[Infowarrior] - A Category 4 Financial Storm

[Richard Forno]

Scrambling to Clean Up After A Category 4 Financial Storm

By Steven Pearlstein
Washington Post Staff Writer
Thursday, September 18, 2008; Page A01

http://www.washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091703834.html?hpid=topnews

You know you're in a heap of trouble when the lender of last resort  
suddenly runs out of money.

Having pumped $100 billion into the banking system and lent $115  
billion more to rescue Bear Stearns and AIG, the Federal Reserve was  
forced to ask the Treasury yesterday to borrow some extra money to  
replenish its coffers. If there was any good news in that, it was that  
investors here and abroad were eager to help out, having decided that  
the only safe place to put their money is in U.S. government  
securities. Indeed, demand was so brisk at one point yesterday that,  
for an investor, the effective yield on a three-month Treasury bill  
was driven below zero, once the broker's fee was figured in.

This is what a Category 4 financial crisis looks like. Giant blue-chip  
financial institutions swept away in a matter of days. Banks refusing  
to lend to other banks. Russia closing its stock market to stop the  
panicked selling. Gold soaring $70 in a single trading session.  
Developing countries' currencies in a free fall. Money-market funds  
warning they might not be able to return every dollar invested. Daily  
swings of three, four, five hundred points in the Dow Jones industrial  
average.

What we are witnessing may be the greatest destruction of financial  
wealth that the world has ever seen -- paper losses measured in the  
trillions of dollars. Corporate wealth. Oil wealth. Real estate  
wealth. Bank wealth. Private-equity wealth. Hedge fund wealth. Pension  
wealth. It's a painful reminder that, when you strip away all the  
complexity and trappings from the magnificent new global  
infrastructure, finance is still a confidence game -- and once the  
confidence goes, there's no telling when the selling will stop.
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But more than psychology is involved here. What is really going on, at  
the most fundamental level, is that the United States is in the  
process of being forced by its foreign creditors to begin living  
within its means.

That wasn't always the case. In fact, for most of the past decade,  
foreigners seemed only too willing to provide U.S. households,  
corporations and governments all the cheap money they wanted -- and  
Americans were only too happy to take them up on their offer.

The cheap money was used by households to buy houses, cars and college  
educations, along with more health care, extra vacations and all  
manner of consumer goods. Governments used the cheap money to pay for  
services and benefits that citizens were not willing to pay for with  
higher taxes. And corporations and investment vehicles -- hedge funds,  
private-equity funds and real estate investment trusts -- used the  
cheap financing to buy real estate and other companies.

Two important things happened as a result of the availability of all  
this cheap credit.

The first was that the price of residential and commercial real  
estate, corporate takeover targets and the stock of technology  
companies began to rise. The faster they rose, the more that investors  
were interested in buying, driving the prices even higher and creating  
even stronger demand. Before long, these markets could best be  
characterized as classic bubbles.

At the same time, many companies in many industries expanded  
operations to accommodate the increased demand from households that  
decided that they could save less and spend more. Airlines added  
planes and pilots. Retail chains expanded into new malls and markets.  
Auto companies increased production. Developers built more homes and  
shopping centers.

Suddenly, in early 2007, something important happened: Foreigners  
began to lose their appetite for financing much of this activity -- in  
particular, the non-government bonds used to finance subprime  
mortgages, auto loans, college loans and loans used to finance big  
corporate takeovers. What should have happened at that point was that  
the interest rate on those loans should have increased, demand for  
that kind of borrowing should have decreased, the price of real estate  
and corporate stocks should have leveled off, takeover activity should  
have slowed and companies should have begun to cut back on expansion.

Mostly, however, that didn't happen. Instead, the Wall Street banks  
that originally made these loans before selling them off in pieces  
decided to try to keep the good times rolling -- and, significantly,  
keep the lucrative underwriting fees pouring in. Some used their own  
"AAA" credit ratings to borrow more money and keep the loans on their  
own balance sheets or those of "structured investment vehicles" they  
created to hide these new liabilities from regulators and investors.  
Others went back to the foreigners and offered to insure those now- 
unwanted takeover loans and asset-backed securities against credit  
losses, through the miracle of a new kind of derivative contract known  
as the credit-default swap.

As a result, when the inevitable crash finally came, it wasn't only  
those unsuspecting foreigners who bought those leveraged loans and  
asset-backed securities who wound up taking the hit. It was also their  
creators -- Bear Stearns, Merrill Lynch, Citigroup, Lehman Brothers,  
AIG and others -- who made the mistake of doubling-down on their  
credit risk at the very moment they should have been cutting back.

We are now nearing the end of the rocky process of uncovering the full  
extent of the credit losses of the major Wall Street banks and hedge  
funds. But as Robert Dugger, an economist and partner in a leading  
hedge fund likes to points out, the markets have only just begun to  
force some financial discipline on the majority of U.S. households  
that relied on borrowed money to maintain their lifestyles.

With nobody willing to finance those lifestyles, there are really only  
two choices.

One is to turn to Uncle Sam to keep the economy and the financial  
system afloat. Unlike businesses, households and Wall Street firms,  
the Treasury can still borrow from foreign banks and investors at  
incredibly attractive rates. And by acting as an intermediary, the  
Treasury and the Federal Reserve have shown a newfound willingness to  
use those funds to keep the housing market and the financial system  
from totally collapsing.

Last spring, the government borrowed $165 billion to send tax rebates  
to households in an effort to boost consumer spending. Now, some  
Democrats want to create a new agency that would use money borrowed by  
the Treasury to recapitalize troubled financial institutions by buying  
some of their unwanted loans and securities at discounted prices. The  
same strategy was used successfully during the Great Depression and  
the savings and loan crisis of the 1990s, and even some Republicans  
are warming to the idea.

In the end, however, there is only so much the government can borrow  
and so much the government can do. The only other choice is for  
Americans to finally put their spending in line with their incomes and  
their need for long-term savings. For any one household, that sounds  
like a good idea. But if everyone cuts back at roughly the same time,  
a recession is almost inevitable. That's a bitter pill in and of  
itself, involving lost jobs, lower incomes and a big hit to government  
tax revenues. But it could be serious trouble for regional and local  
banks that have balance sheets loaded with loans to local developers  
and builders who will be hard hit by an economic downturn. Think of  
that, says Dugger, as the inevitable second round of this financial  
crisis that, alas, still lies ahead.