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As I write this, stock markets around the world are teetering on the verge of major collapse. What only a few weeks ago was a topic of interest for Wall Street bankers and academics has become a global contagion affecting everyone. In previous blog postings, I discussed several topics including mark-to-market accounting and short selling, each of which has played a role in this crisis. But what is now at the forefront of both the diagnosis and treatment of this malady stems from simple human psychology: confidence. Few deny that the overriding lack of confidence in our financial system and leaders exacerbates the current economic crisis. But how has this lack of confidence brought us to where we are today?

Let’s recap what we know so far: banks loaned money to borrowers under very aggressive terms predicated on the notion that housing prices always go up. New home construction reached unprecedented levels causing an excess of inventory. As home values started to decline due to this buildup of inventory, home values started to decline. This created problems for home owners who financed their mortgages with nominal down payments. As interest rates started to rise, it became even more difficult to make the required mortgage payments. At this point, confidence started to erode in the housing market driving down home values in most markets.

What about the banks? With the banks buying and selling complex financial instruments that are based on home prices, concerns started to mount that perhaps the banks would soon feel the pressures of the housing market decline. Sure enough, thanks in part to an obscure accounting rule known as FAS 157, major financial institutions were forced to estimate the loss of value on these financial instruments and record any drop as a charge against earnings. This raised bigger questions: how were they determining these values and more importantly, were they underestimating them. This created a further crisis of confidence among the clients of these banks as well as the investors in these banks. As clients started to close accounts, investors started to sell shares of stock in these companies. These factors worked in tandem to literally collapse several major banks in a matter of days as they no longer had the ability to meet their required capital obligations.

With housing collapsing and the banks collapsing, equity investors grew fearful that businesses would no longer have access to capital. Furthermore, consumers would curb spending out of fear that their most valued tangible asset, their home, wasn’t worth what they thought it was. And more importantly, businesses in turn would curb spending out of fear that consumers would buy few products. Most of all, businesses would have difficulty gaining access to capital due to problems with the banks. All of this ultimately stems from a lack of confidence in the spending ability of institutions as well as individuals.

So here we are in the midst of one major crisis of confidence. How do we fix it? Simple, restore confidence. To do that, the government (Congress, the Treasury and the Fed) has:

1.) passed the $700 billion rescue package which will, among other things, allow financial institutions to sell their distressed mortgage-based instruments to the government and
2.) agreed to loan money directly to companies by purchasing their commercial paper.

Unfortunately, these steps have done little but further undermine confidence in our financial system and leaders. What happens next? Stay tuned. I have a feeling another blog entry will be posted sooner rather than later.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.