Buckle up! The financial ride is getting even rougher

Instead of being held by lenders, loans were bundled together, sliced and diced into securities, then sold to investors, who were attracted to the promise of high returns.

By JERUSALEM POST STAFF
stock market good 88 248 (photo credit: )
stock market good 88 248
(photo credit: )
It started as a panic attack, soothed by assurances that the problem was limited to a relatively small number of reckless home loans. Now it's clear the crisis was anything but contained - and that the US financial system is dangerously close to the edge. It may well pull back. But as policy makers try to guide the economy across a very frayed tightrope, it is growing increasingly difficult to know whether the worst is behind us, or if problems could spin further out of control and inflict more serious damage. "The entire world economy is being held hostage to the welfare of the financial community because we're talking about an industry that provides credit, which is the lifeblood of business and consumer spending," said Bernard Baumohl, chief global economist for The Economic Outlook Group in Princeton, New Jersey. It has been generations since the economy teetered this close to falling into a depression. Could the massive failed bets made by Wall Street and the desperate efforts to stem the damage sentence the economy to years of stagnation, or worse? Policy makers and economists have a much better understanding of how the financial system works now than they did during the Great Depression, where it's widely agreed that much of the damage came because of a failure to act. The lessons learned from the past go a long way to protecting the economy against present dangers. But they don't eliminate them. "This is the biggest risk we've had in a long, long time," said Joel Naroff, of Naroff Economic Advisors in Holland, Pennsylvania. Already one of Wall Street's most storied investment firms, Bear Stearns, has vanished into the abyss. Another, Lehman Brothers, collapsed into bankruptcy early Monday. A third, Merrill Lynch, agreed to be sold in a bid to avoid the same scenario. The Bush administration, which had vowed to let the free market punish risk takers, reversed course when it came to the nation's two largest home-finance companies and stepped in to take over. Meanwhile, dark clouds loom over some of the financial world's most well-known companies, including insurer AIG Inc. and Washington Mutual Inc., both scrambling for a lifeline. "We're definitely living through a moment of history," said Peter Temin, an economic historian at the Massachusetts Institute of Technology. THE CRISIS gripping Wall Street can seem remote from what's happening on Main Street. But the connections are unquestionable. Many home owners are watching the values of their houses plummet while the flexibility they once had to borrow and buy on credit is being yanked away. Comparisons to past crises are not easy. The economy has proven surprisingly resilient despite a crisis that is wildly abstract, widespread and as unpredictable as a game of Whack-a-Mole. It doles out punishment on its own terms and forces policy makers and consumers to invent responses on the fly. "I call the economy right now the Humpty-Dumpty economy," said Eugenio Aleman, senior economist with Wells Fargo & Co. If federal policy makers don't act fast enough, the economy could take a plunge - in the worst-case scenario, falling into a depression. If they continue to shovel money into the financial system, the economy could fall the other way, into an extended period of sharply rising prices and little growth, Aleman said. "So the Federal Reserve is trying to make Humpty-Dumpty walk a line on top of that wall, which is a very tough equilibrium," he said. Will policy makers succeed and keep economic catastrophe at bay? "At the moment, we seem to be ahead of it, but only barely ahead of it," Temin said. THE DEFINING moment of American economic history over the past century was the Great Depression. Ever since, economists and policy makers have studied those events for lessons. If anyone understands that history it is Ben Bernanke, the Federal Reserve chairman and an expert on the conditions and policy decisions that shaped the Great Depression. "Regarding the Great Depression," Bernanke, then a Federal Reserve governor, joked in a speech he delivered in 2002, "you're right, we did it. We're very sorry. But... we won't do it again." The current crisis is putting the resolve of Bernanke and other policy makers to the test. The sharp rise in foreclosures is the payback for nearly a decade of very loose lending. The problems, though, were greatly multiplied by what happened to those loans and many others. Instead of being held by lenders, loans were bundled together, sliced and diced into securities, then sold to investors, who were attracted to the promise of high returns. When housing prices began to fall, the first loans to go sour were subprime mortgages, made to buyers with shoddy credit or uncertain income. Then the problems spread to other home loans and to some types of consumer and commercial loans. But because so many of the loans had been repackaged and resold to investors both in the US and overseas, it was nearly impossible to tell who was left holding the bag. Financial companies were apparently blind to the risks. As the value of their investments in real estate and mortgage-backed securities have fallen sharply, Wall Street has scrambled to unwind those positions. But the big companies have struggled to keep up. "We are witnessing what I think is the final cathartic rehabilitation of the financial industry," Baumohl said. "It is violent, and this is something everyone feared but many expected would come, and I think it is the results of years of excessive risk-taking, cheap credit, a sense of invincibility among lenders and a real disdain for moral hazard." BUT TO what extent will ordinary consumers and businesses on Main Street be forced to pay the price? The economy reflects millions of ordinary decisions to buy and sell, all reliant on the credit provided by the financial system that is seizing up. People can put off or cancel optional purchases, but the freeze-up of the system is now squeezing their ability to make the most necessary decisions, such as taking out a student loan or buying a house. "That is why the economy is feeling the pain," said David Kotok, chairman and chief investment officer at Cumberland Advisors, an investment management firm in Vineland, New Jersey. During the savings and loan crisis of the early 1990s, the damage, while enormous, was somewhat contained. The federal government stepped in, took hold of the distressed assets and sold them. Assessing the damage is more complicated this time. "The problem now is we don't know where all the losses are," said Gus Faucher, director of macroeconomics at Moody's Economy.com. "We don't know where the risk is." Faucher's company estimates the current crisis will cost banks and other investors about $1 trillion. But up to now, they've accounted for only half that amount. Uncertainty about who holds the rest has frozen up much of the financial system. When home owners stopped making payments, the first casualties were mortgage lenders, pressed by investors to back up the loans. Last spring, the market was rocked by the demise of Bear Stearns, which had invested heavily in subprime securities. Federal officials, judging that the firm was too big to fail, engineered a takeover by J.P. Morgan Chase & Co. In recent weeks, the government was forced to act again, taking over Fannie Mae and Freddie Mac, the nation's two largest mortgage-finance companies. Lehman Bros. was gasping for life. But Treasury Secretary Henry Paulson declined to repeat the historic measures undertaken with Bear Stearns. Early Monday, Lehman filed for bankruptcy protection. Hours earlier, Merrill Lynch, working frenetically to avoid a similar fate, agreed to sell itself to Bank of America. WILL POLICY makers take the right actions quickly enough to keep an economic catastrophe at bay? In the best-case scenario, the drop in home prices would begin to slow in coming months and then stabilize. Builders are doing so little new construction that demand for homes could start catching up to supply. The lower home prices and the lower interest rates could send buyers back into the market, gradually easing investors' fears. Faucher's firm expects average home prices nationwide to drop 24 percent from their peak by next spring before leveling off, with values in states such as California, Florida, Arizona and Nevada dropping much more. Meanwhile, companies are likely to keep cutting jobs, driving up the nation's unemployment rate, experts say. Baumohl, who earlier had expected the economy to show signs of a turnaround next year, now says the recovery will probably not come until 2010. But the government's response could come at a price. The Federal Reserve has funneled so much money to shore up banks that it could lead to higher inflation and a drop in the value of the dollar, which could cut Americans' power to buy imported oil and other products. Still, if policy makers don't act, the potential is there for something far worse.