A resolute solution

Bailouts and short-selling bans are band-aid solutions, but a new Resolution Trust would allow assets of troubled banks to be sold in an unstable environment.

In the UK, they’ve banned short selling in financial stocks and it appears that the US they are contemplating following suite. The US regulators and legislators are also working on a structural response to the credit crisis that could end the downward spiral in asset values that has destabilised the global financial system and most of its major participants.

Until now, the response to the credit crisis by governments and their agencies has been to buy time for the markets to stabilise and function more normally, which has involved the sporadically flooding the global system with liquidity.

In the US, there have been largely ad hoc responses to particular crises within particular institutions – the underwriting of JP Morgan Chase’s acquisition of Bear Stearns, the effective nationalisations of Fannie Mae, Freddie Mac and AIG, and the encouragement of mergers between the weaker institutions and their stronger peers.

The regulatory response now appears to be shifting into a rather different phase, with authorities now looking at options that would have been unthinkable even a few months ago.

The latest $US180 billion infusion of central bank liquidity has bought a little time and relief from markets that were threatening to cease functioning, but no permanent solutions.

The UK Financial Services Authority’s (FSA) ban on short-selling of financial stocks, which will last until January at least, and the prospect of similar action in the US and, perhaps, elsewhere, has also helped to scare hedge funds from the market.

However, the canvassing of the possible creation of a 21st Century version of the Resolution Trust strategy – used to resolve the 1980s savings and loan societies crisis in the US – is a signal that US authorities are now looking for a permanent solution that would end the vicious and self-fuelling downward spiral in financial assets that has eroded the foundations of the global system.

The FSA’s ban on short selling followed what appears to have been concerted attacks by hedge funds on HBOS and Barclays and other UK banks. Similar assaults on US banks and investment banks contributed to the implosions in the value of Bear Stearns, Lehman, Fannie Mae, Freddie Mac, AIG and other financial institutions.

This week, Macquarie Bank and Suncorp were subjected to destructive and – particularly for Macquarie – potentially destabilising bear raids.

Short-selling is useful in normally functioning markets. It provides extra depth and liquidity to trading and also helps accelerate the disclosure of corporate weaknesses. These aren’t, obviously, normally functioning markets. There is no long-only fund buying, indeed not much buying from anywhere.

That creates a system-threatening, institution-destabilising, panic-inducing one-way bet for the hedge funds – there is no resistance to the short-selling.

The market purists might argue that short-selling exposes weakness. The problem today is that the hedge fund activity is not just exposing deficiencies that already exist but actually creating them through their actions.

Given the severity of the crisis, and the destructiveness of the attacks on financial institutions, a temporary ban on shorting that sector – until some semblance of normality returns to securities markets – looks like a sensible step.

Bans on short-selling aren’t a solution to the crisis but, like the liquidity injections, are a band-aid to keep the system from falling over. They treat the crisis’ symptoms rather than provide a cure.

A new Resolution Trust, if pursued, would be an attempt to deal with some of the more fundamental issues.

Resolution Trust was a vehicle the US created in 1989 to hold and liquidate nearly $US400 billion of assets, mainly real estate assets, of 747 failed savings and loan institutions, the US equivalent of our building societies. The trust entered partnership with private sector entities that managed the liquidation of the portfolios over the next decade.

The US authorities are talking about a similar vehicle that would acquire distressed assets from the banks and investment banks, presumably including the sub-prime real estate exposures that are at the heart of the financial crisis and the housing market meltdown in the US.

The forced nationalisations of its GSEs and AIG coupled with the realisation that the US taxpayer would probably be called on to bail out other institutions deemed too big or important to be allowed to fail has brought the concept of a broader solution into focus.

The authorities need to devise a mechanism for thwarting the effects of mark-to-market accounting in an environment where there is no liquidity at all for distressed financial assets, no floor under the value of financial assets and no way to stop the cycle of write-downs and losses even where the underlying portfolios are performing well and generating their promised cash flows.

If some of those assets are transferred out of the mark-to-market environment and held at arm’s-length from the financial sector it would help US institutions to stabilise their balance sheets and at reduce the levels of fear and uncertainty and counter-party in the system.

Given the severity of the write-downs so far, if the authorities were selective about the portfolios they acquired, and the prices at which they took what would otherwise be unsaleable assets from the banks, it could ultimately be quite a profitable set of trades for taxpayers.

If the nadir of the credit crisis were reached today, the losses already in the global system would probably eventually reach something approaching $US1.5 trillion.

Net of the capital that has been raised, or that could be raised in the near term if conditions stabilised, there is likely to be roughly $US1 trillion less capital in the system when the crisis ends than when it began.

Geared conservatively, that $US1 trillion or so would support about $US10 trillion of economic activity, or roughly 20 per cent of global GDP.

The challenge for the regulators is to find ways to stop the otherwise inexorable increase in the system’s losses and the continual winnowing out of the system’s capital base it represents and thus both minimise the extent of the damage done to the system and to real economies and bring forward the point at which new capital can be raised.