Markets: Keeping the Bears at Bay

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Sometimes, such as during the Asian financial crisis of 1997, it's unclear exactly how the panic started, Pasquariello says. But once the fear and panic start, they're hard to stop.

Central banks flood banks with temporary liquidity to buy time. (Just as Franklin Roosevelt, declaring "the only thing we have to fear is fear itself," shut down the nation's banks in 1933 as he assumed the Presidency.) In the meantime, bankers and regulators will be grasping for the only thing that can end any financial crisis: the truth. "The best way to alleviate these problems is to provide information to investors," Pasquariello says.

Time for a Portfolio Assessment

The Federal Reserve needs to insist firms "rapidly evaluate their portfolios" to determine exactly how much of the toxic, risky investments they hold, says Jean-Laurent Rosenthal, an economics professor at California Institute of Technology, who has written about financial crises. "That is the fundamental thing markets need now," Rosenthal says.

Even if the prognosis is gloomy, the theory goes, the market can react, rather than panicking every time a bank or hedge fund announces some bad news. It may take a while before investors get the information they need to rest easy at night.

The problem here is that the financial industry has created a raft of new, so-called innovative debt products that are hard, even in the best of times, to place an accurate value on. "You don't have the transparency that exists with exchange products," the second-by-second adjustment in a stock price, for example, says Brad Bailey, a senior analyst at the Aite Group. The products are so complex that many investors might have bought them without realizing how risky they are, he says.

Bank Profits Heading South

Another action by the Federal Reserve that could slow the spread of the subprime crisis is a cut in interest rates. Some are angry that the Fed hasn't acted already. TV host and investing guru Jim Cramer unleashed a memorable rant on the subject on Aug. 3.

But policymakers may be reluctant to bail out investors so quickly. First, the Fed, along with other central banks, is worried about inflation. Second, risk is part of investing, and markets don't operate properly if the central banks step in whenever risky investments fail. Maybe Ben Bernanke, the Fed chairman, "really feels that central banks should not save investors from their stupidity," Stein says.

Of course, a rate cut wouldn't restore the billions already lost in risky subprime hedge funds. Fed action would just be "preventing the crisis from becoming systemic and affecting every other market," Pasquariello says. Rate cuts may be needed soon because the credit crisis, while disturbing the markets, could soon start really hurting the economy.

Credit Markets Freezing Up

Stein has no doubt: "It will hurt the economy as a whole." That's because bank profits are sure to diminish or maybe even disappear, and, with credit markets freezing up, banks will find it harder to sell debt to others. That should cause banks to tighten lending to even creditworthy borrowers, stifling growth.

Fed policymakers "will probably ease credit conditions to institutions at the same time institutions are tightening credit to consumers," Rosenthal says.

Defaults on mortgage loans to poorer Americans may seem like a strange reason for a global financial crisis to begin, but these crises often start in out-of-the-way places. In fact, the world may be especially disturbed that this crisis is starting in the U.S., which has been a rock of stability in the global economy for decades.

Just the Panic Talking

When Asian, Russian, or South American economies underwent crises in the past decade, you saw so-called flights to quality as investors moved their money from developing nations to the U.S. "Now the question is: Where is the quality?" Pasquariello says. He believes the world's markets can relax when they have a better handle on the extent of the problem. "All this information will help investors sort this out," he says.

After all, does it make any sense to sell European stocks because of problems with exotic debt instruments in the U.S.? That might just be the panic talking.

As one more hedge against panic, investors might try putting the current financial problems in perspective. The economic fundamentals around the world and in the U.S. are excellent. Aggarwal lists them: market valuations are reasonable, the interest rate environment is good, employment is strong, and economic growth is booming globally.

Keeping a Cool Head

Despite all the worry and volatility, even stock prices are staying relatively high. The Dow Jones industrial average is at 95% of its all-time highs, Rosenthal points out. That's nowhere near the losses for the NASDAQ composite earlier this decade, when it lost more than half its value in a year.

There may even be some opportunities out there for investors. Take an example from the evil banker Henry Potter in It's a Wonderful Life. As George Bailey told the panicked depositors at his bank: "Don't you see what's happening? Potter isn't selling. Potter's buying! And why? Because we're panicky and he's not."

Potter may have been a miserable old tightwad, but he did have the good sense to keep a cool head amid a crisis and look for opportunities. Investors may want to keep that notion in mind in the weeks ahead.

Steverman is a reporter for BusinessWeek's Investing channel.