Last week’s effort by the world’s central banks to relieve the global credit crunch with a cash injection failed to impress the markets. But the move is bound to win round the sceptics within the next few months. The decision is likely to be just the precursor to much more important, but controversial, operations to ensure the “solvency” of the international financial system.

The distinction between the problems of liquidity and solvency, which looks like the next challenge for monetary authorities around the world, is illustrated by the British Government’s travails over Northern Rock. The Northern Rock crisis looked initially like a liquidity crisis.

Nobody questioned the underlying value of the Rock’s mortgages and therefore its ability to repay depositors in the long term. The problem was simply one of timing – if too many depositors wanted to withdraw their money, the bank could not sell off or “liquidate” its mortgages and other long-term assets quickly enough to pay the depositors back. It is now apparent, however, that Northern Rock also faces a solvency problem. The collapse of confidence in the British housing market has reduced the market value of its mortgages.

As a result, Northern Rock’s problem is no longer just a matter of liquidity and timing. Even if the Rock could liquidate all its mortgages tomorrow, it could not raise enough money to repay its depositors and the Bank of England in full, because the market prices of mortgage assets are today much lower than 100p in the pound. The upshot is that the Government will almost certainly have to nationalise Northern Rock after putting it into administration. The two options of nationalisation and administration are not, incidentally, polar opposites, as suggested in much of the media coverage, but one and the same. The Government could only seize control of the Rock and wipe out the claims of its shareholders by first putting the company into bankruptcy. The Treasury could then buy the bank from its administrator overnight for £1, pay off the depositors out of public funds and, in exchange, take control of all its mortgages and other assets. As these mortgages were paid off, the Treasury would gradually recover its outlay, with interest.

Alternatively, the Treasury could sell the whole mortgage book to another bank, if and when market prices for mortgages recovered. But whether taxpayers’ money was ultimately recouped would depend on whether Northern Rock’s borrowers continued to pay back their mortgages on schedule and on the expectations of the banks that might want to acquire Northern Rock’s mortgage book about how many borrowers might eventually default. The cost of the whole operation, in other words, will be determined by expectations about the housing market and the economy in the years ahead.

This issue of expectations is now at the root of the problem, not only for Northern Rock and the British Government, but for banks and financial authorities around the world. Because of worldwide fears about a housing meltdown, the market value of mortgage-related assets has been downgraded. These downgrades have created doubts about the underlying solvency of some banks and forced all of them to curtail their lending.

The hope since last summer has been that the process of establishing a new lower value for mortgage assets would take until the year-end, after which the banks that were severely hurt would raise extra capital from investors and return to normal operations next year. The role of central banks in this process would simply be to provide temporary liquidity to the markets until the repricing process was completed.

In the past few weeks, however, it has become obvious that this assumption was overoptimistic. Instead of a once-and-for-all repricing of mortgage assets, markets have kept pushing values ever lower, forcing banks to keep revising down their estimates of available capital and rein in their lending even more. As a result, the summer liquidity crisis has been turning into a loss of confidence in the long-term solvency of the global banking system banks. That collapse in confidence has, in turn, aggravated pessimism about next year’s economic prospects, intensifying doubts about bank solvency.

There is now only one way to stop this vicious circle. If banks could convince investors that their audited year-end results offer an honest picture of their potential losses and new capital needs, then most banks could easily raise this extra capital on global markets and normal financial conditions would quickly be restored. But what if the year-end results fail to convince investors, partly because observable market prices for mortgage assets simply do not exist? In that case, governments will almost certainly have to intervene directly to put a floor under mortgage values, thereby underwriting the solvency, as well as the liquidity, of banks.

Ways of doing this could range from governments directly buying mortgages from stricken lenders such as Northern Rock, to administrative guidance from public bodies such as the Bank for International Settlements on the models to be used for valuing mortgages which cannot be traded in the open markets at any reasonable price.

There are numerous reasons for expecting some sort of government intervention if the markets fail to arrive at a private-sector solution by the time the year-end results are published. If shareholders refuse to believe the banks’ audited financial statements or if their auditors find themselves unable to express true and fair options on the value of mortgage assets. First, regulators will be able to present this crisis as a genuine case of “market failure” with far-reaching “external effects” on the global economy – the standard economic conditions justifying government intervention with free markets. Second, the moral hazard of using government money to clear up a banking mess will be mitigated by the big additional losses bank shareholders will suffer if the markets continue to disbelieve their audited financial results.

Third, and most importantly, central bankers will soon face a choice between two unappealing alternatives: stabilise their financial systems with public money or cut interest rates much more steeply to keep the world economy afloat. Since central bankers around the world are justifiably reluctant to keep slashing interest rates at a time when global inflation remains uncomfortably high, they are likely to see bank bailouts as the lesser of two evils.

The upshot is that the year-end results season offers stock markets a last chance to make plausible estimates of mortgage losses and to recapitalise the banks. If the banks, their auditors and shareholders, cannot quickly do this, then government intervention will become inevitable to underwrite the solvency, as well as the liquidity, of the banks. And the biggest losers in such a process should not be taxpayers, but existing shareholders in the stricken banks.

anatole.kaletsky@thetimes.co.uk

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