The US Treasury's new acronym in its long list of programmes - PPIP or the Public-Private Investment Programme - has lifted market hopes that the administration is moving closer to restoring stability in the US financial system.
Improving confidence in bank balance sheets is a crucial step in bringing the crisis to an end. However, it is not enough.
As the history of bank rescue plans during this crisis illustrates, efforts to thaw the winter freeze in bank balance sheets do not automatically launch high summer in inter-bank and credit markets. The effects of this crisis are much bigger than the impact of toxic assets. If policy measures are to stop the market fear they need to reflect this.
The success of banks' sales of their toxic assets will be determined by their willingness to add new risk to their books. Until credit markets once again become the domain of private investor incentives rather than policy announcements, until a clear new regulatory regime is established - minimising future political risk - and until the economy stabilises, then investors, lenders and companies will remain more concerned about risks than returns and will continue to hoard cash.
What is needed are swift efforts to reverse the liquidity and confidence shocks emanating from the dislocation in traditional bank credit and non-traditional structured market credit channels in the wider economy. The US Treasury's plan to subsidise investor purchases of toxic bank assets will help lift financial valuations. But it is only when real assets are valued on their own merits rather than on the availability (or, in truth, lack) of financing to invest in them that this bear market rally will be transformed into a sustainable recovery.
We need three things to follow on from PPIP.
First, the US government must subsidise finance for viable borrowers with sound leverage ratios to aid distressed home sales. The stabilisation of home re-sales in February is an encouraging sign, as it suggests that prices have fallen enough and buyers are returning, but it is not enough. The housing market requires an efficient financial structure to reach a new equilibrium based on supply and demand, rather than on bank lending preferences.
Since this will establish a floor for home valuations, it will ensure the success of broader government measures to stop the rot on bank balance sheets and in the real economy. This will ultimately restore liquidity in mortgage-backed securities, improving confidence in the public sector's own net asset position, including in the Fed's balance sheet.
Second, even if house prices were to rebound from current depressed levels, net consumer debt levels remain elevated and the focus of households will remain on repairing their personal finances. This, together with rising unemployment and expectations of future tax hikes that will be needed to pay for the government's massive bill will continue to drive consumers to rebuild savings and cut expenditure.
Freeing up consumer credit is important even if the objective is just to improve consumers' liquidity positions in the short run. It is the only way to restore confidence and bring de-leveraging in the real economy to an orderly phase that ends the recession. The objective cannot be to fuel another debt spending spree.
Third, somewhere between government efforts to stabilise distressed assets and central bank measures to support high-grade credits lies the credit spectrum that matters most for the real economy. Credit spreads have tightened, but they remain dislocated between the extremes of high-grade and distressed assets, reflecting impaired liquidity flows. Successful measures will restore confidence in the banking system and in the ability of free markets to allocate funds efficiently, halting the process of capacity destruction in the corporate sector.
On balance, further government measures are needed to support lenders' incentives to extend new credit. Increasing lenders' capacity is not enough. Until this is addressed, the risk is that even after PPIP, bank and market liquidity will remain driven by the government and its agents, the FDIC and the Fed, rather than by private sector capital. Stabilisation is not the same as a recovery.
Lena Komileva is head of G7 market economics at Tullett Prebon
Copyright The Financial Times Limited 2009
