The word credit comes from the Latin root credere, which means to trust, and if there’s one thing the credit crisis has taught us is how fragile that trust actually is.
Banking, more than any other industry, is based on trust, and when that trust is lost the system starts to strain. The credit crisis was kicked off last year when evidence started to emerge that lenders had misplaced trust in many subprime borrowers, who weren’t going to be able to pay back their loans. That led to a retrenchment by lenders and the crisis moved into full swing in August 2007 when BNP Paribas froze three investment funds because the market for mortgage-related securities was drying up. That set up a chain reaction that has reverberated in the dissolution of Bear Stearns, the government takeover of Fannie Mae and Freddie Mac and the collapse of Lehman Brothers.
Bear Stearns fell not because it was insolvent, but because other market players lost trust in the company and feared doing business with a company that was under pressure. A similar problem emerged with Lehman Brothers. When counterparties lose their trust in a fellow institution, it becomes impossible to conduct business.
The issue of trust extends to the regulators that aim to keep markets functioning. Most of the Fed’s moves to boost liquidity and support markets were as much about maintaining a level of confidence as they were about supporting financial institutions. Fed Chairman Ben Bernanke has spoken often about the importance of maintaining trust in the financial system.
When Treasury Secretary Henry Paulson was defending to Congress his plan to inject capital into Fannie and Freddie, he focused on the importance of the move as a confidence-building measure that would assure markets that the government is ready to support the system.
It’s no coincidence that most major moves by regulators have come over the weekend. The Fed and Treasury have worked while markets are closed, so that by the time global exchanges open for business, trust can hopefully be restored to the system.
These efforts have been modestly successful thus far, even with today’s 300 point intraday drop in the Dow Jones Industrial Average. Regulatory moves have mostly been stopgap measures, aiming to keep markets functioning while a wider trust is rebuilt. While the markets have taken hit after hit, a true loss of trust has yet to set in, which would have the potential to trigger a wide collapse in markets. –Phil Izzo