How a Lack of Faith Pounded the Markets

In the Bible, Paul warns the Corinthians that "if the trumpet give an uncertain sound, who shall prepare himself to the battle?" And when it comes to economic issues, the lead bugler is badly out of tune. George W. Bush this month pronounced himself surprised to learn that gas was approaching $4 per gallon. On Friday, March 14, as Bear Stearns was melting down, Bush spoke before the New York Economic Club at the Hilton Hotel, just a few blocks away. He cut an oddly jaunty figure, joking about the "interesting time," throwing up his hands at the housing crisis—"That's how markets work. There will be ups and downs"—and expressing his trademark optimism.

After several fat years, this may be the beginning of a few lean ones. David Rubenstein, chairman of the Carlyle Group, the massive private-equity firm, spoke recently of entering a "Purgatory Age, where we're going to have to atone for our sins a bit." The biggest and most sophisticated banks—Citigroup, Goldman Sachs, Merrill Lynch—after misjudging risk on an epic scale, have taken tens of billions of write-downs on mortgages and other loans. Carlyle Capital Group, an investment vehicle sponsored by Carlyle last year, sold shares to the public, then borrowed an astonishing 31 times the amount raised to purchase mortgage-backed securities and other debt instruments. Which is less an investment strategy than a delusional act. As skittish lenders called their loans, Carlyle Capital was forced into liquidation.

Now the overwhelming investor sentiment—voiced on CNBC, and evident in market indexes and bond prices—is fear. Prices for short-term Treasury bills, the safest investments out there, have spiked to 50-year highs. There's $3.5 trillion sitting in money-market funds, and nonfinancial corporations are sitting on mountains of cash. But investors don't have enough trust to put them to work.

There are no quick fixes. While disconnected to a degree, "the turmoil in the financial system will become evident throughout the broader economy in coming months and quarters," says Mark Zandi, chief economist at Moody's Economy .com. "I think it's just going to take time for that fallout to become clear." The flight from risk is already making credit more difficult to come by for students, car buyers and home buyers.

Confidence can't be borrowed from the Federal Reserve. It has to be earned slowly, over time, in part through greater transparency. "The markets can handle almost anything if we know what it is, if we can price it and value it. In order to do that, you need more information," says Donald Marron, the former CEO of Paine Webber who now runs Lightyear Capital. The unfolding crisis has been like whack-a-mole, with problems resurfacing in unexpected places—a hedge fund in London, an investment bank in New York. As a result, bankers and regulators still don't fully grasp the scope of the problem. Banks also have to shore up their balance sheets so that they will be less susceptible to the types of runs that doomed Bear Stearns. "If you put more capital into these banks and financial institutions, we'd be in better shape," says Douglas Holtz-Eakin, former director of the Congressional Budget Office and senior policy adviser to the John McCain campaign. But mostly, they just have to stop losing so much money. Just as failure begets skepticism, competence begets confidence.

One thing Wall Street has going for it is an ability to process failure quickly. Last Monday, JPMorgan Chase executives began to occupy the Bear Stearns offices. By Wednesday, the Bear collapse was yesterday's news. On Tuesday, the Dow Jones industrial average rallied 420 points, only to fall 293 points on Wednesday and recover with a 252-point gain on Thursday. The short-term chart of the Dow now resembles the Sawtooth mountain range. On Thursday, even amid the rally, there was a significant laggard: CIT Group, a company with $83 billion. A major lender to businesses, CIT reported it was unable to access its usual sources of credit, and had to tap a $7.3 billion line of credit it had with banks. The stock plummeted.

For many people who work in the investment world, "Wall Street" is an iconic movie. Given the way in which the crisis of confidence continues to rear its ugly head, perhaps they should watch "Groundhog Day."

With Ashley Harris and Barrett Sheridan in New York, and Daniel Stone in Washington

© 2008