How to unfreeze the system

Anthony Hilton
15 Oct 2008

Markets have breathed a huge sigh of relief since the announcement by European governments of concerted action to provide extra capital to banks. But though the relief is welcome, there is also an understanding that we are not out of the woods yet.

This is because the banks are still suffering from the freezing of the asset-backed securities markets from where they got a major proportion of their funding. The new capital buys them time and some protection against losses, but a long-term solution requires these traded credit markets to start functioning again.

Hence the importance of a paper today from Alistair Milne, an academic at Cass Business School, and Perry Mehrling from Columbia University in New York, which tackles the freezing of the asset-backed securities market head on.

The authors suggest quite simply that government should provide insurance against default on the most highly rated of this debt, the super senior tranches which were deemed to be better than triple A.

This would ensure the debt could not fall below a certain level. Removing the fear of loss would immediately allow trading to resume in these securities and open the door to the further issuing of new paper. This in turn would deliver two more huge benefits. The floor price suggested would in effect provide a $600 billion (£343.1 billion) boost to bank balance sheets as the banks mark the value of these assets to the new and higher market price, then they could begin to re-finance themselves and start behaving like banks again.

The key to why this works though thus far only in theory lies in understanding that a lot of the super senior debt that would be insured this way is trading far below where it should be, even on the most pessimistic assumptions. It languishes unloved because the bankers who understand how cheap it is don't have the money to buy it, while institutional investors like pension funds and insurance companies that do have the money, don't understand it.

Without buyers, these securities have slumped to well below what they are worth. However, if the Government charged an insurance premium of, say, 90 basis points equivalent to a 4.5% discount on a security with five years left to run to guarantee it would make good any loss caused by the highly unlikely impairment of the underlying assets it would in effect guarantee the value of the securities. Then people would buy them at a price that allowed the system to function again.

AIG and others were supposed to have provided this insurance through credit default swaps. They no longer have the credibility to tackle a systemic problem on this scale. But government does, and should.

Chairman with right qualities

There is always a lot of debate about what makes a successful chairman and why some are ineffective.

Steve Norris, the Tory politician and chairman of engineering group Jarvis, was quoted recently as saying: "The only two things a chairman has to do are represent the interests of all the stakeholders, and fire the chief executive if necessary."

With this in mind, it is fitting to mark this week's announcement by Peter Hickson that he will retire in January from the board of Anglian Water Group. As chairman, he did both things Norris suggests are required.

When he took the chair at AWG six years ago, it was reeling from its disastrous acquisition of construction group Morrison and a series of ill-advised adventures overseas, which the company was finding rather more troublesome to manage than its core business in East Anglia. So the chief executive left, a new one was found who stabilised and turned round the business. It was then sold to private equity on one of those pre-credit crunch valuations we are unlikely to see again for years.

Hickson has other attributes that surely contributed to his success but don't appear on the Norris list. First, he did go to great lengths to understand the business. Second, he never shied away from asking what might have appeared to be a silly question. And the results speak for themselves.