Uncertain times

Serious Money:John Travolta became a household name 30 years ago following his portrayal of Tony Menaro in the iconic Saturday Night Fever. The film also propelled the Isle of Man trio of brothers better known as the Bee Gees back into the spotlight as song after song from the movie's soundtrack reached the top of the charts, writes Charlie Fell.

Three decades later and Chuck Prince, the head of Citigroup, declared that "we're still dancing", only to be removed from office weeks later once the music stopped and the tragedy in the world of structured finance became apparent.

Central banks across the developed world have acted but the massive liquidity injections have failed to ease the logjam in credit markets.

Staying Alive should be the top priority of the world's monetary authorities as credit markets remain comatose.

The current crisis cannot be fully appreciated without an understanding of the factors that contributed to the travails in today's credit markets. The problems apparent today can be traced to the financial innovation that was unleashed following the United State's decision to close the gold window in 1971 and bring the precious metal's official role as an anchor for the international monetary system to an end.

The volatility that followed precipitated unprecedented growth in derivatives, while deregulation of the banking industry and interest rates contributed to the metamorphosis in the financial sector's business model from traditional lending to its current "originate and distribute" form.

The transformation from relationship to market-based banking saw the sectors' share of financial assets drop from 50 per cent in the 1950s to just 25 per cent in the 1990s. The downward trend has become even more pronounced in recent years due to advances in computer technology and the global deregulation of capital.

The trend towards a market-based system seemed laudable as risk was spread over a wider pool of players.

Unfortunately, it has created unwanted side effects.

Alex Pollock of the American Enterprise Institute recently declared that "what was recently seen as the creative and innovative democratisation of credit is now viewed as misguided and culpable bungling or worse".

The misguided adventure that saw the value of securitised mortgages exceed the value of federal government debt is now all too obvious as the unintended consequences have come home to roost.

The separation of homebuyer and lender-led mortgage originators to focus more and more on the potential for fee-based income with the borrower's ability to repay increasingly becoming a secondary consideration.

Additionally, the packaging and repackaging of straightforward loans and mortgages to the nth degree and into evermore esoteric securities has raised questions as to who actually holds priority claim on the underlying assets.

Furthermore, the shift to a market-based system filled with loosely regulated non-bank institutions, which do not fall under the preserve of the Federal Reserve has created a financial system in which the central bank's actions have become increasingly impotent.

Indeed, while recent monetary easing has been accompanied by a decline in the yields available on risk-free treasury bills, the rates at which financial institutions lend to one another have not been similarly accommodating and the spread between the two remains at the highest level in 20 years.

Deregulation and innovation brought forth the possibility of a classic bank run and it duly arrived in recent months at Countrywide Financial in the US and Northern Rock in Britain.

More importantly, the outstanding stock of assetbacked commercial paper, the raw material of levered nonbank institutions, dropped almost 30 per cent from the high of $1.2 trillion registered during the summer as the willingness to provide funds to underwrite risk and uncertainty disappeared.

The distinction between risk and uncertainty is important as financial markets function very differently when faced with the latter.

Risk depends on known distributions of events to which investors can assign probabilities. In other words risk can be priced. Uncertainty on the other hand cannot be priced, since it arises when an event has an unknown probability.

Investors are facing uncertainty today as they do not know who owns what or where the next minefield may arise.

Indeed, the first casualty of America's subprime crisis was IKB, a small regional bank from Germany. Consequently, the world's credit markets will remain subdued and spreads versus risk-free instruments will remain wide.

The credit crisis is set to continue and an economic recession in America is inevitable while growth will slow materially in both the euro zone and Britain next year.

Official interest rates will need to be cut dramatically to restore confidence across the developed world, while the penalty attached to central bank emergency lending will need to come down in order to reduce the stigma of such borrowings.

Unfortunately, uncertainty is likely to persist and caution is warranted for now.