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Targeted intervention is the key

There can be only one topic with which to launch a new column headed ‘The real issue’ and that is US Treasury secretary Henry Paulson’s audacious plan to spend up to $700bn of taxpayers’ money to confront the problems in global financial markets.

Of course, those problems are driven by the scale of past policy and regulatory failings in the US. As we know, Paulson wants approval to buy troubled assets from financial institutions “to promote market stability and help protect American families and the US economy”. Whether this is seen as a stick or a carrot hinges on whether non-intervention ends up costing US consumers a lot more in the future. Paulson argued that only when the financial system was working properly again would money flow into and out of households and businesses, not only to fund lending but also economic activity more widely.

He said illiquid mortgage assets were blocking the system and “the clogging of our financial markets has the potential to significantly damage our financial system and our economy, undermining job creation and growth”.

At the time of writing, some of the details of the proposals have not emerged. This was deliberate, allowing Paulson room for man-oeuvre to respond to changing conditions, and thus to make it up as he goes along.

So ‘Trust me’ is his message, but should we? While some details are deliberately sketchy, there is nothing vague about the US government’s commitment to get to grips with the paralysis afflicting financial markets.

Understandably, given the scale of the proposals, there is opposition. But at the time of writing Paulson was pressing Congressional leaders for early agreement to plans to buy up securities backing both residential and commercial mortgages in the US. And he wants discretion to add other assets to the shopping list, as necessary.

His plan reflects not only a political determination to correct dysfunctional markets but also the sheer scale of the problems afflicting the US mortgage market – five million people defaulting on loans and three million facing foreclosure, compared with 170,000 in arrears in the UK and 45,000 possessions.

In the US the source of the problem, sub-prime lending, grew rapidly to account for 25% of the national market compared with only around 8% in the UK. And other features of the US market including the structure of the securitisation sector, the absence of comprehensive regulation and the exaggerated effect of interest rate rises exacerbated payment problems. Of course, it was concern about un-known exposure to this that led to paralysis of wholesale funding markets.

Although the scale of problems associated with sub-prime lending in the UK are much smaller than in the US, we are suffering in the same way from its consequences, with a strike by investors in mortgage-backed securities and growing credit losses.

Therefore the need for concerted action to ward off the worst consequences of the disruption is widely accepted in the UK. We have already seen the extension of the Bank of England’s Special Liquidity Scheme and more funds being made available by central banks on a global, co-ordinated basis.

On the day of the US Treasury announcement, the Financial Times said there was a need for concerted intervention by central banks faced with “a generalised panic in the core of the world’s financial system”.

The FT said central banks needed to convince markets that sound businesses would not be allowed to disappear for lack of funding. When credit and trust had vanished, the only creditworthy institutions left are central banks which then have to fulfil their role as lenders of last resort.

“That is, quite simply, what they exist to do,” the FT concluded.

While the intervention proposed by the US Treasury department may be inappropriate for the scale of problems in the UK, we could do more to encourage a market-led solution to our domestic problems.

The risks of investing in securities backed by UK mortgages are considerably lower than investing in those originated in the US. And the risks associated with UK mortgage-backed securities may be more palatable to investors if the Bank of England was prepared to accept them as collateral.

By the time this article appears, the report of the Crosby Review should have been published. We will need concerted action in re-sponse to that to address the problems in mortgage funding markets. The real issue is to avoid a market overcorrection that will inflict unnecessary pain on borrowers and the wider economy. A targeted intervention is needed and we must trust our tripartite authorities to make it work.

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