Second Wave Cometh

Global financial markets are “fragile” and indicators of systemic risk remain “elevated” almost a year into the credit crisis, the International Monetary Fund said on Monday.

The fund warned credit growth in the US could fall further as a result of ongoing financial system stress and warned that emerging markets would be tested as global financing conditions tighten and policymakers grapple with rising inflation.

The IMF also noted that house prices had softened in a number of European economies including the UK, raising the possibility of further problems in those markets.

The assessment came in the July update to the Global Financial Stability Report, led by former Bank of Spain governor Jaime Caruana.

The IMF said that while likely losses on US subprime mortgages have “largely been acknowledged” in the form of writedowns, financial institutions faced a second wave of losses on other loans.

Credit quality “across many loan classes has begun to deteriorate with declining house prices and slowing economic growth.”

The Fund said bank balance sheets were under “renewed stress” and that the decline in bank share prices had made it more difficult for them to raise new capital.

This “increased the likelihood of a negative interaction between banking system adjustment and the real economy.”

With mounting inflationary pressure, the Fund added: “Policy trade-offs between inflation, growth and financial stability are becoming increasingly important.”

The IMF reaffirmed its controversial earlier estimate that total losses in this cycle could total $945bn – a number that combines mark-to-market losses on subprime-related securities and estimates of likely losses on loans.

Relative to April, when the Fund published its last GFSR, it said “systemic strains in funding markets continue” and the “low level of risk appetite remains unchanged.”

Interbank lending rates “remain elevated” while “long term funding costs have risen” for financial institutions.

The IMF said financial institutions globally have written off about $400bn since the crisis began last August, and that while they had raised substantial amounts of capital, the losses “exceeded capital raised.”

Banks also faced problems maintaining their earnings, weakening stock prices, and making it more difficult to raise further capital.

The Fund said that policy interventions – mostly by the US Treasury and the Federal Reserve – had so far succeeded in containing systemic risk.

But it said the “nature of resolution strategies and the extent of support have come into sharper focus” in recent months – a polite way of saying that the authorities in the US in particular have had to intervene further to preserve financial stability.

It in effect endorsed the need for the US to shore up Fannie Mae and Freddie Mac in the short term – saying their failure would have systemic consequences – but said “the policy challenge now is to find a clear and permanent solution” for the troubled government-sponsored mortgage groups.

The US Treasury has tried to deal with the immediate threat to Fannie and Freddie, while postponing discussion of their long term futures to a later date.

Source - Financial Times