Preventing a Panic

It is now clear that the assumptions underlying the pricing of CDOs and the like were based on over-optimistic computer-based evaluation models or on untested historical patterns—especially during periods of acute market distress. Computers can make fast, accurate mistakes: garbage in, garbage out. The rating agencies too often relied on the information provided by the companies issuing these new securities. Now it is clear that this was a blunder, even by the rating companies themselves, a top official at Moody's rating service acknowledged.

The net effect is that instead of transforming risks and disbursing them widely, the derivatives have turned out to be a liability. Banks have had to take back tens of billions of dollars of lending onto their balance sheets—bonds that are declining in value, either because the credit of the guarantor has declined or in response to market expectations of more defaults as equities continue to evaporate in home prices. Quite simply, a lot of smart people took a lot of foolish risks. The result has been a bursting of the credit bubble and a dramatic tightening of credit in the financial system.

Nobody runs faster than a sophisticated banker who gets scared. Banks are calling in loans or boosting the amount of collateral required to secure financing. Even interbank lending, the core of the financial system, was hobbled because banks had to preserve their liquidity and had lost confidence in the finances of other banks. So, today, the credit system has been virtually frozen. Lending across the economy is plummeting as banks undergo a huge deleveraging, with central banks almost powerless to control this contraction. This poses a grave risk to our financial system since few people even know where the liabilities and losses are concentrated, and they may not know until it is too late. Everybody fears more skeletons will be coming out of the banks' closets.

Fed limits. Lower interest rates promoted by the Federal Reserve Bank cannot fully counter the forces of credit and liquidity contraction created by these large losses, which in the case of banks may require them to reduce their loan portfolios by a multiple of 10 times those losses. Further, lenders are disinclined to lend when credit markets are in turmoil. Many companies, especially small and midsize companies, will now find it much harder to get the money they need to fuel their businesses as banks seek higher rates and more collateral. This freeze will not be corrected until the bad debts and losses work themselves through the financial system.

In other countries where a banking crisis was transmitted through to the economy, it took an average of at least two years for growth to return to normal trend lines, and sometimes even longer. It is hard to see how the U.S. economy will bounce back more quickly.

The crisis has prompted the president and the House of Representatives to agree to a package of stimulants. By no means will it be adequate to the hour. The depreciation allowances will help only at the margins since lack of demand is the issue, not lack of capacity. Businesses won't develop more capacity until they know their customers are capable of purchasing their products. The tax rebates won't have effect until the summer, and then are most likely to be used to pay off debt rather than be spent in the marketplace. Many older people, having lost substantial equity in their homes, and who will lose more as home values continue to shrink, will now begin to save out of income and thus reduce their consumer spending. The December unemployment rate hit 5 percent, the clearest harbinger of the future. Other labor market indicators are similarly negative, including initial and continuing job layoffs and the assessment of job availability. Now some 23 states are estimated to be in a recession, and seven more are verging on a recession.

Quite simply, this financial crisis is the worst since the panic that led to the Great Depression. As a result, the recession may well be deeper and/or longer than any since the end of WWII. No one knows where the bottom is. That is why the level of confidence in both consumers and producers has declined—and must be restored if the financial fiasco is not to turn into a crisis for the broader economy.