Credit Crunch: Part Deux
This time, it's squeezing not only Wall Street but Main Street. Will it trigger a recession?
As any smart investor will tell you, what looks like bad news is often good news in disguise. And that certainly seemed to be the case in March when investment bank Bear Stearns became the highest-profile victim of the credit crisis. Liquidity problems at the 85-year-old firm led the Federal Reserve to orchestrate an emergency loan and broker a merger with JPMorgan to prevent a financial catastrophe. But rather than seeing the unprecedented intervention as a sign that the banking system was dangerously fragile, Wall Street cheered and markets rallied. It was clear to the pros that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson would do whatever it took to prevent a financial meltdown. In April, with Uncle Sam on the case, JPMorgan Chase CEO Jamie Dimon said the credit crisis was now "maybe 75 percent to 80 percent" done. And Goldman Sachs CEO Lloyd Blankfein told investors that "we're closer to the end than the beginning."
Spreading concern. The economy's crankshafts can't turn without credit. Just ask former employees of Bear Stearns, which imploded in a matter of days after clients fled and funding dried up. Since then, credit has become even more elusive. Bond investors pushed the difference, or spread, between the yields of ultrasafe 10-year treasury notes and those of high-yield - or junk - bonds to more than 8 percentage points in late August. That's up sharply from an average spread over the past five years of 4.5 percentage points; it's even wider than spreads reached right after the Bear Stearns collapse. With companies that issue investment-grade debt facing similar headaches, firms of all sorts will be paying more for financing through the end of the year at least, says Diane Vazza of Standard & Poor's. At the same time, spreads between 10-year treasuries and 30-year fixed mortgage rates have returned to mid-March levels - the widest they've been since 1986. That means that, even with the Fed slashing its benchmark interest rate 3.25 percentage points since last summer, mortgage rates remain largely unchanged.
The big problem today is the same one that first seized up markets back in August 2007. The collapse of the housing bubble unleashed a flood of home foreclosures and defaults on subprime loans, which made investors unwilling to buy complex securities backed by mortgages. From there, problems spread far and wide, saddling banks with painful losses, cutting local governments' tax revenues, and forcing consumers to pay more for home loans. Mortgage giants Fannie Mae and Freddie Mac are the most recent victims of the turmoil, and concerns about their financial well-being have been a leading force behind the recent credit tightening, says Kim Rupert of Action Economics.
And despite the interest rate cuts and the Fed's liquidity measures, the credit contagion looks to many as if it has further to run. "There is increasing concern about what's the next shoe to drop," says Stephen Stanley, chief economist at RBS Greenwich Capital.
Failing banks. Indeed, the nation's credit problems seem to have moved off Broadway and out to the rest of the nation via regional and small banks. Federal regulators expect a growing number of small banks - especially those heavily concentrated in real estate lending - to go under in the coming months. The entire industry has reported higher loan delinquencies on everything from business to credit-card loans. The Federal Deposit Insurance Corp., which guarantees accounts at the nation's 8,500 banks, increased the number of "problem" banks to 117 in the second quarter, up from 90 in the first quarter. And the agency has even suggested that it may need the Treasury Department to lend it money to cover the costs of failures. Ten banks have failed so far this year, compared with three last year and none in 2006 or 2005.
Just how many banks will fail? Stanley Tate, the former chairman of the National Advisory Board of the Resolution Trust Corp., which liquidated the assets of failed savings and loans beginning in the 1980s, calls the banking industry's current problems "substantially more significant" than those he faced during the S&L crisis. The turmoil could take out as many as 2,000 banks, either through mergers or outright failures, he says. But few expect the tally to get nearly that high. Dick Bove, a bank analyst at Landenburg Thalmann, argues that the industry, while troubled, still has sound levels of capital, reserves, deposits, and cash flow. He expects 100 to 150 small banks to go under.
It's the failure of a large bank that has the potential to really upend the financial system. Kenneth Rogoff, former chief economist at the International Monetary Fund, rattled markets in mid-August by suggesting that such an event could occur within months. Large banks and brokerages certainly face head winds. Goldman Sachs recently cut its earnings estimates for Lehman Brothers, Morgan Stanley, JPMorgan, Merrill Lynch, and Citigroup, saying that the pace of mortgage asset deterioration hasn't slowed.
But because big banks are so intertwined with the rest of the financial system, the government will not allow one to go under, says Bill Gross, chief investment officer at Pacific Investment Management. "The Bear Stearns situation proves that, at least at the moment, the big banks are too big to fail," he says. But a large regional bank might be allowed to go under, Gross adds. Weiss Research recently released a report that measured bank soundness by taking into account capitalization, asset quality, profitability, liquidity, and stability. It listed National City, Sovereign Bank, and Washington Mutual among the weakest. But that doesn't mean failure is imminent, cautions analyst Mike Larson of Weiss Research. Spokespersons for both National City and Sovereign say the banks have recently raised capital and are on solid footing. A Washington Mutual spokesman declined to comment.
Meanwhile, Fannie and Freddie are fighting for their lives. The companies, which Congress chartered to stabilize the mortgage market, buy home loans from lenders. They hold some of these mortgages in their portfolio and package others into securities for sale to investors. Fannie and Freddie became even more essential to the mortgage market as private-sector buyers vanished during the housing crisis. But with defaults increasing, Fannie and Freddie have been slammed with roughly $14 billion of combined losses over the past year. Paul Miller, an analyst at FBRCapital Markets, says each needs as much as $15 billion in fresh capital to weather the storm. With their stock prices plummeting - down more than 80 percent on the year - it's increasingly unlikely that private investors will pony up that kind of cash. And as bond investors demand higher yields on their debt, more and more economists and investors believe Treasury Secretary Paulson will have to deploy his recently acquired authority to bail out Fannie and Freddie. "The game is over," billionaire investor Warren Buffett told CNBC last month. If bond investors keep buying their debt, Fannie and Freddie might be able to avoid government intervention. But that's looking doubtful. With demand for its debt waning among Asian investors, Fannie was forced last month to pay a record-high interest rate to attract buyers.
Recession? Damage to individual firms is painful enough, but the credit crisis's potential to hammer the broader economy is even more unnerving. "It's the biggest concern that we have right now," says Mark Vitner, senior economist at Wachovia. "If we have a recession, it will likely result from the credit crunch." The impact of the squeeze already can be seen in consumer spending, which represents more than two thirds of the U.S. economy. With bad loans piling up, 80 percent of domestic banks said they had tightened lending standards for home-equity lines of credit between April and July, according to a Fed survey. Sixty-five percent of banks reported doing so for credit-card loans. Less abundant credit - coupled with higher-priced food and fuel - helped drive down consumer spending growth to 0.2 percent in July, from 0.6 percent in June. David Ressler, chief economist at Nomura Securities, expects consumer spending growth to turn negative in the third quarter for the first time in 17 years.
Meanwhile, higher mortgage rates - now roughly a full percentage point above where they would be if credit markets were functioning normally - make home buying more expensive even as prices drop. That could force house prices even lower and prolong the worst housing slump since the Great Depression. And although business spending has held up so far, Ressler expects tighter credit and lower profits to weaken it in the second half of this year. What's more, these developments come as export growth - the one bright spot in the U.S. economy - appears likely to fade as overseas markets cool off.
So what can be done to revive the credit markets? Stabilizing Fannie and Freddie could be a good first step. Treasury intervention could take a number of forms, such as lending them cash or injecting capital. Armando Falcon, Fannie and Freddie's former top regulator, argues for a government takeover that would wipe out shareholders, bring in a new management team, and, he says, imbue the housing market with needed stability. "You remove the uncertainty of what's going to happen with these two companies, and you've...begun to lower interest rates on mortgages," Falcon says. Once they are nursed back to health, he says, Fannie and Freddie should be turned into small government agencies that support affordable housing, thereby allowing a competitive, private mortgage market to develop.
Democratic presidential nominee Barack Obama has said the government can't allow Fannie and Freddie to fail and needs to decide if the companies should be taken out of "the profit-making business." Republican nominee John McCain backs supporting Fannie and Freddie for now, but he says that as president he would shrink them and eliminate their ties to the government. The time is right for radical restructuring, says James Wilcox, a professor of financial institutions at the University of California-Berkeley. "The typical pattern in American financial regulations is that you get major structural reforms - some good, some bad - in times of crisis," Wilcox says. Indeed, Fannie Mae itself was created during the Great Depression.
As a second step, banks need to find a way to get those esoteric, mortgage-backed assets off their books once and for all. These securities have been at the core of the credit crisis from the start, as uncertainty about their value has repeatedly overwhelmed the Fed's efforts to get credit flowing normally. A bottom in housing prices would help a great deal in determining their value, but many analysts don't see that happening until well into next year, if then. Meantime, former Fed Vice Chairman Alan Blinder argues that the government should create a federal entity - modeled on the Resolution Trust Corp. - to purchase the debt from banks and resell it to private investors once demand returns. That would free up banks' balance sheets and promote confidence in the credit markets. However, Blinder believes that the political will for such a program doesn't yet exist - and that only more severe economic fallout from the credit crisis can generate it. "There are 535 people that need to get more scared," Blinder says, referring to members of Congress.
The folks on Wall Street, of course, are already plenty scared. And if timid lenders choke off credit further, it might not be long before this economic fear grips Washington too.