How a Lack of Faith Pounded the Markets

Last Monday morning, $2 bills could be seen taped to the inside of entrance doors at the octagonal headquarters of Bear Stearns in midtown Manhattan. It's hard to decide what was more remarkable: the fact that $2 was the price per share JPMorgan Chase had just agreed to pay to take over the company, whose stock had traded above $60 the previous week, or the fact that at a place where so many employees had suddenly become impoverished, the $2 bills lasted for more than a few minutes.

Like every other Wall Street firm, Bear had taken its lumps on subprime mortgages. But in recent months it had lost the confidence of the markets the way many marriages dissolve: slowly, and then all at once. In July, when two hedge funds it managed were melting down, Bear's septuagenarian CEO, James Cayne, was at a bridge tournament in Nashville. On Wednesday, March 12, Alan Schwartz, who had succeeded Cayne in January, reassured CNBC viewers that Bear Stearns had no problems and projected it would turn a profit in the first quarter. Within two days, Bear was telling government officials it might have to file for bankruptcy. Over that weekend, the Federal Reserve worked out a deal whereby JPMorgan Chase agreed to buy out Bear Stearns for the nominal price of $236 million—in January 2007, the company was worth $20 billion.

The collapse of Bear Stearns, the nation's fifth biggest investment bank, shows just how parlous the state of financial markets has become, as well as the corrosive effect of ebbing confidence. A lack of faith, as much as a lack of cash, killed Bear Stearns. The investment bank failed in large measure because counterparties—other banks, hedge funds and financial institutions—no longer wanted to extend credit to it, no longer felt comfortable trading with the company or leaving their assets in its custody. "A company is only as solvent as the perception of its solvency," as Oppenheimer analyst Meredith Whitney put it in a recent report. Especially when the company is leveraged up the wazoo. Bear Stearns had nearly $33 of debt for every dollar of assets it held. Think of it this way: if tomorrow you had to pay back all your student loans, your entire mortgage, the Visa bill and the $180 you owe your former college roommate, wouldn't you need a bailout, too?

While the underlying economy is stalled, and perhaps shrinking, Wall Street seems to be in near meltdown mode—for reasons that are psychological as much as economic. "Credit" comes from the Latin root credo, meaning "I believe." Money is extended with the faith that it will be paid back at some point. During the recent housing and housing-credit bubble, people came to believe that debt wouldn't go bad because it hadn't gone bad. When a bubble pops, the mood swings ferociously in the opposite direction. "We've just seen markets go from a period of astonishing credit euphoria to the worst credit crisis since the 1930s in the space of eight or nine months," says Roger Altman, chief executive officer of the investment bank Evercore. Given the collapse, it's to be expected that we will have "the questions about soundness and security which are afoot in the market now."

In the 1990s, market players the world over had an unshakable belief in Federal Reserve chairman Alan Greenspan's ability to handle crises. When trouble arose, Greenspan was backed by Treasury Secretary Robert Rubin and his deputy, Lawrence Summers, backstopped by a savvy White House team. Hence, the "Committee to Save the World." But current Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson have yet to prove themselves the equals of Greenspan and Rubin. Bernanke was slow off the mark—declaring the subprime crisis contained last year even as it was metastasizing, and pooh-poohing concerns over inflation as the consumer price index climbed. In recent months, however, he has responded with alacrity and imagination, slashing interest rates and making credit available to banks and Wall Street institutions.

Paulson, the towering former CEO of Goldman Sachs, is still growing into his public role. When he spoke about the Bear Stearns rescue, says David Rothkopf, author of the book "Superclass" and a former under secretary of Commerce, "he looked like a deer caught in the headlights. He was trying as hard as he could to say, 'I have a lot of confidence.' But it was clear he didn't."

While analysts give positive marks to the aggressive stimulus package the Bush administration ironed out with Congress, the overall response has been less than stellar. "In terms of the actual subprime crisis, it became apparent about nine months ago, but this administration hasn't taken any concrete action until the last month, when it was almost too late," New York Sen. Charles Schumer told NEWSWEEK. The administration's response has been to rail against bailouts for home borrowers (while approving a bailout for Bear Stearns) and to reiterate the need to extend the Bush tax cuts beyond 2010. (Marginal income-tax rates in 2011 are the least of the problems for millions of homeowners underwater.)

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."