When faith is frayed
In a modern financial system, nothing is more frightening than a run on the bank.
The U.S. now has suffered through a series of them, and they are escalating in size and scope -- posing a serious threat to the already reeling economy.
On Friday, rumors swamped financial markets that the federal government would be forced to step in to aid mortgage-finance giants Fannie Mae and Freddie Mac, which together own or guarantee $5 trillion in U.S. home loans.
In Wall Street’s version of a bank run, investors drove shares of Fannie Mae and Freddie Mac to 17-year lows, signaling a gnawing lack of faith in the companies’ ability to survive rising mortgage defaults without government help.
Later in the day, regulators took over IndyMac Bank of Pasadena, saying the $32-billion lender had collapsed under the weight of bad home loans and withdrawals by spooked depositors. It was the second-largest bank failure in U.S. history.
Friday’s events were felt around the world, knocking the battered U.S. dollar lower and driving up interest rates.
“This is a flare-up in the financial forest fire that is far beyond anything we’ve seen before,” said Christopher Low, chief economist at investment firm FTN Financial in New York.
And it is triggering worries that would have been unthinkable even a year ago -- including that the U.S. Treasury’s debt might lose its AAA credit grade because of heavy blows to the nation’s fiscal health from the housing mess.
Just four months ago, many on Wall Street believed they had seen the worst of the credit crisis rooted in the housing market’s woes. The collapse in March of brokerage Bear Stearns Cos., a key player in the business of packaging dicey mortgages for sale to investors, was the kind of high-profile calamity that historically has marked the end of financial crises.
Bear Stearns, too, was a victim of a devastating run on the bank, as many of its creditors suddenly stopped lending to the firm and investors dumped the company’s stock.
Reacting quickly, the Federal Reserve took unprecedented steps after Bear Stearns’ demise to make cheap loans available to loss-ridden banks and, for the first time, to securities firms. The Fed’s moves helped restore calm to markets by April.
But by May, investors’ focus had returned to the slumping housing market and the likelihood that banks and brokerages would face more losses on mortgage-related debt. Confidence in the stock market, and in financial institutions large and small, eroded anew.
Worse, the price of oil began a stunning climb in April that still hasn’t relented. Crude prices closed at $145.08 a barrel Friday, up from $100 as April began.
Record energy costs, coupled with surging food prices, raise the risk that more beleaguered consumers could fall behind on their mortgage payments.
“These prices for oil and food, in an economy 70% driven by consumers, are just adding more strains to the financial system,” said Tom Atteberry, a fund manager at First Pacific Advisors in Los Angeles.
As worries about the economy mounted in June, stocks went into another tailspin that has continued in July. Wall Street now is officially in a bear market -- meaning a drop of at least 20% in key stock indexes -- for the first time since the plunge of 2000-02.
The Dow Jones index, which fell 128.48 points to 11,100.54 on Friday, now is down 21.6% from its record high last year.
That’s still a long way from the 38% dive the Dow took from its peak in early 2000 to its low in October 2002.
But there are some parallels between the 2000-02 period and the current one that hint at worse to come.
The stock market’s crash in 2000 began with the bust in highflying dot-com stocks. This time, the decline began with the bust in home prices and its disastrous effects on every industry tied to housing.
In 2002, weary investors were hit by a wave of corporate accounting scandals that began with fabled Enron Corp. By the summer of that year, an extraordinary crisis of confidence had developed: Investors simply felt that they couldn’t trust what many companies were telling them about their sales or earnings. Share prices dived further.
This time, the crisis of confidence is in the U.S. banking system. Because so many banks and brokerages lent heavily to fund the housing boom, the losses from the housing bust permeate the financial system to a degree few analysts had predicted.
As home prices keep falling, “anything tied to U.S. residential real estate is seen at risk,” said Allen Sinai at Decision Economics in New York.
Fearing more severe losses than they’ve already suffered, investors in recent weeks have fled stocks of some of the nation’s biggest financial institutions at a pace that has stunned Wall Street.
This week, investors turned on Fannie Mae and Freddie Mac with a vengeance.
Despite the companies’ assurances that they have adequate capital cushions against surging defaults on the mortgages they own or guarantee, the market doesn’t believe them.
For the federal government, that poses a quandary. Because of their size and importance to the mortgage market, it’s inconceivable that Fannie and Freddie would be allowed to fail. But an outright takeover of the companies by the government, as some experts have suggested, could frighten foreign investors -- who are big lenders to the Treasury -- by, in effect, adding the companies’ $5-trillion debt load to the Treasury’s massive debt of $9.5 trillion.
Nationalizing the companies “would put the full faith and credit of the Treasury at risk,” Sinai said. “It would make foreign investors think hard about buying U.S. Treasury debt.”
The way you stop a bank run is to restore confidence. For Uncle Sam, the challenge isn’t just to restore confidence among Americans, but also to make sure it doesn’t evaporate among our foreign creditors.