On 21 June, Fitch Ratings reported that the 10 biggest US prime money market mutual funds (MMMFs) had half of their assets exposed to European banks. On 23 June, when 16 Italian banks faced a possible rating downgrade, tensions in US MMMFs surfaced: about $3.6 billion in assets were pulled out of prime MMMFs and the three-month treasury bill rate went into negative territory, last seen in late 2008. On 24 June, after a rumour that Italian banks would have to raise more equity after the European stress test, Italian bank stocks crashed within minutes and the weakness of Italian bank stocks quickly spread across Europe.
Although markets showed some relief after the Greek parliament approved the €78 billion austerity programme on 29 June, US MMMFs remain wary of lending to European banks. A few hours before the Greek vote, senior International Monetary Fund officers warned given that many banks in Europe’s core countries are funded in good part by US MMMFs, a spillover of the Greece crisis into the rest of the continent could have dangerous effects. These events may appear reminiscent of the Lehman collapse in 2008. If history is any guide, however, we believe that we are still not there yet.
To explain why, let us go back to 2006 and recall that most non-prime mortgages were securitized. When the US housing market changed course in 2006, the non-prime mortgage market began to deteriorate and many borrowers became insolvent. Since most non-prime mortgages were funded short-term in rollover debt markets, creditors began to refuse funding to their levered debtors in early 2007 and the crisis came in August following a “bank” run on two highly levered Bear Stearns hedge funds investing in non-prime mortgages in June 2007 in the repo market. It took eight months of further runs for Bear Stearns to collapse in March 2008; another five months of runs for Lehman to collapse and Merrill Lynch to merge with Bank of America in September 2008; and two more months for the entire Wall Street system of independent broker-dealers to collapse when Morgan Stanley and Goldman Sachs were forced to convert to bank holding companies.
By Shyamal Banerjee/Mint
Let us fast forward to the Europe of June 2011 and ask: Are we near June 2007, March 2008 or September 2008? We believe even June 2007 has not arrived yet which gives us hope that an appropriate policy response is still possible. In fact, the financial crisis that started in the US in 2007 offers valuable policy lessons in how to avoid the build-up to a Lehman event. One, while liquidity support from central banks to distressed entities can help them live another day, they do not provide a sustainable solution to their distress. Second, distressed entities can get addicted to the liquidity support refusing to make difficult choices to reduce their leverage and recapitalize. And third, a one-time decisive recapitalization of distressed entities based on transparent and credible assessment of how much capital the system needs is the only policy action that restores growth and stability by calming markets that are worried about distress.
While the European situation is more complex due to the inter-mix of bank and sovereign debt exposures, we believe that similar principles apply:
• First, a recapitalization of banks
• Second, a recapitalization of the distressed sovereigns
In particular, the possible steps of a comprehensive plan may be:
1. Sovereign bond holdings of the European Central Bank—where bonds are distressed—should be separated from its balance sheet into a special purpose vehicle. Any potential losses on these bond holdings should be met through the funds put into the European stabilization mechanism.
2. Sufficiently severe stress tests should be applied to systemically important European financial institutions, where the tests include reasonably plausible haircuts on sovereign bonds on both banking and trading books. Those systemically important financial firms found to be short of capital should be recapitalized privately and promptly. For those that cannot, stabilization funds should be used to do government recapitalization of these firms, as necessary.
3. Sovereign debt restructuring should follow this recapitalization of exposed financial firms. There is no way some of the troubled sovereigns can generate growth without first reducing the debt overhang. Further, any failure to reduce debt overhang puts at risk the welfare of future generations in these countries.
In summary, full bailouts of all troubled nations are beyond the pockets of even the wealthiest countries. Those who aim to avoid restructuring debt by simply window dressing it are delaying the inevitable; in the short run, their efforts help the financial sector in wealthy countries, but produce little to fix the core issue—the insolvency problem of troubled countries. The real risk is that in the end, as with Lehman bankruptcy, all will have to pay. This risk can be managed through appropriate policies as the endgame of full-scale run on sovereign debt—and the likely market freezes that may result— has not even started!
Viral V Acharya & T Sabri Oncu are C.V. Starr professor of finance at New York University Stern School of Business, and assistant professor of international finance at Kadir Has University, respectively.
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