Confidence Crisis Prolongs Credit Crisis

By LIZ PEEK
April 3, 2008

"Show us the money" is the refrain from businesses and buyout firms that are unable to raise funds despite huge injections into the banking system by central banks in America and abroad. Even amid widespread recognition that the banks are flush with cash, many borrowers appear no better off than they were last summer, when the commercial paper markets all but closed.

In fact, commercial paper markets do offer evidence that borrowers are under duress. Double A-rated commercial paper lent to financial companies at the end of March amounted to only $4.9 billion, down from an average of $18.6 billion in 2006.

Tuesday's market surge, led by the beleaguered financial stocks, signaled optimism that the worst of the industry's write-downs are behind us. The ability of UBS AG and Lehman Brothers Holdings to raise capital, notwithstanding further expected charges, buoyed hopes that the firms are out of the woods. Still, financial industry managements are so shell-shocked by the rapid collapse of their businesses and balance sheets over the past year that they continue to hoard cash, much to the annoyance of their clients.

The government has pulled out every stop to tune up the financial machinery, to no avail. Consider: The Fed has cut the discount rate by 375 basis points; cut the Fed funds rate 300 basis points; opened the discount window to investment banks and agreed to accept mortgage-backed and other collateralized securities (which is huge); joined the Bank of China, the Bank of England, the Bank of Canada, and the European Central Bank in injecting liquidity; pumped up the Term Auction Facility; encouraged the Federal Housing Administration to lend to subprime borrowers; taken other measures to contain defaults, and backed the administration's plan to send checks to millions of Americans.

This is a classic case of pushing on a string.

"There's plenty of liquidity," Richard Bove of Punk Ziegel, who made headlines last week by turning positive on the investment banks, says. "The banks are not capital constrained at all."

Why are the banks sitting on their hands?

The main answer, according to leaders in the industry, is confidence. The industry is reeling from the meltdown of seemingly sound assets and from the near demise of Bear Stearns. Bankers are worried that further dangers lurk ahead, including write-downs of commercial mortgage-backed securities and further losses in Europe and Japan, which have been ominously quiet. There are, however, other factors at play.

A senior fellow at one of the big banks says firms like his are allocating their marginal dollars to the most profitable opportunities, which do not include traditional lending. Instead, they are buying up corporate debt at a discount or the top triple A-rated tranches of collateralized loan obligations, or other assets being dumped by hedge funds busily unwinding their leveraged portfolios. Returns on such investments can be two or three times more than the banks can earn from traditional loans. This is bad news, because the deleveraging process is expected to take a while.

Another ingredient in the mix today is accounting regulation FAS 157, which requires the treacherous "marks to market" that can undermine a balance sheet overnight. Mr. Bove points out that while the Federal Reserve and the Treasury have actively pursued options old and new to shore up the financial system, the SEC has not budged on one of the industry's biggest problems.

The "marks" are panned by those who recognize the snowball effect of asset write-downs leading to credit downgrades leading to more asset write-downs. Supporters of the accounting treatment suggest it leads to greater transparency, while detractors point out that in some cases the assets being written down today will likely have to be written back up again over the next couple of years. Such non-cash charges and gains only confuse investors, and don't disclose much about the underlying business.

Another ingredient gumming up the credit markets is the same lack of perspective that led the banks into their current fix. Merrill Lynch (and others) got into trouble partly because their risk management systems were organized by business line. There was little overall grasp of the company's exposures. Now Merrill has a risk management committee that is responsible for taking on new projects across the firm. Imagine the enthusiasm of those in the debt trading department for lending to private equity sponsors. It's much easier to say "no" to new ventures, especially when you don't understand them. Not all firms followed Merrill's path, but you can be sure that all have revamped their approach to risk management, and the result is industry-wide risk constriction.

Another accounting change that's prolonging the financial market discomfort is the tightened restrictions on taking writedowns. In the past, a management could attempt to get ahead of problems and take a "kitchen sink" write-off, all but guaranteeing that results would thenceforth improve. These days, auditors look askance at any such effort, leading to the "death by a thousand cuts" sensation many investors are feeling.

What will get this train back on track? Lenders and investors need assurance that there will be no more horrors. As one private equity player points out, in recent months the correct decision was to wait and allow asset prices to sink lower. The positive is that hedge fund and private equity investors seem to agree that once the market senses that a bottom has been reached, the recovery will be robust. There are substantial amounts of money on the sidelines; hedge funds hold historically low net exposures currently, and money market funds hold $2.5 trillion in America alone.

How will we know the bottom has been reached? Stay tuned.

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