Investors, bankers have lost their faith

— -- With its alphabet soup of CDO and CDS and TAF and TARP, the current financial crisis can seem hopelessly complex. But it really boils down to one word: confidence.

The global financial system is grinding its gears because, from big banks to small investors, the essential confidence required to buy, sell or invest has disappeared.

Except for cash-and-carry deals, every capitalist transaction requires a certain amount of faith: faith that an asset to be purchased has some genuine value, faith that a party borrowing money will survive to repay it. Right now, that basic element of trust is gone, and until it comes back, financial markets will remain skittish and economies around the world will suffer.

"You have a crisis of confidence because people don't believe the bankers, and the bankers don't believe each other," says David Smick, author of The World Is Curved: Hidden Dangers to the Global Economy.

What President Franklin Roosevelt in 1933 called "nameless, unreasoning, unjustified terror" now rules global markets. Fearing the future, investors are selling stocks they worry will be worth less tomorrow than they are today. Even the White House publicly mulling the government taking direct ownership stakes in several U.S. banks — something that would have been nearly unthinkable just a few weeks ago — did nothing Thursday to salve investors' frazzled nerves.

In the four weeks since investment bank Lehman Bros. declared bankruptcy, trust has drained from the system like water through a sieve. Rather than risk their capital by lending it to business borrowers, banks — many weakened by massive subprime mortgage losses — are hoarding cash.

"What we're scared about is not the bad news. It's rather the news that we haven't gotten yet. And human imagination is nothing if not limitless in its ability to create disastrous scenarios," said Andrew Lo, a finance professor at MIT's Sloan School of Management. "Right now, everybody's imagination is working overtime."

Institutional investors likewise have almost no appetite for short-term debt offerings by most businesses. Even blue-chip companies, such as General Electric ge or Caterpillar, cat are either paying higher interest rates for routine financing or striking deals with private investors such as Warren Buffett to raise cash. Earlier this week, the Federal Reserve tried to tackle that problem by announcing that it would buy commercial paper directly from U.S. companies.

Bankers aren't solely worried about unseen dangers on another institution's balance sheet. They're worried that in this environment, even seemingly solvent institutions can fail overnight. Until it suddenly emerged as a weak link requiring rescue, Wachovia Bank wb seemed like an industry stalwart.

The normal rules that long governed lending decisions no longer offer security, said Ed Yingling, president of the American Bankers Association.

"It is a lot of money at a very small margin or profit. So you want it to be supersafe," says Yingling. "It's just a total lack of confidence in the market. It really is a panic."

Using every tool and then some

It's not that government authorities have sat on their hands. For the past year, the Federal Reserve and U.S. Treasury have been using every tool at their disposal — and creating some — to arrest the erosion of confidence and restore a sense of normalcy to markets. But some market watchers say the moves haven't done enough to address financial institutions' capital shortage and to provide greater disclosure about the ownership of troubled securities.

The Fed, under Chairman Ben Bernanke, has cut interest rates eight times since September 2007, pumped hundreds of billions of dollars into clogged financial channels and bought most of the country's largest insurance company, American International Group. The Fed last March also midwived the sale of investment bank Bear Stearns to rival JPMorgan Chase.

Treasury, with Fed support, last month effectively nationalized mortgage finance companies Fannie Mae fnm and Freddie Mac fre and secured $700 billion from Congress. The government may use some of that money to take direct ownership stakes in banks, the White House said Thursday.

The administration acknowledged that such a move would be at odds with the president's longstanding economic policies. "The radical and bold aggressive steps that we are taking on the economy are not ones that were part of his natural instincts," said White House spokeswoman Dana Perino. "But when presented with the evidence that the financial crisis about to hit the United States would affect every single American up and down the economic food chain, this president decided that it was important that the government take robust action."

Treasury is still pondering the details of any capital injection into U.S. banks. But Perino said any resulting ownership stake would not amount to a "takeover."

Astonishing federal involvement

Still, the multipronged government response to date amounts to an astonishing expansion of federal involvement in the economy. But it hasn't been enough to stem the Panic of 2008. Thursday, in its seventh consecutive decline, the Dow sank 679 points to close at 8579. Credit markets, too, remain spooked.

The pervasive lack of confidence saturates the bond market, where a high yield is evidence of elevated fear. Bonds are long-term IOUs issued by corporations. When investors worry that an issuer will default, they demand higher yields, just as banks demand high interest rates from shaky borrowers.

"Wall Street has priced debt instruments in a manner that anticipates the worst recession since the Great Depression," says John Lonski, chief economist for Moody's Investors Service.

Those yields reflect much lower confidence in borrowers than would be customary, even taking into account gloomy forecasts for the economy.

One measure of how great the fear is in the credit market is the difference in yield between high-quality, investment-grade industrial bonds and U.S. Treasury securities.

In good times, the yield gap between high-grade bonds and Treasuries is fairly narrow — a percentage point or so. Today, that spread is almost four times as large — 3.89 percentage points. It hasn't been higher since April 1933.

"Trust and confidence are the oil of American capitalism, and the oil is draining out of the system. … Once this cascade begins, the crisis of confidence becomes a panic, a cascade effect where no matter what is done, nobody wants to hold the hot potato," says Richard Peterson, a California psychiatrist and manager of the MarketPsy Capital hedge fund.

Almost a century ago, before the U.S. had a central bank, a lone financier was able to stem a financial panic. In 1907, amid bank runs, sinking stock values and recession, J.P. Morgan jpm gathered the top bankers of the era in the library of his Madison Avenue brownstone and held them there until they agreed to join a financial rescue.

After auditing the books of one troubled trust company, Morgan issued the verdict that launched the salvage effort and stemmed the panic: "This is the place to stop the trouble then."

Ron Chernow, Morgan's biographer, says, "Morgan was essentially marshalling the resources of the stronger banks to bail out the weaker banks."

Today's crisis is too big and too global for any single investor to thwart. The fabled banker was able to distinguish between the strong and the weak because he had access to the banks' books, which offers a lesson for today's policymakers, according to Chernow.

More information must be disclosed to investors about which banks hold how much in unwanted asset-backed securities. "The fear is universal and indiscriminate. Investors are making the panicky, but understandable, decision that every bank and every insurer in the country is hopelessly contaminated by these mortgage-backed securities," Chernow said.

President's approval rating

Government leaders have been unable to stop the slide in public confidence. President Bush is weeks from leaving office and is at historically low levels of public approval. His Treasury secretary is more widely respected for his financial acumen than for his bully-pulpit skills. The Fed chairman is a soft-spoken academic who lacks the outsized reputation of his predecessor, Alan Greenspan.

Treasury Secretary Henry Paulson has urged Americans to be patient, saying steps already taken will eventually pay off. Laurence Kotlikoff, economics professor at Boston University, agreed, saying, "We've rounded the corner. We're going to get this under control."

But others believe that additional action undoubtedly will be needed to turn the tide. One option would be for the government to guarantee all lending between banks, said Morris Goldstein of the Peterson Institute for International Economics in Washington, D.C. That would eliminate bankers' fears that a commercial borrower might collapse before being able to repay a short-term loan. But it would add another potentially massive liability to the taxpayers' shoulders.

Smick, the author and investment manager, says a global clearinghouse to handle all bank-to-bank transactions should be established with a mix of public- and private-sector capital. That would provide greater transparency than simply a government guarantee of interbank lending, he said.

Meanwhile, as the U.S. struggles to rebuild confidence in its financial system, some critics seem to be enjoying the superpower's plight.

"Trust in the United States as the leader of the free world and the free economy, and confidence in Wall Street as the center of that trust, has been damaged, I believe, forever," Russian Prime Minister Vladimir Putin said during a Communist Party meeting in Moscow. "There will be no return to the previous situation."

Contributing: Kevin McCoy and John Waggoner