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Whistling into the wind

THE dark shadow of the subprime loan crisis refuses to go away. Citibank saw profits plummet while its stock rose on the belief that things might have been worse.

Now its friends and rivals are riding to their own rescue. Meanwhile what some may hope will still prove to be the "crisis that never was" rumbles on.

Activity or action

The major US banks have unveiled a plan to mitigate the effects of the subprime loan fiasco, or at least to stop the housing-related debt crisis from worsening. This plan offers to do all that is required - except perhaps, use the banks' own money to pay for their errors.

New plan — new vehicle

In outline the concept is to introduce a new vehicle that it is hoped will restore confidence in the market while minimising the banks' risk. It is hoped that this vehicle, unlike its predecessor, will not lose its wheels as it trundles at speed into the real world of commerce.

As more facts become known the ramifications of the debt crisis tend, in the eyes of some commentators at least, towards market meltdown. So all nuts and bolts have been carefully tightened and the US Treasury has given a "certificate of road worthiness" to the scheme.

The situation sometimes looks calmer from afar. Stock markets have reached and are being sustained close to record levels — some of the time. The concern, however, is that the questionable securities are proving almost impossible to sell at anything like their previous price. If prices continue to dive there would be repercussions for hedge funds, investor confidence, credit and financial liquidity. A global recession may still loom.

The plan is to create an artificial demand for currently questionable assets. This would, it is hoped and believed, avoid any precipitate desire to sell off those assets at any price. So how is this desirable outcome to be achieved?

Master liquidity enhancement conduit

If impressive titles build confidence this ought to do it. The new vehicle, "Master Liquidity Enhancement Conduit", simply called "M-LEC" among its friends is expected to raise as much as $200 billion through the sale of its own securities. This income will be reinvested in the purchase of those securities that might otherwise be dumped on the market and thus create a period of tranquillity leading to price "discipline".

Officialdom and press — or public relations

There are many authorities that see this as little more than a stunt or PR exercise that will give an appearance of taking action, but that will have little effect. Although Citigroup stock value benefited from losses being lower than feared - so far, the markets remain hypersensitive. The Dow Jones dropped on 14 October by 108 points. This was mainly due to the reaction to massive profit write-offs by Merrill Lynch, J.P. Morgan Chase and Bank of America.

In a world where more and more simple souls like myself are investors, any suggestion that major financial institutions did not fully understand their vulnerability causes deep concern — and it is not only the above firms that underestimated the problem.

Risky mortgages

Prior to the upheavals of July onwards, rating agencies had decided that the securities at the heart of the subprime crisis were unlikely to collapse. Unless a substantial percentage of default took place, and this was deemed to be unlikely, the securities were considered to be "safe" overall. Unfortunately much of the business that was being traded was subprime and the danger of default was gravely underestimated. Even the great financial institutions seem to have been fooled by their own cleverness. Misplaced confidence in the rating agencies and major players has introduced market volatility.

Time and the Treasury

Time, as we so frequently say in business and economics, is of the essence. In effect the role of M-LEC would be to inject extra time in which the market can return to normal — as it is hoped that the total level of default will prove to be less than now feared.

If current assumptions about the final level of default are more of a panic reaction than a careful and objective assessment of risk it is predicted that all should eventually be well.

The role of the Federal Reserve as lender of last resort to the banks is expected to bolster confidence and enable the new vehicle to do its main job of buying time. Suspicions may be re-assessed and things could return to the status quo ante. If, however, the worst fears are realised most experts believe that M-LEC will serve little or no purpose.

Government and the crisis

Opinions vary as to the role of government in this situation. Some believe that in effect the Fed has already condoned and even rewarded very questionable activities by the banks as lending was eased by easing interest rates.

Others claim that because no public funds have been committed government has only "smiled on" this purely banking initiative and that the questionable securities have merely been undervalued for the present. By buying what is currently unsaleable the banks hope for profits when prices return to normal while governments hope for economic stability.

Private Banks

In the UK we have seen a bank's customers queuing for days to withdraw their savings. This "run on the bank" led to a fall in the equity of the Northern Rock that has not been stemmed by government intervention. The confidence of savers has been restored somewhat by the Chancellor's direct intervention only to be damaged again when the CEO and Chairman of the bank indicated to members of a parliamentary committee that they have no prior banking experience. While savers are protected, investors in the bank have lost around 90 per cent of their stake.

In the US there are a number of private banks that operate similar strategies to Northern Rock, but with less protection. They too "borrow short" in order to be able to "lend long" but lack the protection of having the national bank behind them as a lender of last resort. These banks are, in the short term, in the unfortunate situation of having to attempt to fund their current needs by selling their paper in a market with few buyers and many hopeful sellers. The new vehicle seeks to ameliorate this situation. Private Banks will be able to sell their securities to the new fund, but at a considerable cost. The larger banks will benefit both ways if their scheme works.

The take away