LIGHT AT THE END OF THE TUNNEL IS REAL

By Gillian Tett 2008-10-15

In recent months, investors have been frantically squinting to see light at the end of the tunnel of banking doom. Time and again, however, glimmers of hope have turned out to be a mirage.
Last March, for example, many observers – including myself – thought the implosion of Bear Stearns might mark the worst moment of financial stress. Then, when Lehman Brothers tumbled in mid-September, some investors thought this marked another nadir.
But now we know these were merely preludes to an even more extraordinary drama that has convulsed the financial system in recent days. Never mind the (oft-quoted) suggestion that we are witnessing the worst crisis since the 1930s. Some of the more gloomy – and geeky – policymakers who assembled in Washington last weekend now think we need to reach further back for parallels, such as to 1914, when the onset of war sparked banking panic.

Yet, while such parallels might now look terrifying, they also – perversely – contain the seeds of real hope. For while last weekend's Washington meeting did not produce what some investors desperately wanted to see – namely a blanket guarantee for all interbank lending – it did offer something else: an end to official policy denial. Most notably, there is now a clear consensus among western policy leaders that they cannot continue to pretend the current banking dramas are merely about liquidity.
Instead, what finance ministers now accept is that liquidity concerns reflect genuine solvency and capital fears. More important still, they also now recognise – even in the US – that the only way to address this is to use taxpayer cash to recapitalise banks in a systemic manner, instead of demanding that central banks should solve the problem with ever-more creative liquidity tricks.
Of course, it is truly shameful that it has taken global policy leaders so long to come to this point. After all, lessons from history have long pointed in this direction, and the International Monetary Fund has warned for months that a systemic recapitalisation would be needed.
However, the history books also shows that such denial and delay is not unusual: in almost every other bout of banking rot, including Sweden and Japan, politicians have resisted using taxpayer cash until they had a full-blown crisis on their hands. And in the 2008 crisis, the collapse of Lehman Brothers has at least created the preconditions for politicians to act.
After all, modern western voters (and investors), who are bred on a diet of Hollywood, know all about cliff-hanging dramas to prevent global destruction.
That does not, of course, mean that we can prepare to see the closing credits of this great financial drama anytime soon. The bank bail-outs now being announced will not prevent an economic slowdown. Nor will they avert further deleveraging. Equity markets are thus likely to remain jittery for some time, as debt-laden countries and companies continue to writhe in pain.
However, if investors want to find reasons to feel cheerful right now they should take a look at what has just happened to the cost of insuring bank debt against default, with credit default swaps.
When Lehman collapsed in September, CDS prices spiralled. But since the UK became the first country to bite the bullet and announce a comprehensive bail-out for banks last week, CDS spreads tumbled for big banks, particularly in the UK. That has not translated into a dramatic decline in interbank borrowing costs yet.
However, I suspect that is simply a matter of time, and if nothing else the CDS pattern suggests that conditions are stabilising.
The light at the end of the tunnel might still seem very distant and faint – but this time I believe it is real.