The New York Times-20080127-O Wise Bank- What Do We Do- -No Fibbing Now-

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O Wise Bank, What Do We Do? (No Fibbing Now)

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THE Federal Reserve's surprise early-morning interest-rate cut last Tuesday has calmed, at least for now, a stock market storm that began in the Pacific Rim and roared around the world a day earlier. It was the Fed doing what it does best -- simultaneously reducing the cost of money for the nation's financial institutions and signaling to investors that it would act quickly to counter fears of a consumer-led recession.

But for all its power, the Fed cannot change this troubling fact: trust in much of the financial system -- banks, brokerage houses, ratings agencies, bond insurers, regulators -- has been severely damaged by the subprime mortgage crisis. And that damage cannot be reversed with a quick cut in interest rates.

It is not just a matter of attracting fresh capital from overseas to replace some of the $100 billion lost or written off so far -- a figure that is sure to grow. The underlying problem for some of the world's largest financial firms is restoring confidence, among big institutional investors and 401(k) nest-egg holders alike. That's what has to happen if the capital markets are to run smoothly over the long term.

It is easy to see why the executives and directors of blue-chip firms like Merrill Lynch and Citigroup lost sight of the importance of risk management and vigilant oversight. Their companies have been prodigious profit machines for so long that complacency had set in.

For generations, while other industries experienced booms and busts, financial services pretty much kept chugging along, making money off the swings and shifts in the economy. Standard & Poor's index analysts said 2001 was the only down year for financial sector earnings since they began collecting data in the late 1980s. Even the recession of 1990 did not interrupt the industry's rising profits.

But analysts estimate that financial company profits fell 25 percent in 2007 (the year's actual numbers aren't yet in), and financial stocks experienced a significant decline, losing 21 percent of their value, the biggest drop since 1990.

Richard E. Sylla, professor of market history at New York University's Stern School of Business, said one had to go back to the Great Depression, a period of regular bank failures and relentlessly falling stock prices, to find a time when losses at a broad swath of financial firms were as profound as they were last year.

I don't think it will be as bad this time because we have better management by the Fed, he said. But people are much more skeptical of the wisdom of these banks now. There will be less trust.

The Federal Reserve that investors have learned to rely on so heavily was created after the Panic of 1907, a classic bank run that began when the Knickerbocker Trust Company in New York could not satisfy its depositors' calls for their money. Like many panics, this one began with the ruin of a single speculator, F. Augustus Heinze, who had tried to corner the market in United Copper Company shares.

His failure might have gone unnoticed but for the fact that Mr. Heinze was president of a bank and deeply involved in the world of New York finance. One of his business associates was the president of Knickerbocker Trust and when that relationship emerged, the bank's depositors clamored for their money. One day in October, Knickerbocker tellers paid out more than $8 million in three hours, then had to close its doors.

The financier J. P. Morgan stepped in, asking a committee of bankers to examine the trust's books. He decided not to bail it out, choosing instead to help another institution, Trust Company of America, that was less troubled. Later, Mr. Morgan persuaded bankers to put up $25 million to rescue problem banks and trust companies. The crisis abated.

With the exception of the Depression, which saw the failure of thousands of small banks unable to withstand demands from depositors, panics have been rare since the Fed's creation in 1913 set up a national system of banks serving as fiscal agents of the United States Treasury. One of the Fed's marching orders is to protect the nation against such liquidity crises. Lowering interest rates and injecting money into the system are powerful tools because they help skittish banks get back to the business of lending.

Warding off a credit crisis like the one created by the lax lending of recent years is quite a different matter. The Fed cannot turn a bad mortgage loan into a good one. And it may not be able to convince investors that their money is safe in institutions whose risk management was so lax that their shareholders have absorbed billions in losses.

Indeed, while the Fed's rate cut soothed investors, it treated only a symptom of the ailing markets, not the ailment itself. That illness is the loose lending that produced complicated securities whose risks were vastly underestimated by the institutions that bought them.

One of the more disturbing aspects of the current woes, and a reason that this crisis is unfolding in slow motion, is the inability of these sophisticated institutions to assign accurate values to their holdings. Morgan Stanley shocked investors last month when, just a few weeks after estimating its mortgage-related write-downs at $3.7 billion, it added another $5.7 billion to the figure.

Firms have had difficulty computing their losses because the securities central to this mess are complex, even incomprehensible. A share of stock is a stake in a business. But a mortgage security includes thousands of loans, some more risky than others.

Investors who bought these securities clearly did not know what they were buying; they relied on credit rating agencies like Moody's Investors Service, Standard & Poor's and Fitch Ratings to tell them whether their stakes were risky or not. But the rating agencies were disastrously wrong in their risk assessments and spent late 2007 downgrading securities they had recently rated as solidly AAA. Their reputations have been tarnished.

In the latter part of the 1970s and early 80s we had the problems of Brazil, Argentina, Mexico not paying their debts, said the economist Henry Kaufman. Those were kind of nice, isolated items and could be clearly defined. They weren't as opaque and they weren't as heterogeneous as the problems in the credit market now.

Even though the credit crisis has been unfolding for almost a year, the complexity of the securities and the fact that their ownership is not easily tracked means new losses are still being tallied. Just last week, Credit Suisse analysts said Fannie Mae and Freddie Mac, two government-sponsored buyers of home mortgages, may face losses of $16 billion because of declines in values of subprime mortgages on their books.

Last November, Mike Mayo, an analyst at Deutsche Bank Securities, estimated that losses from falling values of subprime mortgages could reach $400 billion. But that figure does not include losses in other areas of the credit market, like those that may crop up in prime mortgage loans or corporate debt.

In other words, it is likely to take many more months to plumb this well of losses. And it will far exceed the $150 billion federal stimulus plan being hashed out in Washington.

The financial markets have become more and more opaque and so we don't know enough about where the weaknesses are and what the magnitude of those weaknesses may be, Mr. Kaufman said. So far the Federal Reserve and other supervisory authorities have done little about removing the opaqueness and setting new ground rules for financial disclosure. And I have not heard a call from Congress for an investigation where it will ask the Federal Reserve, the Securities and Exchange Commission and federal and state banking regulators, 'What did you miss and why did you miss it?'

Certainly, greater disclosure of the risks in these complex securities and the institutions that hold them is in order. And investors must be confident that the values assigned to these holdings reflect market reality. So far, no one has come up with a plan to correct these market shortcomings.

You only find out who is swimming naked when the tide goes out, Warren Buffett wrote in a letter to Berkshire Hathaway shareholders six years ago. Unfortunately, this crisis's outgoing tide has exposed some of the nation's most esteemed institutions. Naked truths like these are never a pretty sight. And even after the tide comes back in, they are not likely to be soon forgotten.

[Illustration]PHOTOS: GOING DOWN: Some trying times for traders. (PHOTOGRAPH BY SPENCER PLATT/GETTY IMAGES); LINING UP: The cycle of bank runs at the turn of the 20th century led to the creation of the Fed. (PHOTOGRAPH BY CORBIS)(pg. 10)DRAWING (DRAWING BY DAVE PLUNKERT)(pg. 1)