Column : Everyone’s down but who’s right?

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: The recent turmoil in financial markets across the globe has exposed the vulnerability of countries with even moderate exposures to financial globalisation. Accordingly, various governments are busy designing “rescue packages.” But only the US and UK have so far come up with structured plans spelling out broad mechanisms, whereas Ireland, Germany, Spain and others have floated piecemeal plans and Iceland is still on the verge of bankruptcy

Financial ailments on both sides of the Atlantic have similar root causes. A low interest rate at the beginning of the decade coupled with the housing price bubble led banks and FIs to expand their nets to clients who might not have qualified for loans under stricter standards. These institutions also sold securities to investors based on mortgages with a slice that had a greater likelihood of default, involving underwriters, insurers, rating agencies among others, in the process. They created securities of a complex nature, whose values became dubious once the bubbles started bursting and the number of defaults piled up, leading to a stampede towards the exits. Then the value of these institutions’ assets fell far short of the value of their liabilities and the whole system got severely undercapitalised, while the ratio of debt to equity started crossing into the danger zone. In response, banks started disbursing fewer loans, the inter-bank market froze and the commercial paper market started contracting, finally leading a severe credit crunch.

The picture is the same on both sides of the Atlantic. In Britain, bank assets have declined by £340 billion in a six-month period, with the London inter-bank rate rising to an incredible 5.84% this week. In the US, the market for commercial paper contracted by 10% in July. In both cases the solution lies in infusing fresh equity into the ailing institutions. As markets are not functioning properly, governments are intervening to improve private entities’ balance sheets, to prevent a systemic failure.

But British and American approaches are different in both style and substance. The Paulson approach reserves $700 billion for buying back the distressed mortgage backed securities via reverse auctions. The UK approach is offering the willing eight banks a stake in preferred shares of up to £50 billion, guaranteeing new debt to the magnitude of £250 billion and preparing to infuse extra liquidity if needed.