Trust still matters

August 11, 2009

Trust is one of those touchy-feely words that gets thrown around a lot, but whose true value isn’t felt until it’s lost.

The Congressional Oversight Panel’s latest report on the troubled assets still embedded in bank balance sheets reminds us that one of the first casualties of the credit crisis, trust, is still up for grabs.

Those toxic assets that started the whole mess, culminating in last fall’s financial market meltdown, are still there — they’re just harder to see.

This is so even after the government has pumped trillions of dollars into the financial system, including the $700 billion of funds initially targeted at removing those assets, but redeployed to vulnerable financial institutions themselves.

Trust is one of those things that bind financial markets together. When it’s breached it can get ugly, with last year’s maelstrom one of the worst examples.

While it’s unlikely we’ll see again the likes of the mayhem last fall, the persistence of toxic assets on bank balance sheets means some financial institutions remain vulnerable should they lose the trust of the investors and taxpayers who have kindly supported them so far.

For the moment, the markets don’t seem too worried, since euphoria about the expected rebound in the economy means few are thinking too much about the niceties of whether bank executives or policy makers can be trusted to do right by shareholders and taxpayers. (UPDATE: The stock market decline Tuesday and climb in Treasury yields, however, shows how fragile confidence in the recovery and the financial sector is, however.)

But this is likely to come into sharper focus should that euphoria be replaced with a more sober assessment of the economy’s long term prospects, and in particular, of the many smaller financial institutions still weighed down with toxic assets more than two years into the credit crisis.

The Oversight Panel’s sobering words on troubled assets are a reminder of why trust still matters.

“It’s likely that an overwhelming portion of the troubled assets from last October remain on bank balance sheets today,” the panel wrote. “If the troubled assets prove to be worth less than their balance sheets currently indicate, the banks may be required to raise more capital.”

In a struggling economy, convincing investors to pony up more funds to help bolster capital positions, or taxpayers to shoulder more risk, will be extremely difficult, maybe impossible.

TARP, which was crafted during that week of mayhem in September to suck venomous assets out of the financial system, instead recapitalized banks as a way to put them on an even keel.

Since then, the government has come up with a more complicated public/private scheme to create a market for these unwanted assets that’s yet to be tested.

A change in accounting that gives financial institutions more wiggle room in how they value the assets means investors are left guessing about how aggressive banks have been in marking down the assets. It’s also meant that there’s a big disincentive to sell the assets if they’re underwater. Many of the big banks — Goldman Sachs stands out as a good example — will be able to simply earn their way out of their toxic mess, since they can afford to write down assets now that they’re making money hand over fist in trading and investment banking.

But the hundreds of smaller banks that have stuffed their balance sheets with problem loans, especially those to the commercial real estate sector, won’t necessarily be so lucky.

The recovery in financial markets has allowed some to pad capital cushions through fund-raising and improved valuations in risky assets that were pummeled after the Lehman Brothers bankruptcy, but this has less to do with trust than relief that the world isn’t about to fall off a cliff.

If the economy picks up steam, not only over the next two quarters as many economists expect, but into next year, it’s likely investor and public trust will be rebuilt on the back of fatter retirement savings and possible job growth.

But should things fizzle after businesses restock their inventories, skepticism will return, especially if there’s more fund raising to be done. Then this small matter of trust won’t be so small anymore.

So speed up the implementation of the private/public funds aimed at dealing with these assets; delay no longer. Otherwise, should the tide turn, we could be back where we started, but with a far less trusting public willing to help lessen the pain.


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