At a conference of the Chartered Financial Analyst Institute in the U.S., Gillian Tett, assistant editor of the Financial Times of London, spoke of a five-stage process to understand the current crisis and to try to predict the types of financial markets that will emerge from the lessons ecently learned. Here is a summary of her address.
The financial crisis seriously undermined the hopes and shook the confidence of many investors. For investors, individual and institutional alike, this experience has been like a tragedy. In psychiatry, all healing processes involve five stages: shock; denial; anger and bargaining; depression; and, finally, acceptance and resolution.
First stage: shock, which took two forms. First, Americans learned that many borrowersmight default on their loans at the same time, and that this could have a domino effect on the banking system and end up causing major financial losses. Then another, equally serious, problem occurred: loss of confidence. Even after many warnings that the development of structured financial products was spinning out of control, people continued to believe that the systemwould still function. After all, the rating agencies were doling out AAA ratings left and right, without hesitation. However, when the first floors of the house of cards started to collapse, people realized that the financial experts had not sufficiently diversified the risk undertaken by institutions and had created leverage on a staggering scale. They saw that fundamentally, even the experts had failed to truly grasp the scope of what was happening.
Second stage: denial. In mid-2007, the U.S. government believed that, even in the worst-case scenario, subprime loan losses would not exceed $100 billion, and that if the central banks added a little liquidity, the problem would quickly disappear by itself. They refused to face reality.
Third stage: anger and bargaining. According to Gillian Tett, anger is coming out andmay just be starting because we still don’t know the impact all these financial losses will have on ordinary people. For example, each dollar invested in some pension funds is now worth only 10 cents, which will have a definite impact on benefit payments. So we have identified the problem, we think we have a pretty good idea of its scope, and we are starting to put in place different programs and negotiate various ways to solve it.
Fourth stage: depression. This phase is generally characterized by big spreads between high-yield bonds and Treasury bonds, which means a high risk of defaults. At the same time, real estate prices are stagnating and auto sales are plummeting, as is consumption in general. And many people are losing their jobs.
Fifth stage: acceptance and resolution. People are realizing the scope of the crisis and witnessing the collapse of the foundations that were underpinning the financial system. The financial industry feels the need to restructure, to redefine the capital adequacy standards for banks, to adopt stricter regulations and to put in place measures to limit leverage.
It is utopian to believe that the free market will suffice to solve all these problems. Society, which has always resisted state intervention, will have to learn to accept it. But this won’t happen overnight.
Gillian Tett’s conclusion is interesting: “I don’t know what the financial industry will look like five years from now, but I know it will be run by managers who have lived through a bruising, scarring, terrible crisis. Experience will have taught them that even a big bank can fail, which will make them much more humble.