Central banks need new playbook to tackle credit crisis

LONDON (Reuters) - The global financial crisis that has raged for months shows no signs of ending and the chiefs of the big central bank chiefs are scratching their heads over how to restore faith in the world's credit markets.

Global policymakers have unveiled a catalogue of measures since August 2007 to try and return confidence to markets. All have failed and left in their wake multi-billion dollar banking casualties in the United States, Britain and Germany.

Massive injections of emergency funds worth hundreds of billions of dollars, a giant $150 billion U.S. economic stimulus package and wholesale rewriting of the rules to allow commercial banks to pledge risky assets to secure high quality central bank funds, have all come to nothing.

Banks will still not lend money to each other in the wholesale interbank market that ordinarily provides the lubrication to keep the global financial system turning because the fundamental problem that remains to be tackled is how to put a floor under plunging U.S. real estate prices.

"The mortgage problem in the U.S. is a direct consequence of a failure of policymaking through the 1990s and it's going to take corrective action from policymakers to sort it out," Paul Markowski, president of New York-based investment advisory firm Global Research Partners, told Reuters.

"Some form of mortgage bailout is likely to have to feature at the core of the solution and that's what central bankers and regulators are now coming to terms with."

So far, central banks have only been prepared to lend against mortgage-backed securities -- one of the fastest growing area of the global capital markets and worth about $4.5 trillion -- rather than buy them outright.

A Financial Times Story on Saturday said officials in the U.S., the UK and the euro zone were now in talks about the feasibility of mass securities purchases using public funds as a solution to the credit crisis, but the Federal Reserve and the Bank of England dismissed the story. The European Central Bank declined to comment.

COLOSSAL PROBLEM

The scale of the problem the leaders of the world's banking system face is colossal.

Banks have written down over $125 billion of assets since November alone, hammering their shares.

Another raft of credit-related writedowns are expected to be announced this week when the latest batch of quarterly results from the global banking industry are published.

Ratings agency Standard & Poor's said earlier this month that the total bill for U.S. subprime losses could hit $285 billion. The ripple effect from losses booked so far has forced bank bailouts in the U.S. and Europe and asset price writedowns from Berlin to Beijing.

The S&P/Case-Shiller index of all U.S. house prices fell by 8.9 percent in the fourth quarter of 2007 versus Q4 2006, the biggest drop in the survey's 20-year history and more than three times the rate of decline at the peak of the 1990-91 U.S. housing recession. Prices in Miami fell 17.5 percent on the year.

Subprime mortgage losses were bad enough on their own, but that problem is now compounded by plunging property values that have impaired portfolios of even high quality mortgage assets and made it impossible, at least so far, for credit investors to gauge when the U.S. real estate slide will come to an end.

Until the Fed can tell investors that rock bottom has been hit, there will be no confidence that the value of trillions of dollars of credit derivative products essentially priced off of the U.S. real estate boom can be accurately calculated.

It's that certainty that the world's commercial banks need before they will begin lending to one another again, thereby restarting the seized global financial system.

There was mayhem last week after the U.S. Federal Reserve orchestrated the firesale of Bear Stearns BSC.N -- then the fifth largest U.S. investment bank -- after it became obvious the venerable institution was no longer regarded by the market as creditworthy.

After putting together a deal that gives JPMorgan (JPM.N) Bear Stearns for just $2 per share, the Fed then said it would allow brokerages to borrow directly from it for the first time since the Great Depression of the 1930s and it cut the interest rate it charges commercial banks.

It then cut its main lending rate by 75 basis points to 2.25 percent on Tuesday making a total of 3 percentage points slashed since mid-September.

Share prices eventually ended the week higher, but not without massive gyrations in financial stocks around the world that forced the Bank of England to issue a statement saying it had not met any British bank to discuss potential problems, and triggered an investigation into irregular share price moves by the UK's Financial Services Authority.

Investors doubt the crisis will end without a turnaround in the mortgage-backed securities market where prices have plunged because of risky U.S. home loans.

As prices keep going down, more and more banks are facing solvency issues, leading to a vicious circle of forced sales, falling prices and even weaker balance sheets for banks, especially as new accounting rules mean assets have to costed at current prices rather than their face value.

BUY OUT?

Influential U.S. lawmaker Barney Frank wants the White House to agree to an ambitious plan to guarantee federal aid in the form of insurance for up to $300 billion in refinanced, affordable-cost mortgages to ease the strain on Americans at risk of losing their homes.

The U.S. government has indicated it wants more private aid to resolve a crisis in the property market where home foreclosures and the share of borrowers who face losing their homes hit records in the fourth quarter of 2007, and where economists expect three million more failures.

The British central bank said on Saturday that taxpayers should not have to pay for the risks taken by bankers. But it added it was considering a number of other, unspecified options to address the market turmoil but these were at an early stage.

"Central banks, including the Bank of England, have been looking at ways to ease the strains," a spokesman said.

One big concern is that a bailout would engender moral hazard. Banks would only be encouraged to take more risks because they knew that if things went wrong, the authorities would always step in.

But it may yet turn out that central banks are left with no choice but to pursue a radical, even unpalatable, solution as so far their actions have failed to end the crisis.

"It is worth spending a little time on outside-the-box thinking about more radical things the authorities might consider if things don't improve or get worse, in case the air inside the box runs out," said Andy Chaytor, rates strategist at RBS.