Sunday, September 21, 2008

Calm must prevail in war of psychology

(Gillian Tett @ FT.com) A few months ago Paul Tucker, head of markets at the Bank of England, confessed that policymakers felt as if they were fighting a financial war. The only problem, he added, was that it was fiendishly difficult to work out exactly who the enemy really was – or where it might be.

It is a comment American financial leaders might echo on Monday as markets reopen. Late last week Hank Paulson, US Treasury secretary, unleashed his most potent, self-styled “bazooka” to date, proposing to use $700bn (€485bn, £382bn) of taxpayers’ funds to purchase toxic debt (on top of money being used to purchase AIG or backstop money market funds).

In terms of heavy artillery, this is potent stuff. The $64,000bn question, though, is whether it will truly end the fight. For, as the implications of last week’s events sink in, policymakers now face a supremely difficult challenge to persuade investors that they are able to turn the recent tide of utter fear into greed. And the stakes in this battle are sky-high. After all, the unpalatable truth is that if this latest salvo does not calm the panic, then Mr Paulson simply does not have many more bazookas left in his arsenal.

To be sure, there is reason to hope the tide is turning. The battle plan proposed by the Treasury on Saturday is dramatic and tackles some of the causes of the current fear. Better still, last week’s events also show there is real, proactive global co-operation in this fight (even if some of Mr Paulson’s counterparts are a tad surprised by the degree to which he is imposing the financial equivalent of martial law).

But recent events have also left market participants so exhausted that nerves are stretched to breaking point. That creates the risk that euphoria could flip to terror again. And while the equity markets might have ended last week in a jubilant mood, in the arena where it matters most – the murky bowels of the credit and debt world – terror remains widespread.

Take the interbank funding market. The cost of borrowing overnight funds in that sector (as measured by Libor) tumbled late last week after central banks offered to inject an eye-popping $180bn on Thursday morning. However, on Friday the cost of borrowing in the three-month money markets – that is, the sector in which central banks did not directly intervene – was still spiralling up.

What that means in essence is that financiers around the world remain very scared about the medium-term health of banks. There are good reasons for that. Last week’s events, when the Federal Reserve decided to save AIG but let Lehman Brothers collapse, has now left credit officers confused about which institutions are safe. They are also uncertain about when they might get back cash or assets that were entangled in the Lehman net, via derivatives contracts or other funding deals.

Thus far – thankfully – that collateral issue has not sparked visible panic, partly because most institutions were so shell-shocked last week that they played for time. However, the counterparty problem poses a real risk that the cogs of the system could start to seize up again in the coming days. Over in Japan – to name just one small example – the repo market has been drained of liquidity because the failure of the Japanese branch of Lehman’s has caused numerous yen repo contracts to fail.

In Europe, some hedge funds are panicking because they cannot get back collateral that they had posted with Lehman Brothers, prompting them to unwind trades. Meanwhile, other hedge funds in New York and London are now trying to get collateral back from other groups, creating more pressures. And the ban on short-selling has thrown another spanner in the works, forcing some trading desks to stop business and awakening concerns about possible hedge fund collapses. That, in turn, is now prompting banks to call in credit lines to funds that had “short” positions.

Of course, none of these problems need be insurmountable. If the optimism afoot last week in the equity world spreads into the credit sector this week, then trust will be restored. What the financial world needs, in other words, is to heed the advice dished out in the second world war: just stay calm (preferably with a nice cup of tea). But the events of last week have left patience and sanity in short supply. This is a monumental psychological war. Mr Paulson – and the rest of the US policy world – cannot afford to put a foot wrong now.

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