Is this the worst financial crisis since World War II?
When trust is destroyed and the banking system operates in the shadows, how can we tell where it will end? asks this British advisory
Watching those up and down arrows or the indexes that track
the charts every morning is not good for one’s peace of mind. Even
when things are looking up for a day or two, it’s easy to get the
sinking feeling that it’s only temporary and that more bad news is
just around the corner.
Of course, there is a very persuasive school of thought that
says patient long-term investors need not be frightened by this turn of
events. Holding a strong stock portfolio through thick and thin will bring
prosperity. And you can scoop up good stocks at bargain prices during
the general selloff.
There’s no doubt that this philosophy has a great deal
to recommend it. But what if this crisis keeps spinning further out of
control? What if even the most powerful players in the game don’t
know what to do next?
And what if the rest of us just can’t trust the way
things are being done anymore?
Those are the questions posed by the editor of a leading
British advisory, The Fleet Street Letter. “The unfolding
financial crisis is so momentous that it cannot possibly pass without
comment,” writes Mr. Brian Durrant.
Credit is trust
Mr. Durrant begins by noting that the word ‘credit’
comes from the Latin word ‘credere,’ which means to believe
or to trust. “It is a lack of trust that has turned a squall of reckless
lending to house buyers with poor credit histories into arguably the worst
financial crisis since the Second World War.”
That loss of trust doesn’t just extend to one or two
identifiable targets like Bear Stearns or subprime mortgages, says the
editor: “There is a loss of faith in a style of finance based on
complex computer models.”
Banks used to operate on risk, lending out money at recognized
rates. Now they operate on uncertainty, bundling up debt securities and
selling them on in complex packages that even the people in the big corner
offices at the banks may not fully comprehend.
“Nobody believes the numbers anymore,” says Mr.
Durrant. And the figures that came from Bear Stearns are still hard to
believe.
$80 to $2
$80 to $2 is the most jaw-dropping figure. Or maybe it’s
$20 billion to $240 million. Those are, respectively, the losses in the
value of Bear Stearns’ shares and of its total worth.
On March 14, the CEO of the big investment bank was on TV
insisting that any rumours about trouble at Bear Stearns were false. Two
days later, the firm was facing a total shutdown. No less than $30 billion
— think about it, $30 billion — was needed to bail it out. If
Bear Stearns fell, the whole derivatives market was in danger.
Mr. Durrant uses a British analogy from the turf. “On
a much smaller scale, imagine Ladbrokes going bust immediately after the
favourite won the Grand National.” All those winners demanding their
money, and the off-track betting shop closed down.
Of course, we know that JP Morgan Chase swept in to buy up
Bear Stearns at $2 a share. Yet a week before it was trading at $80 a
share! A year ago, Bear Stearns was worth $20 billion. Morgan paid $240
million.
Since then the shares have been bid back up above $10 amid
rumours, counter-rumours and indignant protests from Bear Stearns shareholders.
But is the firm suddenly worth more to JP Morgan Chase, or is it all smoke
and mirrors of the Wall Street variety? Who can you trust?
And there’s a deeper question: is this an isolated case,
or the sinister symptom of a deeper sickness?
Religion without sin
“From time to time, banks go bust,” says Mr. Durrant.
“We should not weep for Bear Stearns chairman Jimmy Cayne, who 10
long years ago was reported to be the one senior investment banker who
refused to put his hands in his pocket to rescue Long Term Capital Management
(LCTM). Capitalism without failure is like religion without sin, it doesn’t
work.”
Only when the shareholders are wiped out, it seems, can a
government rescue package convince others to avoid the same disastrous
path. Otherwise, a government safety net just encourages the worst offenders
to go ahead and play chicken with other people’s money.
If a Wall Street institution falls in isolation, explains
the editor, it usually signals a market bottom. So it was with Drexel
Burnham Lambert in 1990, Kidder Peabody in 1994 and LCTM in 1998. The
stock market was up an average 17 per cent in the 12 months that followed
these failures.
But the parallels between then and now may not hold. The
market bottom theory relies on just one bank failing. “Although policy
makers and chief executives are spinning the carefully reassuring message
that Bear Stearns is an isolated case, nobody quite believes financial
spin anymore.”
In fact, says Mr. Durrant, the Federal Reserve Board is caught
in a Catch-22. “On the one hand, the Fed is taking bold and radical
measures to counter the liquidity squeeze. On the other hand, when the
Fed initiates dramatic action, it confirms the sense of crisis.”
Devilishly hard
History shows that all financial storms come to an end, says
the editor. It may be that further government intervention will be needed
to end this one. “In other words, U.S. taxpayers’ funds would
be conscripted and pumped into failing institutions to prevent their collapse.”
Fair or unfair, it worked with America’s troubled Savings
and Loan Institutions two decades ago.
“In the meantime, no one really knows what the next
twist in the drama will be,” concludes Mr. Durrant. “Banking
has become complex and opaque in recent years, making it devilishly hard
for ordinary investors to predict what might happen next.
“No wonder there has been a scramble to buy gold. The
precious metal has the compelling attraction of being easier to understand
than a mortgage bond; and formed the basis in Roman times for ‘credit’
being synonymous with ‘trust’.”
Let us hope that those two words start to mean the same thing
again, very soon.
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