T C A Srinivasa-Raghavan: The financial crisis and the central banks

OKONOMOS

The BIS nannies the world's central banks, which are now scurrying around with pots and pans and plastic cups to save the sinking ship.

The Americans have finally panicked. We have seen the 1.25 per cent interest rate cut over nine days and the $157 billion fiscal stimulus package that President Bush is trying to push through. Clearly, Armageddon is nigh.

Everyone knows it was unsupervised greed buttressed by water-tight contracts that has caused the problem. We in India have plenty of greed but it is reasonably well supervised. And, thankfully, we don't have lawyers who draw up 300-page contracts for just one collaterilised debt obligation (CDO). The imagination boggles at how many trees have been cut for all the CDOs in existence.

Be that as it may, how come no one foresaw what was coming? You get strange answers to this question.

"Oh, we knew all right that the loco was coming at us but we didn't know just how big it was." Amazingly, even the Bank of International Settlements (BIS) didn't have a clue as to how big it was. The BIS nannies the world's central banks, which are now scurrying around with pots and pans and plastic cups to save the sinking ship. As an IMF man put it recently, hope has now turned to prayer.

So it seemed like a good idea to take a look at the BIS website. If anyone could have out the warning flags, it could have. It did, too, but they were buntings, really. On December 10, it published its quarterly review* and devoted all of eight pages out 106 to what it called credit woes of the banks.

There was a one-page box on sub-prime losses and there was a small section on bank write-downs. But if you read it in December, which many people did, you would have thought all was well, nothing to worry lads, back to work now.

"Uncertainties about the size and distribution of mortgage-related losses have been among the key drivers of the broader financial market turbulence... A key result (of the analysis) is that plausible model assumptions can generate sizeable projected losses at current delinquency levels, and that relatively modest changes in model assumptions can lead to marked increases in projected losses across different tranches of instruments with sub-prime exposure."

In short, this gobbledygook meant we don't know how bad things are, they could get worse but they seem pretty bad. Then came the reassurance which fooled people.

"...there are long lags involved in the transmission of delinquencies on underlying subprime (and other) exposures... the foreclosure process can take more than a year to complete, and collateral pools are not usually marked to market, many recent securitisations will therefore not experience material write-downs until 2008." When in 2008, please? January or December? Silence.

And there was no mention of the bond insurers who seem to be in the danger of going belly-up now. To be fair, after working out how the sensitivity analysis was conducted, the review did warn that there was a "likelihood of more downgrades were housing fundamentals to deteriorate further". But said nothing about how likely this was. Net result: the review was of no help in assessing the magnitude of the problem.

Nor was the US Fed of much help. Its website, the bit that gives you the economics research, had papers on other things. Ditto, pretty much, given the fashion, the other central banks. You had to read the newspapers to get sense that something was very, very wrong.

So here is the question: are central banks carrying the Greenspan method too far? Does all this signaling, whispering, and the Morse code really help, especially since the markets had turned skittish way back in April, or at least July?

This crisis may not result in controlling greed and lawyers, but one must hope that it will help starting a more forthright approach by central banks. Coyness is nice, but only up to a point.

*BIS Quarterly Review, 10 December 2007, http://www.bis.org/publ/qtrpdf/r_qt0712.htm