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Restoring Confidence
By: Dr. Charles Lieberman
Date: 11/24/2008
Policymakers are working overtime to restore confidence. The turmoil in the credit markets reflects investors' concern that firms will be unable to refinance debt when it matures or that buyers will pay a fair price when an asset is sold. Consumers and businesses are cautious about spending. It is necessary to restore confidence across the board to enable an economic recovery to take root.
The plunge in Citigroup's stock highlights the confidence issue. Citi has plenty of capital, access to the Fed's discount window to get as much liquidity as it needs, and highly profitable businesses that produce plenty of profits to offset any losses that need to be absorbed. A research report by Dick Bove of Ladenburg Thalman suggests that Citi has $35 billion in profits annually to absorb losses, which seems to be ample, yet the stock still declined very sharply. As Citi cuts costs, this net cash flow will rise further. But if investors fear the losses might overwhelm the company, they can withdraw funding and cause problems. So, restoring confidence in the banking system and various credit markets is absolutely necessary to stem the economic and financial slide. Guaranteeing $300 billion of questionable assets from Citi to restore confidence in the banking system is a good move.
In fact, the confidence issue is even broader than just the banking system. Key credit markets are still frozen, while others are struggling. Short-term markets are performing somewhat better. Libor rates have declined, commercial paper issuance has increased, and money is pouring into banks and money market funds. That's the good news. Longer-term credit markets are full of bad news, however. Residential mortgage rates have declined very little. Commercial mortgage markets are frozen. Longer-term bond issuance is limited, so firms are forced to rely on banks to pay off maturing debts, which increases the stress on bank balance sheets. And investors in the equity market fear that firms will be unable to meet their obligations when their bonds mature and might default, instead. In addition, asset backed securities markets are not working and even the municipal market is experiencing problems.
Treasury and the Fed have their work cut out to restore these markets to normal operations. Likely steps include buying questionable assets, providing guarantees and liquidity to markets that are not working, investing capital in financial firms that need more capital, and lowering interest rates to reduce financing costs. A sizeable fiscal stimulus package is coming early next year. It may also be helpful to helpful to modify accounting rules to limit reported losses on performing assets.
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