It occurs to me that most of the market panic and turmoil of the past few weeks has been primarily a crisis in confidence. Liquidity was sucked from global markets because of fear and uncertainty. Banks, hedge funds and other financial institutions lost a great deal of money in areas they didn’t anticipate would be affected by a downturn in housing, or the creation of derivative mortgage instruments. The more they look, the worse it appears. And they are still looking. Pimco’s Bill Gross has written an interesting article that focuses on this issue. He writes using the analogy of the game “Where’s Waldo” and that, “When no one really knows where and how many Waldos there are, the trust breaks down, and money is figuratively stuffed in Wall Street and London mattresses as opposed to extended into the increasingly desperate hands of hedge funds and similarly levered financial conduits.”
He also makes an excellent point about how difficult it is to identify subprime exposure: “...many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors and, importantly, to other lenders. The significance of proper disclosure is, in effect, the key to the current crisis.”
I also see parallels with the concerns over retail goods manufactured in China. Many U.S. consumers are increasingly concerned about product safety regarding Chinese imports. Consumers are uncertain and lack trust and confidence about these products because they don’t “know what they’re made of.” It’s the same thing with mortgage bonds and the subprime mess. Now China is working to restore confidence in their product safety and quality control measures. The same thing must happen institutionally with regard to banking, lending and perhaps even investing. With greater disclosure and “financial quality control” over time, confidence will return. In the meantime and with a crisis of confidence, the central banks have necessarily weighed in.
Last week’s discount rate cut provides critical liquidity to the banking system, and will help the financial system work through the challenges they face. More than anything, I think it sends the signal that the government’s Federal Reserve System stands ready and willing to do what is necessary to ensure the banking and financial systems are sound. Beyond the Fed’s monetary charter, that brings financial strength and confidence to the markets, and the nation, and is precisely the reason the system exists.
“After all, there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people.”
Franklin Delano Roosevelt - First Fireside Chat “On the Banking Crisis” - March 12th, 1933
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[…] in our financial markets as a whole, and the ability of the U.S. economy to bounce back. The same theme about confidence that we’ve seen for several months now. If this confidence crisis spills […]