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S. Balakrishnan

Imagine a bank’s balance sheet with utterly illiquid assets, which can neither be sold nor used as collateral for borrowing.

Now, imagine an entire banking system saddled entirely with unmarketable and unliquifiable assets. Such is the sorry plight of US banks today.

It was not the happiest of backdrops for the bimonthly meeting of the Federal Open Market Committee (FOMC), which sets US interest rates.

The picture was not bad till recently – in fact, less than a year ago, the very same balance sheets could be easily funded.

Financing housing in a booming property market, through securitisation and resecuritisation (Collateralised Debt Obligations-CDOs), seemed a one-way ticket to profits.

There was money to be made in the first securitisation, then CDO structuring, pricing and fees, spreads and, most of all, leveraging. With the rating agencies ever ready to help with prime ratings, it was easy to finance investments at interest rates well below the yields on these assets. A sliver of equity could, therefore, earn juicy returns.

As long as the loans underlying the mortgages were serviced, that is. Once, however, house prices started falling and interest rates were reset at higher levels, the game was up. Borrowers fell behind in their payments and pretty soon mortgage portfolios and CDOs became suspect.

The raters were as quick in downgrading - often by several notches in which a ‘AAA’ could move to junk in one go – as they were earlier in awarding premier credit status.

There was hardly time to react. The worst punishment was the obligation to mark-to-market all downgraded assets – even those which were not in default. Expectedly, a credit gridlock overtook the inter-bank market.

The Fed had to do much more than cut interest rates, providing liquidity either as cash or Treasury notes and bonds against non-Treasury collateral.

In the latest move, it has enlarged the list of borrowers eligible for direct financing as well as the period of funding.

Banks will undoubtedly welcome the Fed’s help in financing the unfinanceable in today’s jittery financial markets.

But will it get the credit wheels moving? For, it is the ‘credit shyness’ or incapacity of banks to lend and of borrowers to borrow that is stunting consumer and business spending, apart from sinking confidence and stratospheric oil and gold prices. Just interest rate cuts and liquidity support will not be enough.

Before the current crisis, the Fed worried about soaring asset prices, but thought it could tackle a bursting asset bubble by sufficiently lowering interest rates.

It probably underestimated the contribution of the ‘wealth effect’ as a growth stimulus and the downside of wealth disappearance after an asset price collapse.

Now, it seems the answer to force an economic revival lies not as much in soft interest rates as a revival of prices in the still stricken housing market.

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