Worst Crisis Since '30s, With No End Yet
in Sight By Jon Hilsenrath,
Serena Ng and Damian Paletta
Wednesday, September 17, 2008
The financial crisis that began 13 months ago
has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful
of financial institutions that made bad bets on mortgages
have evaporated. New fault lines are emerging beyond the original
problem -- troubled subprime mortgages -- in areas like credit-default
swaps, the credit insurance contracts sold by American International
Group Inc. and others firms. There's also a growing sense
of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry
-- hoping for better times in which to raise capital, sell
assets or acknowledge losses -- are now clear and brutal,
as falling share prices and fearful lenders send troubled
companies into ever-deeper holes. This weekend, such a realization
led John Thain to sell the century-old Merrill Lynch &
Co. to Bank of America Corp. Each episode seems to bring intervention
by the government that is more extensive and expensive than
the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast.
"I think it's going to last a lot longer than perhaps
we would have anticipated," Anne Mulcahy, chief executive
of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the
Great Depression. There is no question about it," said
Mark Gertler, a New York University economist who worked with
fellow academic Ben Bernanke, now the Federal Reserve chairman,
to explain how financial turmoil can infect the overall economy.
"But at the same time we have the policy mechanisms in
place fighting it, which is something we didn't have during
the Great Depression."
The U.S. financial system resembles a patient in intensive
care. The body is trying to fight off a disease that is spreading,
and as it does so, the body convulses, settles for a time
and then convulses again. The illness seems to be overwhelming
the self-healing tendencies of markets. The doctors in charge
are resorting to ever-more invasive treatment, and are now
experimenting with remedies that have never before been applied.
Fed Chairman Bernanke and Treasury Secretary Henry Paulson,
walking into a hastily arranged meeting with congressional
leaders Tuesday night to brief them on the government's unprecedented
rescue of AIG, looked like exhausted surgeons delivering grim
news to the family.
Fed and Treasury officials have identified the disease. It's
called deleveraging, or the unwinding of debt. During the
credit boom, financial institutions and American households
took on too much debt. Between 2002 and 2006, household borrowing
grew at an average annual rate of 11%, far outpacing overall
economic growth. Borrowing by financial institutions grew
by a 10% annualized rate. Now many of those borrowers can't
pay back the loans, a problem that is exacerbated by the collapse
in housing prices. They need to reduce their dependence on
borrowed money, a painful and drawn-out process that can choke
off credit and economic growth.
At least three things need to happen to bring the deleveraging
process to an end, and they're hard to do at once. Financial
institutions and others need to fess up to their mistakes
by selling or writing down the value of distressed assets
they bought with borrowed money. They need to pay off debt.
Finally, they need to rebuild their capital cushions, which
have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there
are few if any buyers. Deleveraging also feeds on itself in
a way that can create a downward spiral: Trying to sell assets
pushes down the assets' prices, which makes them harder to
sell and leads firms to try to sell more assets. That, in
turn, suppresses these firms' share prices and makes it harder
for them to sell new shares to raise capital. Mr. Bernanke,
as an academic, dubbed this self-feeding loop a "financial
"Many of the CEO types weren't willing...to take these
losses, and say, 'I accept the fact that I'm selling these
way below fundamental value,'" says Anil Kashyap, a University
of Chicago Business School economics professor. "The
ones that had the biggest exposure, they've all died."
Deleveraging started with securities tied to subprime mortgages,
where defaults started rising rapidly in 2006. But the deleveraging
process has now spread well beyond, to commercial real estate
and auto loans to the short-term commitments on which investment
banks rely to fund themselves. In the first quarter, financial-sector
borrowing slowed to a 5.1% growth rate, about half of the
average from 2002 to 2007. Household borrowing has slowed
even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates
that in the past year, financial institutions around the world
have already written down $408 billion worth of assets and
raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial
firms and investors suggest that they've written assets down
enough and raised enough new capital, a new wave of selling
triggers a reevaluation, propelling the crisis into new territory.
Residential mortgage losses alone could hit $636 billion by
2012, Goldman estimates, triggering widespread retrenchment
in bank lending. That could shave 1.8 percentage points a
year off economic growth in 2008 and 2009 -- the equivalent
of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen
before," said Robert Glauber, now a professor of Harvard's
government and law schools who came to the Washington in 1989
to help organize the savings and loan cleanup of the early
1990s. "The S&L losses to the government were small
compared to this."
Hedge funds could be among the next problem areas. Many rely
on borrowed money to amplify their returns. With banks under
pressure, many hedge funds are less able to borrow this money
now, pressuring returns. Meanwhile, there are growing indications
that fewer investors are shifting into hedge funds while others
are pulling out. Fund investors are dealing with their own
problems: Many have taken out loans to make their investments
and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter
in the months ahead, forcing them to sell their investments,
further weighing on the market.
History of Trauma
Debt-driven financial traumas have a long history, from the
Great Depression to the S&L crisis to the Asian financial
crisis of the late 1990s. Neither economists nor policymakers
has easy solutions. Cutting interest rates and writing stimulus
checks to families can help -- and may have prevented or delayed
a deep recession. But, at least in this instance, they don't
In such circumstances, governments almost invariably experiment
with solutions with varying degrees of success. Franklin Delano
Roosevelt unleashed an alphabet soup of new agencies and a
host of new regulations in the aftermath of the market crash
of 1929. In the 1990s, Japan embarked on a decade of often-wasteful
government spending to counter the aftereffects of a bursting
bubble. President George H.W. Bush and Congress created the
Resolution Trust Corp. to take and sell the assets of failed
thrifts. Hong Kong's free-market government went on a massive
stock-buying spree in 1998, buying up shares of every company
listed in the benchmark Hang Seng index. It ended up packaging
them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU
economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America
Corp. last weekend was an example of the perniciousness and
unpredictability of deleveraging. In the past year, Merrill
has hired a new chief executive, written off $41.4 billion
in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more
it was forced to write off. When Merrill CEO John Thain attended
a meeting with the New York Fed and other Wall Street executives
last week, he saw that Merrill was the next most vulnerable
brokerage firm. "We watched Bear and Lehman. We knew
we could be next," said one Merrill executive. Fearful
that its lenders would shut the firm off, he sold to Bank
This crisis is complicated by innovative financial instruments
that Wall Street created and distributed. They're making it
harder for officials and Wall Street executives to know where
the next set of risks is hiding and also contributing to the
crisis's spreading impact.
The latest trouble spot is an area called credit-default
swaps, which are private contracts that let firms trade bets
on whether a borrower is going to default. When a default
occurs, one party pays off the other. The value of the swaps
rise and fall as market reassesses the risk that a company
won't be able to honor its obligations. Firms use these instruments
both as insurance -- to hedge their exposures to risk -- and
to wager on the health of other companies. There are now credit-default
swaps on more than $62 trillion in debt, up from about $144
billion a decade ago.
One of the big new players in the swaps game was AIG, the
world's largest insurer and a major seller of credit-default
swaps to financial institutions and companies. When the credit
markets were booming, many firms bought these instruments
from AIG, believing the insurance giant's strong credit ratings
and large balance sheet could provide a shield against bond
and loan defaults. AIG believed the risk of default was low
on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps
on more than $446 billion in credit assets, including mortgage
securities, corporate loans and complex structured products.
Last year, when rising subprime-mortgage delinquencies damaged
the value of many securities AIG had insured, the firm was
forced to book large write-downs on its derivative positions.
That spooked investors, who reacted by dumping its shares,
making it harder for AIG to raise the capital it increasingly
Credit default swaps "didn't cause the problem, but
they certainly exacerbated the financial crisis," says
Leslie Rahl, president of Capital Market Risk Advisors, a
consulting firm in New York. The sheer volumes of outstanding
CDS contracts -- and the fact that they trade directly between
institutions, without centralized clearing -- intertwined
the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times
without massive government intervention. Increasingly, officials
are coming to the conclusion that even more might be needed.
A big problem: The Fed can and has provided short-term money
to sound, but struggling, institutions that are out of favor.
It can, and has, reduced the interest rates it influences
to attempt to reduce borrowing costs through the economy and
encourage investment and spending.
But it is ill-equipped to provide the capital that financial
institutions now desperately need to shore up their finances
and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise
money on their own. In the current crisis, a number of big
Wall Street firms, including Citigroup, have turned to sovereign
wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing
expectation that U.S. taxpayers will either take the bad assets
off the hands of financial institutions so they can raise
capital, or put taxpayer capital into the companies, as the
Treasury has agreed to do with mortgage giants Fannie Mae
and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts
Democrat who chairs the House Financial Services Committee.
Rep. Frank is looking at whether to create an analog to the
Resolution Trust Corp., which took assets from failed banks
and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there
are only three people that can take the loss -- the bondholders,
the shareholders and the government," said William Seidman,
who led the RTC from 1989 to 1991. "That's the dance
we're seeing right now. Are we going to shove this loss into
the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any
analog today would be even more complex. The RTC dispensed
mostly of commercial real estate. Today's troubled assets
are complex debt securities -- many of which include pieces
of other instruments, which in turn include pieces of others,
many steps removed from the actual mortgages or consumer loans
on which they are based. Unraveling these strands will be
tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their
rules didn't fit the rapidly changing financial system they
were asked to oversee. Investment banks, at the core of the
crisis, weren't as closely monitored by the Securities and
Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created
after the Great Depression in part to avoid sudden runs by
depositors. Now, runs happen in spheres regulators may not
fully understand, such as the repurchase agreement, or repo,
market, in which investment banks fund their day-to-day operations.
And regulators have no process for handling the failure of
an investment bank like Lehman Brothers Holdings Inc. Insurers
like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail
in the coming months. The Federal Deposit Insurance Corp.
is drawing up a plan to raise the premiums it charges banks
so that it can rebuild the fund it uses to back deposits.
Examiners are tightening their leash on banks across the country.
One pleasant mystery is why the crisis hasn't hit the economy
harder -- at least so far. "This financial crisis hasn't
yet translated into fewer...companies starting up, less research
and development, less marketing," Ivan Seidenberg, chief
executive of Verizon Communications, said Wednesday. "We
haven't seen that yet. I'm sure every company is keeping their
eyes on it."
At 6.1%, the unemployment rate remains well below the peak
of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively.
The Fed's classic mistake that led to the Great Depression
was that it tightened monetary policy when it should have
eased. Mr. Bernanke didn't repeat that error. And Congress
moved more swiftly to approve fiscal stimulus than most Washington
veterans thought possible.
In part, the broader economy has held mostly steady because
exports have been so strong at just the right moment, a reminder
of the global economy's importance to the U.S. And in part,
it's because the U.S. economy is demonstrating impressive
resilience, as information technology allows executives to
react more quickly to emerging problems and -- to the discomfort
of workers -- companies are quicker to adjust wages, hiring
and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread
to Main Street, as credit tightens for consumers and business.
Already, U.S. auto makers have been forced to tighten the
terms on their leasing programs, or abandon writing leases
themselves altogether, because of problems in their finance
units. Goldman Sachs economists' optimistic scenario is a
couple years of mild recession or painfully slow economy growth.