Banking mistakes of the past and the present

David Ignatius:

When airport rescue crews are worried that a damaged plane may have a crash landing, they sometimes spread the runway with foam-- to reduce the probability of fire on impact. That's what the Federal Reserve and other central banks are doing now in pumping liquidity into severely damaged financial markets.

Make no mistake: The central bankers' announcement Wednesday of a new coordinated effort to pump cash into the global financial system is a sign of their nervousness. The global credit squeeze that began last summer still hasn't run its course, and the central bankers fear that the stressed financial system could pull the world economy into a deep recession.

Thus the bankers' decision to shower the system with money, through a new system of auctions that will allow banks to borrow more cheaply than they can through the commercial interbank market. What's unusual is that five leading central banks agreed to act together as a joint rescue committee.

The aim isn't so much to prevent a downturn -- the bankers aren't sure that's possible, or even desirable -- as to mitigate its effects. Fed officials have decided they need to let the adjustment happen in financial markets, with prices of mortgage-backed securities and other assets falling to levels that will allow the markets to clear.

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Fed officials want to avoid two mistakes made in past financial crises. They don't want to be overly harsh, as banking authorities were after the real estate collapse that hit New England in the early 1990s. Back then, regulators forced banks to clean up their balance sheets by selling off assets in a falling market, which made the downward cycle even worse.

The Fed also wants to avoid being overly tolerant, as Japanese authorities were during that country's long-running financial crisis. The Japanese banks were allowed to keep bad loans on their books, in the hope that they could gradually grow their way out of the crisis. Instead, this lenient policy simply delayed the day of reckoning.

What scares the central bankers now is the evaporation of trust from the system. Banks don't believe each other's numbers; since nobody knows the real value of some of the mortgage-backed securities everyone is holding, they assume the worst. They start hoarding cash as a buffer against their own losses and because they're nervous about lending to anyone else.

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The current problems are the result of several factors. The bankers failed to have a proper risk analysis of the debt instruments they were trading. The only way to lose the kind of money that has been lost in the sub prime market is through leverage. In some cases you had double leverage, beginning with the obvious leverage of home buyers. In the commodity market which is also highly leveraged, mechanisms are in place to deal with fluctuation in price and because of the liquidity of the investments, sales can be forced to prevent bigger losses. The same can be done with securities that are bough on margin. But, homes are illiquid investments in an imperfect market. In a falling market it can take months to sell a home. So as the market declined an more homes were forced onto the market the decline accelerated. Many of the instruments used to finance the sub prime borrowing were also leveraged adding more risk.

Some of the risk was also caused by the decoupling of the lending decision from the lenders, who used mortgage brokers whose main incentive was to make loans and not to protect the lenders' investment. This led in some cases to outright fraud. The Harris county District Attorney is prosecuting several of these cases now where the amount taken was in the millions. The extent of this kind of fraud nationwide is not known, but papers like the Wall Street Journal should put some reporters on the story.

It does appear that the reaction of the government is smarter this time, but then it has a lot of guarantees outstanding on mortgage debts that are not on its balance sheet.