5 Reasons To Welcome A Credit Crunch

Source : TODAY, Thursday, August 16, 2007

STOCK markets have tumbled, lending has been frozen and central banks have injected emergency funds into the banking system. It has been impossible to miss the atmosphere of panic in financial markets for the last 10 days.

But hold on. So long as it doesn't turn into a rout, it's healthy to blow the froth off the top of a four-year bull market. Once you get rid of the excess, you can see the substance underneath. Here are five useful things that might come out of the current credit crunch.

say hello to the Trichet Put

Now that Alan Greenspan is no longer Federal Reserve chairman, traders could be forgiven for thinking there are no more central bankers willing to bail them out of a crisis. They certainly wouldn't have been looking to the stern monetarists at the European Central Bank in Frankfurt.

As it happened, ECB president Jean-Claude Trichet stepped up with a massive injection of cash: On Aug 9, the ECB loaned an unprecedented 94.8 billion euros ($195.6 billion) at a fixed rate of 4 per cent, the same level as its benchmark refinancing rate, to calm the markets. It followed with smaller amounts of emergency money-market financing on the next three trading days.

Maybe that signals the start of a Trichet Put in the credit markets. It certainly shows that, contrary to its reputation, the ECB is willing to drop dogma in favour of pragmatism and flexibility in the face of a potential crisis.

Dodgy hedge funds exposed

Just to prove the inexhaustible entrepreneurship of the Internet, check out www.hf-implode.com for its Implode-O-Meter. It lovingly lists the hedge funds that have gone pop since the crunch started, including two run by Bear Stearns and Sowood Capital Management. Even the value of some funds run by large investment banks such as Goldman Sachs Group dropped.

Bad news? If you rent out office space in London's Mayfair district, or sell Ferraris for a living, probably so. But not for anyone else.

Overall, hedge funds have sharpened up the financial system, expanding the range of assets that investors can own, and providing liquidity in obscure markets. That said, too many funds were launched, and too many of them relied on flaky, unproven trading systems to beat the markets. If the crunch sorts out the real innovators from the bandwagon-hoppers, then so much the better.

managing assets

Easy credit markets have made running an LBO fund too easy. With money cheaply available, it was simple for the buyout funds to raise a pile of cash, pick off a big company, then sell it back to the stock market a couple of years later at a profit.

Quality buyout funds should still make money, even if it is costing them 6 per cent or more to borrow. But they will have to work harder, improving the performance of the businesses they own, and shutting the units that don't have a future. As financial engineering becomes harder, they will have to go back to real engineering — and that can only be a good thing.

Sanity returns

Cheap credit has fuelled crazy housing booms from New York to Sydney and from London to Madrid. Huge banker bonuses have made property unaffordable in some places. In London, house prices rose almost 18 per cent in June compared with a year earlier, according to the Department for Communities and Local Government. The average cost of a home in London was £332,009 ($1 million), up almost £10,000 from the previous month alone. The average person didn't earn £10,000 more in the same period, though.

If tighter credit markets can bring some sanity back to the property market, it would be an improvement.

What we will find out

Where's the pain felt from overheated US property prices? It turns out to be in Germany, which has the dullest real-estate market in the developed world: The German government was forced to bail out IKB Deutsche Industriebank AG because of its subprime losses.

There are few better examples of how the globalisation of financial markets has spread risk around the world.

Theorists would say that makes markets more efficient: It is parcelled out so no single institution or country is saddled with catastrophic losses.

It's a pretty good theory.

But as they say in the science labs, you don't really know if it is true until you try an experiment.

The credit crunch should tell us whether the globalisation of markets has genuinely made them better at absorbing shocks — or whether changes are needed. That way, we should be more prepared next time something nasty comes along.

So long as it isn't disastrous, an occasional slump in financial markets can be healthy: It tests the system and leaves it in better shape to face the next crisis.

Matthew Lynn is a Bloomberg News columnist.