Wednesday, September 17, 2008

WSJ: Worst Crisis Since the Depression

From the WSJ:

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.

For the longest time there were all sorts of juicy rationalizations going on. It was contained to subprime; most people were paying their mortgages so everything was OK, it was a few bad apples in the bunch, everything outside of the financial sector was doing well. There were many more. But the problem -- as correctly seen primarily by the blogs -- was simple: the US went on a debt acquisition spree the likes of which we haven't seen for a really long time. But all of that debt has to go somewhere. As a result, everybody owns a little piece of this problem.

The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.

Who would have thought a year ago that the US would now basically be the biggest shareholder in AIG insurance? Or how about the massive bail-out of Freddie and Fannie? These are huge commitments of capital the likes of which we're just beginning to understand.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

That's exactly what the problem is -- way too much debt that no one ever had any intention of paying back. Enter all sorts of great loan documentation schemes like "stated income loans" and the like. "Just tell us what you really want to make in your wildest dreams and we'll base out loan to you on that." Well, now we know what it has gotten us.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

The first issue is huge because assets that were hard to value to begin with are trading an an illiquid market. That means the value is incredibly low -- if the owner can find a value at all. In other words -- this is the exact worst time to be trying too figure out what these instruments are worth.

Then remember that paying down debt takes money. Earnings are way down at financial institutions. The money they are getting for their assets is way low. So paying down debt is incredibly difficult.

And then there is rebuilding balance sheets. Who in their right minds would inject cash into any of these institutions? Their stock charts are all terrible and indicate traders are looking for bankruptcies across the board. The early round of infusions came last fall. Anyone else who puts money into one of these companies is going to ask for a ton of conditions.

Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.

But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.

"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."

Short version: this is going to take a lot longer than anyone wants to admit. Sometime over the last few weeks, Paul Krugman wrote he thought the next president will simply be going from financial crisis to financial crisis. I think that's about right.

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow

Wouldn't that just be wonderful -- a new set of problems with an entire financial sector that is far more opaque than any publicly traded sector. That will just be a joy -- I simply can't wait for that shoe to drop.

Here's the shortest version of all: this isn't over by a long shot. And it stands a decent possibility of getting worse.