A New Direction on Wall Street

Panic and uncertainty have sent markets reeling.

If housing is the core problem, when do home prices turn around?

The housing bottom seems to be perpetually just around the corner. Current economic consensus is for the U.S. housing market to finally bottom in mid to late 2009 with price increases coming a year after that. Mark Zandi, chief economist at Moody's Economy.com, guesstimates home prices still have another 5 to 10 percent to fall from current levels. But even after leveling off, home values won't actually begin increasing until the fall of 2010, Zandi says. "We need to get rid of all the excess inventory before prices start rising."

Healthy housing markets have a five to six month supply of unsold homes. The current level in the United States is 11.2 months. But "if [employment] weakens more than I expect—which is very, very possible—then the bottom in prices is further into the future and the day when they start to rise is well into the next decade," Zandi adds.

Is a bigger bailout coming, or is this it?

For all of the government's rescues so far—and there may be more—what's missing is an organized framework for dealing with the crisis. The best precedent for a federal bailout agency is the Resolution Trust Corp., which the government established in 1989 to deal with hundreds of insolvent thrifts that weren't covered by FDIC insurance. The RTC was generally successful: It assumed the powers of a ganglion of predecessor agencies and eventually helped dispose of more than 1,000 troubled thrifts while protecting most of the depositors.

An RTC-like agency that would buy bad debt or even entire institutions may make sense today, by bringing order to what seems like an ad hoc rescue. "It's ironic to say that AIG is too big or too interconnected to fail but then approve Bank of America's acquisition of Merrill Lynch," says Barth of the Milken Institute. "Doesn't that make Bank of America even bigger and more interconnected?" With its hands full, the Bush administration is likely to defer such thorny questions to the next president, though there is plenty of talk now in Congress about just such a plan.

Will the financial mess cause a severe recession . . . or worse?

Bold bailout moves by the Treasury and Federal Reserve may help stop the slide, but don't expect a quick return to normal economic conditions. "It's preventing a broader collapse but doesn't necessarily mean we'll turn around and start growing like mad because all our problems are over. It just prevents a much broader downturn," said Scott Brown, chief economist with Raymond James.

Despite surprisingly robust economic growth of 3.3 percent during the second quarter and help from lower energy prices in the third—which frees up spending money for consumers—economists were already anticipating growth would slow through the end of the year. Job losses, the defining figure in any economic slump, are worsening. In September, the jobless rate jumped to 6.1 percent from 4.7 percent a year ago. The economy has shed more than 600,000 jobs in the past eight months. At the same time, corporate profits are still under pressure, and the factory sector is struggling. Faster economic growth makes the crisis less severe, but right now that seems as unlikely as getting a subprime loan.

What will Wall Street look like a year from now?

Investors spooked by the financial sector in general have been dumping shares of Wall Street's last two big investment banks, Morgan Stanley and Goldman Sachs. But unlike their now defunct competitors, Morgan and Goldman are both still profitable, with some cash to ride out tough times. "I think we've seen the worst institutional failures we're likely to see," says David Beim of Columbia Business School.

But the shakeout of the securities industry is likely to continue. Since the repeal of the Depression-era Glass-Steagall Act in 1999, investment banks that cater to corporations and wealthy investors have been merging with commercial banks that take deposits from ordinary consumers, and that's likely to continue. The Bank of America—Merrill Lynch deal may prove to be a tipping point, and both Morgan and Goldman may end up in the arms of a bank—or vice versa. Such a linkup gives the investment bank access to the vast reserves provided by depositors, and—theoretically—makes the overall enterprise more stable, since there's more cash available to back up investments that Wall Street has been accustomed to financing with debt.