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.