Wall Street's Day of Reckoning

Fear, panic, and uncertainty pervade the world of finance. It's not 1929. We don't have speculators jumping from windows, but we see some great financial companies going splat—AIG, Lehman Brothers, Countrywide, Bear Stearns, Merrill Lynch—and most spectacularly and most disgracefully, Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) with a portfolio of $5.5 trillion. What happened to make the heavens fall in?

In the '20s, conventional banks took deposits and made them work to drive the economy; the rule was they could lend 9 dollars for every dollar deposit. The process is called leverage—the one dollar levers nine. It was simple enough, except in panics, when every depositor wanted his money back at the same time and it wasn't there; the money was out working, so thousands of banks went belly up and the Depression deepened.

What's new and scary is that the principal role in channeling funds from savers to borrowers now comes from nondepository institutions such as investment banks, hedge funds, and private equity funds. They invented new ways to slice and dice loans, packaging them as securities that could be sold to investors the world over. But who knew what they were really buying? The securitizers financed assets with a growing volume of credit and with ever higher leverage. In short, the new but opaque pyramids of structured securities enabled the new institutions to lend more against less.

The world was awash not with cash but with credit. The global issuance of credit instruments went from $250 billion to $3 trillion a year. Many of these securities were rated, but last year, the agencies started downgrading billions of dollars of debt they had once deemed safe. Prices tumbled as investors stopped trusting the ratings and stopped buying complex instruments. Financial institutions began to hoard cash and cut back on loans even to other banks. Witness the sharp rise in the London Interbank offered rate—the main measure of banks lending to one another.

Bad timing. The funding crisis meant financial firms were no longer able to turn assets such as subprime mortgages into securities and sell them. These markets became illiquid, forcing securitizers to turn to their banks for help. But that squeezed the balance sheets of the banks at the very moment when banks were facing their own losses on debt securities.

Decisions have been frozen, as no one knows whom to trust. Bank credit has fallen at the fastest rates since the Federal Reserve began collecting weekly figures, as have total bank deposits and money-supply numbers. Issues of collateral debt obligations fell 94 percent between the first quarter of 2007 and the first quarter of 2008. This credit liquidation will continue for a lot longer than most people think, regardless of what the authorities do.

The investment banks, hedge funds, and private equity funds that took on the most risks are the ones facing the possibility of going under. This is exacerbated by the evaporation of trust. The word "credit" derives from the Latin crederi, which means to believe. People stopped believing both in the borrowers and in the new credit instruments. Too many of the investors had no idea of the risks they were exposed to, so now we have a postmodern version of a run on the banks. In the old days, the depositors lined up outside the closed bank doors; today, the money leaves these financial institutions through electronic transmissions. Cash is withdrawn, credit lines are pulled, counterparty risks are unwound, and the result is a freeze up of credit and a downward spiral of asset values, which paralleled what happened during the great bank runs of the 1930s.

The Feds are doing their best, orchestrating a series of ad hoc plans to restore credit in these nondepository institutions. The Feds are right to keep the financial plumbing lubricated by providing liquidity for different kinds of assets, for longer periods of time and to more borrowers, secured not just by fixed income securities but also by equities. But this provision of more aid to more borrowers than ever before is an unprecedented expansion of the role of the Feds.

These steps may have saved the system to date but have barely improved financial conditions since the abrupt takeover of Bear Stearns by JPMorgan Chase in the spring. Now, there is fear of what economists call an adverse feedback loop. Deleveraging puts downward pressures on the prices of securities, which in turn forces financial institutions to deleverage more. The same thing happens when home prices fall and households are forced to cut back their spending or walk away from their home mortgages.

The speculation did not just begin yesterday. It began with the technology stocks in the 1990s, turned to real estate, commodities, and private equity buyouts in this past decade, and then took over many other financial markets. Now, a significant fraction of the speculative loans that banks made during the boom years are underwater, and the risk of these losses will overwhelm banks that have limited capital to absorb them.

Investors including sovereign-wealth funds have put billions into Citigroup, Merrill , Lehman, and others, only to suffer mammoth losses on these investments, which in turn is causing them to balk at any future flow of equity capital. This raises the prospect that other banks, especially regional and community banks, might fail.

We are into the second year of this credit crisis, triggered by the subprime mortgage disaster. Why hasn't the healing begun? The answer lies in the way leverage works. Banks are not only providing loans to customers, they also use leverage themselves. When they make profits, they borrow more money to make more loans and book still more profits. But for every dollar of bank wealth that they lose, government-regulated commercial banks must eliminate $10 of lending, and for investment banks, the figure may be as high as $30. If the total losses across the credit markets exceed $1 trillion—and some think they will go to $2 trillion—then you have to put on a leverage multiplier of 10 or 15. This kind of gigantic number of more than $10 trillion poses a systemic risk that could drag many financial institutions down and take years to work through the system.

The problem is the financial markets and firms are interconnected with increasingly complicated securities such as credit default swaps and money market instruments such as repos. The failure of one firm can send ripple effects through the whole system, but the market and regulators have limited experience in how to handle such a crisis.

Credit drought. Today, the challenge is to build a new sense of trust in finance, as well as to rebuild equity. That makes it hard to predict when the credit crunch will end and how big the losses may be. This crunch is much more serious than in 1987, when the crash was confined to the equity markets and over within a few weeks. This one has greater scope to harm the real economy: Without credit, business dries up.

Lower economic growth in turn makes things worse in the financial markets. It is affecting not only housing but autos, credit cards, commercial mortgages, commercial and industrial activities, and the leveraged buyout loan markets. Without credit, the domestic private economy cannot generate profits, and without solid profits the health of lenders and the availability of credit will deteriorate even further.

The fear stalking the financial world is a counterpoint to the downright greed that produced it. The corporate leadership of Fannie and Freddie clearly inflated the value of their equity base by treating possible tax credits as assets, by extending delinquent loans from 90 days to two years so they wouldn't have to write down tens of thousands of them, and by refusing to mark some of their paper to market but keeping it at par value. They did this to avoid falling below the financial regulatory requirements they should have met. The result was to dramatically expand the exposure of the taxpayers to their losses. Management took on excessive and unnecessary risks because it focused on profits and bonuses and failed to protect adequately against potential mortgage defaults. How else to explain they had $65 of debt for every dollar of equity? How else to justify taking on $600 billion in subprime mortgages, or in securities backed by those mortgages, over the past half dozen years? These included many 100 percent mortgages to borrowers whose incomes were insufficient to cover the debt payments. Meantime Fannie and Freddie were dispensing vast rewards to their private management along the way. Outrageous!

The investment bankers took ungodly and unnecessary risks and then really did not speak openly about them or address them soon enough in order to avoid the collapse of some of the firms. This was the case of Lehman Brothers and its real estate holdings. As Woody Brock of Strategic Economic Decisions points out, mismanagement, along with "greed, perverse incentives, poor risk assessment . . . are deeply rooted in human nature and thus cannot be changed." But too much leverage, which amplifies those human failings like ignorance and bad judgment, can certainly be reformed and regulated.

What is to be done?

Both presidential candidates recognize that in the post-securitization world that has emerged in the past decade, a new system of regulation is inescapable. First, it will have to limit mortgages to viable buyers, and it will require imposing maximum loan-to-value mortgage ratios. Secondly, we will have to change our monetary policy framework to take explicit account of asset prices whose escalation was what blew up the bubble and finally burst it. Thirdly, a whole system of regulation (including limits on leverage) will have to apply to the investment banking, hedge fund, and private equity world: When firms directly or indirectly have to rely on the federal government to bail them out, they invite something similar to the Federal Reserve policy that was put into place in the 1930s toregulate banks and avoid systemic risk. In the short run some new federal agency may have to buy at a discount illiquid assets in order to enable private financing to resume.

The world of finance will never escape the existence of fear and greed. The appropriate degree of regulation will clearly be needed to prevent the kind of excesses that have now put at risk the entire economy.