Three lessons from the credit squeeze

This was the week that Chuck, Marcel and Josef stepped into the room.

After two months of fear and paralysis in capital markets, started on August 3 by a memorable Bear Stearns conference call with analysts to reassure them that it was not going bust, Chuck Prince of Citigroup, Marcel Rohner of UBS and Josef Ackermann of Deutsche Bank each disclosed terrible results. Instead of sliding further, shares in the banks rose because their investors now believed they knew the worst.

Bear’s call included an admission by Samuel Molinaro, its chief financial officer, that market conditions were as bad as he had witnessed in 22 years. But the moment that spooked some investors was when an analyst tried to question Jimmy Cayne, Bear’s chairman and chief executive, who had opened the call with a calming statement. “Jimmy stepped out of the room,” said Mr Molinaro.

Who knows what Mr Cayne was doing at that moment? He had just demanded the resignation of Warren Spector, the bank’s co-president and there was a lot on his plate. Perhaps he needed to talk to a colleague or take a bathroom break. But the impression he left was that Bear was so fragile that he could not stick around to answer questions.

At one bank, it has become known as the “Jimmy stepped out of the room” event – the moment when investors and bankers collectively lost their nerve. After that, shares in banks jolted downwards and a run started on the deposits of Northern Rock . Investors and banks themselves lost faith in the securities they had sold in the days of easy credit.

Now, things feel just a little more secure. Mr Rohner swept out the senior ranks of UBS and took a loss of SFr4bn ($3.4bn) in its bond division, while Mr Prince brought out the kitchen sink, taking a $1.4bn write-down on leveraged loans for private equity deals and raising provisions on Citi consumer loans by $2.6bn (which may or may not save his skin). Investors were so docile that, by yesterday, Mr Ackermann was purring about the “substantial opportunities” ahead.

So, with credit markets easing slowly, and everyone having to wait to see whether the US enters a recession, it is a good time to ponder some lessons of 2007. One, following from the above, is that investors are only human. They live in fear of the unknown, and the things they imagine may happen are often worse than the reality. A conference call to announce bad news is like a visit to the dentist or a school exam: the experience is painful but it is preferable to worrying beforehand about everything that could go wrong.

By the middle of this week, one bank that disclosed its results earlier was muttering indignantly that its write-downs had been at least as severe as Citi’s. The mood at Merrill Lynch, which is expected to disclose big losses soon, must have been lifted: bankers are lining up to confess how badly they have behaved.

A second lesson is that the trader’s option has changed hands. One age-old problem faced by banks is that traders are incentivised to take undue risks with their employers’ capital because of the way they are rewarded. They gain bonuses based on revenues they generate during the year, while banks are stuck with credit and trading losses that emerge later.

Banks have mitigated this risk by paying the bulk of bonuses in restricted shares and options: it is common for half of annual bonuses only to vest three years later. The fact that this year’s blow-up occurred in August helps as well: bonuses will be lower because fees from arranging loan financing will have been diminished by write-downs before they end up in bankers’ pockets.

But that does not save the credit funds and other institutions that bought previous mortgage-backed and structured securities and are suffering losses at least equal to what Citi, Deutsche and UBS have endured. Financial innovation means traders still have an incentive to make risky trades or sell bad securities; the difference is that most of the pain now ends up outside the bank.

A third lesson is that liquidity is priceless. Until August, virtually anyone could raise cash from others without having to pay a lot of interest to offset the risks. That applied to subprime mortgage borrowers and to private equity funds buying companies. “Liquidity was free. You could get liquidity at the local drug store,” says one banker.

This, however, was an illusion. Although there was still money around in August and September – deposits were flowing into Treasury bonds and money market funds – the tap turned off in the interbank market. “Liquidity is a very tricky risk to manage,” says James Wiener, a managing director at the financial consultancy, Oliver Wyman. “Many times, there is either an abundance or a complete lack of it.”

In the latter times, financial institutions rediscover that liquidity is priceless, first because they are unable to obtain funding at all and second because everything else follows from it. An illiquid broker or bank is potentially a bankrupt one; no matter how much its assets are worth, or may be worth in the future, it must jettison them at fire-sale prices to stave off collapse.

Now, having suffered a bout of uncertainty and illiquidity, banks are slowly regaining their poise. This week’s disclosures at Citi, Deutsche and UBS helped because they showed exactly how bad things got over the past two months. The answer is: they were nasty but not terminal for a big Wall Street bank or hedge fund. It could have been worse.

john.gapper@ft.com