Gridlock and panic follow loss of compass

By Gillian Tett

Published: September 18 2008 20:52 | Last updated: September 18 2008 20:52

As markets trembled on Thursday, Standard & Poor’s, the US rating agency, detonated another small grenade. After announcing in March that it expected banks to write off $285bn of mortgage assets, it casually raised that estimate by $100bn-odd, owing to falling asset values.

Compared with recent dramas, that $100bn might not look so disastrous (Nouriel Roubini, the American economist, expects $2,000bn total credit losses before the end.)

However, the S&P revision highlights a problem that explains much about the current storm: namely that recent events have left investors and financial institutions so utterly disorientated, that there is widespread confusion about what anything might now be worth. The financial world, in a sense, has lost its compass.

And that has left investors so disorientated they are either rushing for safety, or simply refusing to trade at all. The result is gridlock and panic.

This marks the culmination of problems that have been quietly intensifying for a year. This decade, investors have relied heavily on rating agencies to act as a compass in the world of complex financial products. However, when the agencies started to downgrade mortgage-linked securities last summer – sometimes moving AAA securities to junk – confidence in the ratings was shattered.

At that point, some investors looked to markets to make sense of complex finance. After all, American capitalism has an in-built reverence for market price signals; so much so, that regulators have increasingly forced financial institutions to mark their books to market prices this decade.

However, over the past year, trading has dried up in many corners of the complex financial world, making it almost impossible to get real market prices. So, in desperation, investors and auditors have started using other, potentially flawed sources of valuations – such as the so-called “ABX” index, which tracks the cost of insuring mortgage-backed bonds against default.

That has had devastating implications for the banks. Over the last year, the ABX has tumbled: the implied price of some AAA instruments was just 45 per cent of face value on Thursday.

As a result, financial institutions, such as AIG or Merrill Lynch, have reported massive mark-to-market losses – often seemingly out of the blue.

That has ravaged their capital base. However, it has also caused investors to increasingly lose confidence in banks and their published accounts. And as investors have shunned banks, these institutions have tumbled into funding problems too.

Central banks have tried to allay those immediate liquidity concerns: on Thursday they pledged $160bn. But this is unable to allay the root cause of the concern: namely a fear that the banking system lacks the capital needed to cover the ever-swelling credit losses. Worse, with estimates of that gap ranging from $200bn to $500bn, investors cannot see how it can be raised from private sources.

Some investors hope that governments could end up stepping in. But the US Treasury’s contradictory stance on Lehman Brothers and AIG this week has sown confusion about what Washington is willing to do – or not – creating more uncertainty.

In the long term, the saga will undoubtedly strengthen calls for regulatory reform. The credit default swap (CDS) market, for example, is likely to face more scrutiny; mark-to-market accounting may also come under fire too.

However, the more pressing challenge now is how to end the disorientation. That will not be easy. After all, market confidence is unlikely to return until it is clear how banks will plug the capital gap. And investors are unlikely to start purchasing assets until they have a real sense of what clearing prices should.

Wall Street theory would suggest that market forces should eventually produce those all-important clearing prices, at least when institutions recover enough nerve to start trading assets again. Merrill Lynch, for example, recently sold a portfolio of distressed securities, at 23 per cent of face value.

However, private sector led initiatives could take months to materialise, partly because many banks are reluctant to sell in case this creates more capital losses. Consequently, some bankers are now lobbying for the government to step into the breach, by creating a modern-day version of the Resolution Trust Corporation, an institution that purchased assets from troubled banks in the early 1990s and then sold these at state-sponsored auctions.

On paper, that idea has something to commend it, given that the RTC did establish clearing prices a decade ago.

But sadly, it could be fiendishly hard to implement any such initiative in an election year, let alone at the speed that investors so desperately need to see, to regain their sense of a financial compass. It is indeed a terrible political and financial trap. Stand by for plenty more disorientation in the weeks ahead.

gillian.tett@ft.com

Copyright The Financial Times Limited 2008