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The ongoing credit crisis and Irish finance Back  
The ongoing credit crisis and Irish finance In our November issue we forecast that the credit crisis would unfold in a series of events, not unlike a play in several acts, with stages occurring, involving writeoffs by the money centre banks at the heart of the banking system, and with other vehicles, such as conduits, hedge funds, and monoline insurers all following suit. It would be accompanied by second round effects, with the mortgage markets, and the property crisis, feeding back into the core banking system. The severity of the whole process in turn would be affected by the external economic environment, in particular stemming from developments in the world oil and food markets. It would of course also depend on the skill of central banks and governments in finding solutions to what is an unique crisis – in that it is primarily a liquidity crisis stemming from a breakdown in the short term money markets, caused by the breakdown in confidence in the markets about counterparty credit risk. So far, the reassuring thing is that all of this is happening as it should, so solutions should not be far off. The action of central banks in helping to solve the liquidity problems by issuing Government paper against private mortgage paper is along the right lines. The contaminated securitised paper that is out there can be sidestepped, with the help of the guarantee provided by the taxpayer. Not reassuring is that the money markets have not yet by now unfrozen – so the crisis continues, at the time of writing, in full force, without any signs of an easement. However, continued efforts to clean out the system, with skill, can and hopefully will, prevail in due course. When that happens, and the clue to the end of the crisis will lie in the short term money markets, we can breathe a sigh of relief. In the meantime, there should be no delay in applying the lessons that should already have been learnt from this historic credit crisis. One key lesson is that prudence, conservatism regarding credit, and the eternal values of banking and capitalism need to be reasserted. This applies, not just within the financial services industry, but to Irish business in general.

Rates spreads show credit crisis still in full force In an analysis of credit market liquidity, NCB economist Brian Devine in April remained unimpressed by claims that the worst of the credit crisis is over. Analysing the spread between lending rates on secured and unsecured loans, he found that after declining in March they once again began to rise in April. Similarly the spread between the US $ 3 month Libor (unsecured) and the 3 month treasury-backed interbank repos (secured) has shot up since August and remained at elevated levels. A paper by John Taylor of Stanford University and John Williams of the San Fransisco Fed shows that over the last 16 years there have been several spikes in the unsecured/secured spread but the current spike is far and away the largest. Furthermore they show that the Federal Reserves Term Action Facility (TAF)- designed to introduce liquidity into the market- did not reduce the spreads and that it is counterparty risk between banks that is driving the rise in these spreads. In another departure from the normal functioning of the credit markets, there is an ongoing process of reversal of the long-term risk premia relationships between the credit markets and equity markets. Until August 2007, interbank lending market volatility was strongly positively correlated with stock market volatility, even after controlling for the FOREX and monetary policy fluctuations. Since August 2007, this correlation became and has remained weaker in absolute magnitude and has actually become negative. This can potentially be accounted for by the decline of credit-financed equity market activity and the fall-off in carry trades, further contributing to the ongoing decline in overall liquidity in the equity markets and a spillover of liquidity shortages from the credit markets to the equity markets (credit contagion). “A number of high profile investment bank CEOs have recently stated that they believe the worst of the credit crisis is over, however the evidence from the financial indicators presented above do not, as of yet, point to this being the case. Despite the lowering of interest rates and the coordinated initiatives of Central Banks to provide liquidity, the persistence of liquidity problems is still being driven by concerns”, he says.

Equity market threatens pension fund solvency
The poor performance of equities in the first quarter, coupled with negative returns seen in the second half of 2007 have left Irish pension funds reeling, according to a report by Watson Wyatt. The report, ‘Funding Crisis II: Credit crunch threatens pension fund solvency’ warns that funds that report on year end dates other than March 31st may not even be aware yet that there is an emerging problem. And while some worries already existed at the end of 2007, ‘the impact of subsequent market conditions is potentially frightening for trustees and sponsors of DB [defined benefit] schemes.’

The report said that a significant proportion - perhaps more than 50 per cent - of schemes would, if measured at 31 March, face deficits under the statutory minimum Funding Standard.

It said that unless the market shows signs of a significant recovery in the next 12-18 months, over half of DB pension trustees could be forced to seek additional funding. The report recommends that the issue should be brought up as part of the current consultation process relating to the Government’s Green Paper on pensions.

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