alleviated by removing from the system the debt that created the problem in the firstplace.

In an ideal world, the process for such removal is one in which a new set of economic agents, unaffected by the problems that have beset the financial system and with access to long-term capital, step in to the buy the debt at attractive prices.

As that occurs, confidence and risk appetite should return to the system and markets return to a state of equilibrium.

However, the scale of debt involved in the current crisis is of such magnitude that demand from opportunistic investors alone may not be sufficient to remove the problem. In addition, much of this paper is difficult to price, further exacerbating the situation.

It may therefore be appropriate for a core group of leading financial institutions to consider the idea of a "bail-out" vehicle that would be capitalised with the purpose of providing both pricing for the market and a source of demand for paper that cannot find another home.

The fact that such a vehicle is funded by financial institutions rather than governments would not only shield regulators from the accusation of "moral hazard" but could actually involve them in a very pro-active way.

They could play an important role in providing transparency with regards to the scale of the problem and with regards to the different pricing mechanisms used bydifferent banks for exactly the same typeof paper.

Thus regulators such as the Securities and Exchange Commission in the US and the Financial Services Authority in the UK could play the pivotal role of referee, while central banks provide the appropriate level of liquidity that the system needs in the meantime.

History has shown that there are examples analogous to what is being proposed above that have proved to be a success.

The bail-out of Long Term Capital Management in 1998 by a consortium of investment banks (and brokered by the New York Fed) is an example. Prior to that, the early 1990s saw the creation of a "bad bank" in Sweden as part of measures to keep the banking system solvent when it became overburdened with bad debt.

The savings and loan bail-out of the late 1980s in the US is another example. In fact, one may also argue that the lack of such a measure in Japan in the 1990s exacerbated deflation in that country as the government instead chose continuously to recapitalise banks that still held bad debt on their balance sheets. This bad-debt overhang reduced their willingness to lend to anyone other than the government, leading to significant overvaluation of the government debt market.

Although the structure and details of a new bail-out vehicle to alleviate the current crisis would be extremely complex, this is exactly what banks should be good at.

They have a long history of successfully negotiating work-outs and restructurings. In this instance, they are all in it together as it is their balance sheets that are being put towork to act as lenders of last resort. Thus a common solution towards removing "bad" or "unwanted" debt from the system would be beneficial to all.

The measure being discussed above would not only play a critical role in finding an equilibrium price for "bad" or unwanted debt but would also create a vehicle which such paper could be sold into, thereby unclogging the arteries of the financial system. The writer is a partner at Arundel Iveagh Investment Management, a London-based wealth manager