I've long noted how important attitudes and beliefs are in credit-based societies like ours. The same holds true, of course, for financial markets. If enough people have doubts about whether a counterparty will be around tomorrow or whether the funds they hold at an intermediary are truly secure, than that can be enough to set off a scramble for the exits that ensures their worst fears are realized. In "A Lack of Trust Spells Crisis in Every Financial Language," the Financial Times' Gillian Tett explores the notion of confidence in greater detail.
In recent years, bankers have succumbed to the idea that the credit world was all about numbers and complex computer models. These days, however, this assumption looks ever more of a falsehood.
For as anyone with a classical education knows, credit takes its root from the Latin word credere (“to trust”) And as the current credit turmoil now mutates into ever-more virulent forms, it is faith – or, rather, the lack of it – that has turned a subprime squall into a what is arguably the worst financial crisis in seven decades.
Make no mistake: what we are witnessing right now is not just a collapse of faith in one single institution (namely Bear Stearns) or even an asset class (those dodgy subprime mortgage bonds). Instead, it stems from a loss of trust in the whole style of modern finance, with all its complex slicing and dicing of risk into ever-more opaque forms.
And this trend is not just damaging the credibility of banks, but the aura of omnipotence that has enveloped institutions such as the US Federal Reserve in recent years. The credit world, in other words, now lacks credit – in the original meaning of “he/she trusts”.
The most graphic illustration of this can be seen at Bear. Just a week ago, this was an institution with a book value of about $80 a share, if you believed the way that computers were valuing Bear’s complex credit products. Moreover, its top executives categorically denied that the bank faced any liquidity squeeze.
But now JPMorgan is paying just $2 a share to purchase the once mighty Bear and its towering mountain of mortgage assets. Meanwhile, the Fed has indicated that Bear’s liquidity position is so bad it needs a $30bn (€19bn, £15bn) safety net to keep its operations running without roiling the derivatives markets.
This has scary implications for other investors holding banking shares or mortgage assets like those owned by Bear. Judging from publicly reported accounts, there is no reason to believe that any other large US or European bank should implode. And in the last 24 hours, every bank executive worth his or her salt has been telling counterparties that they are awash with liquidity. Meanwhile, policymakers have been quietly spinning – in carefully reassuring tones – the message that Bear was an “isolated case”.
But the problem is that nobody quite believes official financial spin any more. Thus the Fed is caught in a peculiar policy trap. On the one hand, the market wants the US authorities to take radical steps to counter the liquidity squeeze, such as making more rate cuts; but on the other hand, when the Fed does produce dramatic action, this merely confirms the sense of crisis.
Of course, the good news is that history shows that eventually this storm – like all others before – will come to an end. Better still, one factor that might hasten such healing is that by many measures, the global financial system is still cash rich. Never mind the bulging coffers of sovereign wealth funds; there are also huge pockets of money sitting in mainstream pension funds and with other mainstream western asset managers right now.
Thus, the desperate hope of many policymakers – and bankers – is that if confidence in the system can only be stabilised for a while, funds should eventually flow back into credit markets again as investors move to snap up bargains. If so, that should ease the current crisis faster than anyone can say the word “bail-out”.
But do not expect to see that salvation happen too soon – and possibly not without further US government intervention, perhaps in the form of a decision to make state purchases of troubled mortgage assets. After all, what makes the current crisis so pernicious is not simply that it is severe, but that it is also unpredictable.
More specifically, banking has become so complex and opaque in recent years, as a result of financial innovation, that when shocks occur in one obscure corner of finance this creates all manner of unexpected chain reactions. This makes it hard for policymakers to formulate policy – and even harder for ordinary investors to predict what might happen next.
No wonder so many asset managers have been scrambling to buy in sectors such as government bonds or gold. After all, gold has the compelling attraction of being easier to understand than a mortgage bond; better still, it has existed long before even the Romans.
In the last resort, in other words, the key to resolving this crisis will not lie with just the injection of billions more of central bank dollars; instead what is needed is the restoration of credit, in the most basic, faith-based sense.
But rebuilding trust will emphatically not be an easy task. Brace yourself for more turbulent days – in whatever language you choose.