08.12.11

Why Markets Freak Out

Stock charts now resemble cardiac arrest because of a deficit – a credibility deficit. Zachary Karabell on why Wall Street’s credibility gap translates into market anarchy.

In case you stepped away for a few bucolic summer days, emulating Nicolas Sarkozy and much of France itself, you probably noticed that global markets swooned yet again on Wednesday to the tune of nearly 5 percent down before staging an equally impressive comeback on Thursday. The latest precipitating cause of this yo-yo action was a rumor that Société Générale was on the verge of insolvency and about to implode.

The rumor was placed front and center by a story run in The Daily Mail in the U.K., which claimed that the French bank was in a perilous state because of its $4 billion exposure to Greek sovereign debt. That story was enough to ignite a new round of fear that the European Union was about to witness a financial meltdown and that France might soon be downgraded much as the United States was late last week.

The reaction to the story was swift. The bank’s CEO Frederic Oudea went on television to denounce the story as “stupid and unfounded rumors,” and the ratings agencies (including the much reviled ­ and legitimately so ­ S&P) said unequivocally that there was no imminent downgrade of France itself. Barraged with criticism for running a story with no hard facts or figures and no named sources, the Daily Mail then issued an apology, but not before global markets had lost trillions of dollars and shares of SocGen had plunged nearly 20 percent.

This was not some obscure regional bank. While Société Générale, SocGen for short, is not a household name to those outside of France or finance, it’s the third largest bank in Europe, with more than $1 trillion in assets, employing more than 120,000 people. Its history dates back to the Second Empire and the gloriously sordid days of Napoleon III and his Princess Di of the day, Empress Eugenie. (A few years back, a 20-something trader named Jerome Kerviel went rogue and lost billions of dollars, nearly destroying it.)

In short, SocGen is one of the most substantial and significant financial institutions on the planet, and it has been sent close to the brink not by its balance sheet but by a panicky community short of trust fueled by a rumor.

So this is what we’ve come to: a world where a brief article in a British tabloid citing unsourced worries about a French bank can precipitate a global equity sell-off and a wave of panic. And more to the point, a world where the heated, emphatic, and unequivocal refutations of those worries by regulators, ratings agencies, and the bank’s CEO are dismissed as less credible and less trustworthy than a newspaper with a long and dishonorable history of running stories later shown to be without a scintilla of truth.

We have, in short, arrived in Looking Glass world where no one believes anything that anyone in finance-land says. And for that, we have Dick Fuld, Lehman Brothers, and the entire culture of Wall Street, Washington, and European finance over the past five years to thank. They are the inverse of the boy who cried wolf, and no one now believes that the wolf is not at the door.

We have, in short, arrived in Looking Glass world where no one believes anything that anyone in finance-land says.

Said Dick Fuld about rumors of problems at Lehman in the summer of 2007, a year before the bank collapsed: “Do we have some stuff on the books that would be tough to get rid of? Yes. Am I worried about it? Will these things will we lose some money? Yes. Is it going to kill us? Of course not.” Similar statements of confidence in the underlying strength of financial institutions were voiced at various times by Stan O¹Neal and then John Thain of Merrill Lynch and by various executives of Bear Stearns, AIG, and Citibank. Regulators ranging from the SEC to the ratings agencies ­ and yes, Standard & Poor’s ­ also affirmed that the balance sheets of these institutions were more than able to withstand the downturn in the housing market.

Those assurances proved to be utterly without foundation, and three years later no one is prepared to give credence to even unequivocal statements by people supposedly in the know and responsible for the health of their institutions or the stability of the global economic system. We have a severe trust deficit, and the events of the past few days show just how toxic and destructive that deficit can be.

Of course, what 2008 showed us is that with $500 trillion of derivative contracts sloshing around the globe, many times over the $50 trillion size of the global economy, and with many pockets of those unregistered, unaccounted for and unknown, even stable financial institutions might not be as stable as they look. That is where trust becomes even more essential: we have to know that executives are behaving responsibly, in their own self-interest, and that regulators are ensuring that leverage isn’t excessive and capital is. We have to believe that ratings agencies are diligent in affirming strength, especially if we then give them credence when they announce weakness à la downgrading the United States. And we have to imagine that the media report things that have a tangible relationship to something called the truth.

But we do not live in that world, and that is a headwind pushing against currents of balance, growth, and repair. In that world of trust deficit, we’d do well to repeat the following mantra: just because it happened last time doesn’t mean it is happening again. Being skeptical is healthy; being cynical, not so much. And the only way to judge the present is on the present, not on false application of the lessons of the past, and not on irrational fears of what the future might hold.