Frontiers of Growth
Unfreezing Credit
Raghuram Rajan and Douglas Diamond
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CHICAGO – Little political enthusiasm exists for further support to the banking sector. One reason is that banks that received money in the initial rescues do not seem to have increased their lending, without which monetary and fiscal stimulus are unlikely to be effective. For banks to start lending again, even more intervention may be needed.
To see why, we need to understand why banks are still so reluctant. One possibility is that they worry about borrowers’ credit risk, though this would have to be extremely high to justify the complete cessation of long-term lending. A second possibility is that banks worry about having enough resources to meet their own creditors’ demands if they lock up funds in long-term loans. But the many central bank lending facilities that have been opened around the world should assuage these concerns, especially for large and well-capitalized banks.
On the other hand, perhaps banks’ reluctance to lend reflects a fear of being short of funds if investment opportunities get even better. Citicorp CEO Vikram Pandit said as much when he indicated that it was cheaper to buy loans on the market than to make them. And buying may get cheaper still!
Consider, for example, the real possibility that a large indebted financial institution faces a run on its deposits, as Lehman did, and starts dumping loans onto the market. Not only will those loans’ price fall if only a few entities have the spare funds to buy them, but other distressed entities’ scramble to borrow also will make it hard for any institution without funds to obtain them. Anticipating the prospect of such future fire sales (of loans, financial assets, or institutions), it is understandable that even strong banks will restrict their lending to very short maturities, and their investments to extremely liquid securities.
This may also explain why markets for some assets have dried up. Some distressed banks clearly possess large quantities of mortgage-backed securities, and are holding onto them in the hope that their prices will rise in the future, saving them from failure. At the same time, buyers expect even lower prices down the line. While there is a price today that reflects those expectations, it is not a price at which distressed banks want to sell.
As a result, there is an overhang of illiquid financial institutions, whose holdings could be unloaded if they run into difficulties. For some, low prices would render them insolvent. For others, low prices would be a tremendous buying opportunity, whose prospective return far exceeds returns from lending today. Political exhortations to lend can have some, albeit limited, impact. Any voluntary resumption of lending will necessitate reducing both fears and potential opportunities.
Here are some ways to reduce the overhang. First, the authorities can offer to buy illiquid assets through auctions and house them in a government entity, much as was envisaged in America’s original Troubled Asset Relief Program. This can reverse a freeze in the market caused by distressed entities that are unwilling to sell at prevailing market prices.
The fact that the government is willing to buy in the future (and now) should raise prices today, because it reduces the possibility of low prices in a future fire sale. Moreover, once a sufficient number of distressed entities sell their assets, prices will rise simply because there is no longer a potential overhang of future fire sales. Both effects can lead to increased trade in illiquid assets today, and unlock lending, though this outcome may require significant government outlays.
A second approach is to have the government ensure the stability of significant parts of the financial system that hold illiquid assets by recapitalizing regulated entities that have a realistic possibility of survival, and merging or closing those that do not. For those entities that are closed down, this would mean moving illiquid assets into a holding entity that would gradually sell them off. One problem is that the public’s appetite for a bailout of the unregulated and hemorrhaging “shadow” financial system, consisting of institutions like hedge funds and private equity firms, is rightly small, yet it too can serve to hold back bank lending if a large proportion of the distressed assets are held in weak institutions there.
Perhaps, therefore, a mix of the two approaches can work best, with the authorities buying illiquid assets, which can help even unregulated entities, even while cleaning up the regulated financial sector, focusing particularly on entities that are likely to become distressed. This differs substantially from the current approach (in which well-capitalized entities are given even more capital), which does not deal with the overhang of illiquid assets that more distressed entities hold. Unless the regulated financial system is systematically audited, with weak entities stabilized through capital injections, asset purchases, or mergers, or liquidated quickly, the overhang of distressed institutions will persist, constraining lending.
One lesson from Japan’s experience in the 1990’s is that the sooner the authorities bite the bullet and clean up the financial system, the sooner the economy will be on the road to recovery. The longer officials remain paralyzed, hoping that the financial system will right itself, the higher the eventual cost of the cleanup will be.
Douglas Diamond and Raghuram Rajan are professors at the Booth School of Business at the University of Chicago.
Copyright: Project Syndicate, 2009.
www.project-syndicate.org
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tvselvakumaran 10:40 03 Mar 09
Q5. Why have the markets for mortgage securities continued to remain illiquid?
A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories about risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information.
(written in October 2008)
alexferro 02:42 25 Feb 09
Off-ladind low - lquidity
By giving these institutions an additional option, over say afive year period:
To repurchase the very security they are off-loading, you might be able to get them to self rate them.
alejandro ferro