Wall Street's Day of Reckoning

Fear, panic, and uncertainty pervade the world of finance.

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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!