Mark PittmanCentral Banks Lack Tools to Fix `Panic,'Wed Sep 19, 2007 20:15
Central Banks Lack Tools to Fix `Panic,' Moody's Says (Update2)
By Mark Pittman and Kabir Chibber
Sept. 19 (Bloomberg) -- Central banks may not have the tools to restore stability to credit markets amid the ``Panic of '07,'' and instead should demand greater transparency from financial companies, Moody's Investors Service said today.
Derivatives and the growth of hedge funds using unprecedented amounts of debt have magnified the impact of a rise in borrowing costs, New York-based Moody's said in a report.
``The new financial paradigm has brought with it some problems, which the world's financial policy technicians have not yet solved,'' Moody's said in a report by Vice Chairman Christopher Mahoney and Senior Vice President Pierre Cailleteau. ``Each credit crisis teaches new lessons, often resulting in corrective reforms. The current `Panic of '07' will as well.''
Central banks failed in their initial efforts last month to stem a credit crunch that was sparked by rising defaults on subprime mortgages. The banks used their traditional instruments for propping up markets such as adding cash to the financial system through overnight lending and cutting interest rates.
The cost of overnight borrowing in pounds rose yesterday by the most since June as the bailout of U.K. lender Northern Rock Plc stoked concern that more home-loan providers will be forced to seek emergency funding. The Bank of England yesterday made 4.4 billion pounds ($8.8 billion) of emergency loans to U.K. banks and the U.S. Federal Reserve cut its benchmark interest rate by half a percentage point to 4.75 percent to prevent the economy from sinking into recession.
At least 110 mortgage companies have halted operations or sold themselves since the start of 2006, including American Home Mortgage Investment Corp., the Melville, New York-based lender. Countrywide Financial Corp., the biggest U.S. mortgage company, was forced to tap bank credit lines after being shut out of the short-term debt market and banks provided $21.4 billion to shore up GMAC LLC, the lender owned by General Motors Corp. and Cerberus Management LP. Hedge funds, including two run by Bear Stearns Cos., collapsed and Newcastle, England-based Northern Rock sought its bailout last week.
Foreclosures set a record in the second quarter and overdue payments on U.S. subprime mortgages rose to the highest level in five years, according to the Mortgage Bankers Association.
Moody's itself, as well as Standard & Poor's and Fitch Ratings, were criticized by investors, lawmakers and regulators for being too slow to respond to the rising defaults. The ratings companies are being probed by the U.S. Securities and Exchange Commission and policy makers including European Central Bank President Jean-Claude Trichet have pointed to possible conflicts of interest between the ratings companies and the banks that pay their fees.
Moody's, S&P and Fitch waited until April to downgrade some subprime securities, after their value had fallen by as much as 80 cents on the dollar. Analysts have been updating ratings ``as fast as we can,'' Mahoney said.
Investors have an ``over-reliance on ratings for pricing,'' he said. Some ``have no idea what they have and they have no idea how to price it.''
The global financial system, Moody's said, has evolved from a ``sleepy'' world dominated by banks and fixed exchange to one in which capital flows across borders and is allocated by the market, not financial institutions.
``It has become clear that not knowing where the risk is can undermine confidence in the stability of counterparty credit,'' Tim Frost, a portfolio manager at London-based hedge fund Cairn Capital, said in an interview yesterday. ``The palpable loss of confidence in the market recently will reinforce to management and regulators that firms need to `fess up' when they have losses.''
A $1.6 billion debt fund run by Cairn was last month bailed out by Barclays Plc, the U.K.'s third-biggest bank, after it was unable to raise money in the credit markets.
Traditionally, the Fed's control over banks has enabled it to ease any credit crunch by adding money to the financial system, Moody's said. The Fed has almost no control over the hedge funds that are among the biggest investors now, Moody's said.
``The intensity of the impact of a financial shock on the economy will depend on the central banks' ability to restore `fluidity' throughout the system,'' Mahoney and Cailleteau said in the second of a series of reports addressing the crisis. ``We expect market and official pressure to require greater transparency from financial actors.''
In the previous report on Sept. 5, Mahoney and Cailleteau said the adjustment in prices of mortgage bonds tied to borrowers with poor credit will last at least six more months.
``We expect some pressure on capital ratios'' for banks, Mahoney said during a conference call today. ``We don't expect any major banks to breach capital ratios, but it will be bearish for credit creation during the period banks digest this unwanted meal.''
The next report from Moody's will study the role of credit rating companies in the market, Mahoney said in an interview.
The ``deficiencies exposed'' by the present turmoil are mostly the same as when Greenwich, Connecticut-based hedge fund Long-Term Capital Management LP collapsed after Russia defaulted in 1998, Mahoney and Cailleteau wrote.
``The greater the loss of confidence, the harder it is to restore and crucially the greater the erosion of confidence, the greater the contagion and the broader the financial safety net may have to be spread,'' the analysts said. ``This is the ultimate conundrum of the philosophy of market discipline.''
Moody's last month said a hedge fund collapse on the same scale as LTCM was possible. Investment banks are facing larger losses than when LTCM had to be bailed out after wrong-way bets on global bond prices, Standard & Poor's said last month.
``Risks have been unbundled and rebundled into tradable instruments,'' the Moody's report said. ``The new financial world created by securitization had not been subjected to a stress test of this magnitude until now.''
Derivatives are financial instruments derived from bonds, loans, stocks, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
``What turned an overdue risk reappraisal into a financial panic is the combination of untested financial innovation, price- sensitive accounting rules, leverage and opacity,'' Mahoney and Cailleteau said. ``This cocktail has proved explosive.''
To contact the reporters on this story: Mark Pittman in New York at email@example.com ; Kabir Chibber in London at firstname.lastname@example.org
Last Updated: September 19, 2007 10:20 EDT
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