The Credit Crunch: How America's Banks Lost their Reputations

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After the near-collapse of Bear Stearns, some of America's biggest banks are reeling badly. The markets are falling into a state of panic -- and elbow room is shrinking when the banks need it most.

With new bank earnings statements due, this could be the "Week of Truth" for markets.
REUTERS

With new bank earnings statements due, this could be the "Week of Truth" for markets.

He may be retired and out of office, but his words still carry considerable heft -- especially when it comes to quieting things down. "We will never have a perfect model of risk," market guru Alan Greenspan wrote in Monday's edition of the Financial Times. There have always been periods of euphoria and periods of fear on the markets, and "asset price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved."

The former Fed chief's message was clear: Despite all the turbulence currently rocking the markets, there's no reason to panic. But it remains to be seen whether people will actually follow Greenspan's advice. After all, the near bankruptcy of Bear Stearns, a company as American as peanut butter and jelly, has reinforced the devastating impression that some of the world's biggest banks no longer have any clue how to steer relatively unscathed out of a seemingly never-ending loan crisis.

But Bear Stearns, which was just acquired in a last-minute rescue by JPMorgan, may not be the only market-moving news this week. Other major investment banks including Goldman Sachs, Lehman Brothers and Morgan Stanley are set to release earnings. On Tuesday, Goldman Sachs announced write-offs totalling $1.72 billion -- less than anticipated by analysts, but still dramatic, with a drop in profits of 53 percent. Investors are calling it the "Week of Truth."

But it's not as if these financial institutions knew the precise scope of the losses they faced. "The valuation of securitized loan packages is highly dependent on how the market is behaving," said Dorothea Schäfer of the German Institute for Economic Research (DIW). "Last autumn, 30 percent write-offs were considered realistic, but now that figure is 50 percent and nobody knows when it will hit 60 or 70 percent." That goes a long way toward explaining why the banks are having such a tough time providing statements on the scope of their losses.

"Until now, financial markets were considered a fast, fair measure of the valuation of securities, but it has collapsed in the areas" affected by the credit crisis, said Manfred Jäger of the German Business Institute (IW). There's now a crisis of faith in the markets that won't be easy to mend. That's why it doesn't surprise Jäger that banks are waiting so long to release figures -- to extent that they can even reliably provide them. "The markets are responding to every new bit of information in an exaggerated manner, depressing share prices."

'It's a Vicious Circle'

The high level of nervousness in the markets is also creating a situation in which the banks have less and less room to maneuver at a time when they urgently need money. "If, for example, they call on hedge funds to increase their security, then they are forced to buy bonds. But those purchases push down the value of bonds and the degree of debt climbs. It's a vicious circle," said IW expert Jäger.

But experts claim it is the banks themselves that have created the mess. "They entered into fairly reckless transactions with high-risk loan packages, always trusting that things would go well," said Roland Döhrn of the RWI Essen economic research institute. In order to secure money from markets, the banks also took advantage of loopholes in regulations, he said. "Credit lines for subsidiaries, which then went into speculative finance products, were limited to 364 days -- because after one year, banks are forced to deposit their own capital." So the banks' slide into the crisis was far from coincidental.

"Innovation euphoria" is how Ms. Schäfer, the DIW expert, diplomatically described the reason for the banks' enormous problems. Financial institutions have believed for a long time that they could minimize risk by rolling up all their loans in special packages. Now disillusionment is setting in, as it did after the New Economy balloon deflated. "Although speculation and hyperbole belong to the system," said Schäfer, "a healthy skepticism is always recommended over lofty profits."

No Clear Blame

"The banks should have known that securitized loans are high-risk," said IW expert Jäger. The problem is that structured loan packages are so complex that they don't reveal any clear culprit -- thus allowing everyone to shift blame to someone else. "Everyone's pointing fingers at the ratings agencies now, but everyone bears some of the guilt," said Jäger. He's therefore calling for greater transparency: In retrospect it always has to be clear who is assuming risk, who's responsible, and who can be made responsible. "If you rent a car at your own risk," he said, "you automatically drive more carefully than you would if the insurance was covered."

In the meantime, the banks have all come to understand this -- and now they're working in overdrive to counter the impression that, out of pure profit motive, they fundamentally underestimated their risks. Since October, financial experts from the world banking organization have worked on a new code of conduct to help prevent similar crises in the future. By doing so, the Institute of International Finance, led by Deutsche Bank chief Josef Ackermann, is hoping to not only restore faith in banks, but also to keep regulatory authorities and political bodies at bay and prevent them from pressing ahead with stricter rules.

In that sense it might be enough if banks could shift their thinking toward what market expert Wolfgang Gerke describes as a "return to normality." And what does normality mean? "The law of returns is not the only law," Gerke said. "Awareness of risk also has to be considered. That's an old, simple virtue."

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