In this economy, failure is an option
The U.S. economy appears to be caught in a cycle of recurrent panic attacks. So many things have gone wrong, and so much anxiety has accumulated in the financial system, that nothing seems safe.
As a result, no sooner has one crisis seemed to recede than another has popped up, to be followed by another and still another.
“We’ve gotten to that classic point in a financial crisis where it’s gone on for long enough we know there are losses. We just don’t know where they are,” said Joseph R. Mason, a financial economist at Louisiana State University in Baton Rouge.
“The only way to find out is for investors to push every institution toward failure and see which ones keep operating,” Mason said.
About the sunniest assessment that analysts will offer is that if the current crisis holds to historical patterns, it could end as unexpectedly as it began.
“Most panics are like summer storms,” said David A. Moss, an economic historian at Harvard University. “They come up abruptly, are erratically intense, then suddenly dissipate.”
The cycle started last summer with the near collapse of two Bear Stearns Cos. hedge funds specializing in exotic mortgage-backed securities. What followed was a succession of panics that went so far that even the mainstays of the U.S. mortgage market -- Fannie Mae and Freddie Mac -- had to be propped up by the Federal Reserve.
And a series of other crises are tugging at such disparate threads of the nation’s financial fabric as credit cards, student loans, municipal debt and even money market funds.
Last week held true to the storm pattern Moss described. After another round of potentially catastrophic developments in the housing, financial and energy markets, the system pulled to the brink, caught its breath and took a turn for the better.
Oil prices not only halted their upward rush, they fell back a remarkable $16 a barrel in the space of a few days. And after a frenzy of concern about the banking system, markets suddenly calmed when three major institutions -- Citigroup Inc., Wells Fargo & Co. and JPMorgan Chase & Co. -- reported better-than-expected results.
Few economists think the storms are over, though.
“This thing simply hasn’t run its course,” said veteran banking consultant Bert Ely of Alexandria, Va. “We have a multiple-chapter housing saga that could go on well into the next decade.”
And when home values fall, shocks destabilize the financial system and the economy, setting off still more ripples.
Trouble has even been showing up in a seemingly safe and sound corner of the financial world: money market mutual funds. Most people treat such funds as the equivalent of bank savings accounts. Customers, who favor them because they generally pay higher rates than bank accounts, have parked $3 trillion in them -- nearly a quarter of all the money held by the nation’s mutual fund industry, according to the Investment Company Institute.
The problem is that money market funds differ from bank accounts in two key ways.
First, they’re not covered by the Federal Deposit Insurance Corp. (Money market funds, which are offered by mutual fund companies and are not federally insured, should not be confused with money market accounts, which are offered by banks and are insured.)
Second, a fraction of the money put into money market funds recently has been used on investments that have gone sour. That has forced some companies offering the funds to rush to plug the losses.
Legg Mason Inc. and SunTrust Banks Inc., for example, recently had to pump $1.4 billion each into its money market funds. Bank of America Corp. has injected $600 million.
The culprit in those cases doesn’t appear to be housing prices alone so much as the wildly complicated securities that investment firms created out of mortgages and a laundry list of other hard-to-price (and therefore risky) assets such as timber and highways.
The idea behind such financial concoctions was that if each security contained only a small share of each of those items, the overall security would be safer than the individual assets that underpinned them. But it hasn’t worked out that way, according to Mason of Louisiana State University.
“New financial instruments are invented every day. Normally they get boiled down to a standardized form,” he said. But this time, banks and investment houses sought to maintain high profits and a lock on the markets by keeping their inventions “customized.”
The result today is that nobody can figure out how risky the new securities are, how much they are now worth or how dependent their owners -- mostly big institutional investors -- are on them.
In such circumstances, investors and customers will seek answers by using the extraordinarily crude technique of trying to knock over one institution after another and seeing if each survives.
“It’s not a very efficient way to run a financial system, but how else are you going to find out?” Mason said.
That’s precisely what happened to Fannie and Freddie, which are especially exposed to slumping housing prices because they own or guarantee nearly half of the nation’s $12 trillion in mortgages.
Investors tripped over one another last week to sell shares of the government-sponsored but shareholder-owned companies, slicing Fannie’s and Freddie’s market values by nearly half. That prompted the Treasury and the Fed to rush out a plan that plants the federal government firmly behind the two mortgage giants.
Much the same thing happened to Bear Stearns in March. Investors in the nation’s fifth-largest investment bank battered its stock, but what really sank the company was the fact that its lenders cut off the firm’s lines of credit. Lenders feared that the brokerage was so burdened with bad mortgage securities, it couldn’t repay what it had borrowed.
The Fed was forced to assume control of some of the least appealing securities and provide $30 billion in financing to pave the way for a fire sale to JPMorgan.
For Countrywide Financial Corp., the situation was similar. The largest private-sector mortgage lender watched its finances fall apart as late payments on its loans surged with tumbling home prices. The Calabasas-based lender was forced in January to let itself be snapped up by Bank of America -- for a sixth of its year-ago market value.
In each instance, the most prominent culprit behind the financial troubles has been a housing market that has fallen faster and further than almost anybody predicted.
As housing prices have continued to fall, they have exposed the weakness of firms built on the presumption that prices would keep rising. As banking consultant Ely, quoting legendary investor Warren E. Buffett, put it: “When the tide goes out, you find out who’s swimming without their trunks.”
But the nation’s troubles have not remained neatly confined to housing, suggesting that other forces besides tumbling home prices are at work.
Just as Americans were growing accustomed to the housing slump and the slump-fed credit crisis, problems broke out in the market for the sort of municipal bonds that underwrite such plain-vanilla projects as hospital and college dorm construction, and that fund student loans.
The trouble was especially surprising because, unlike the typical municipal bond, which requires lenders to fork over funds for lengthy periods in return for fixed interest payments, the bonds at the center of this crisis were so-called auction-rate securities -- on which interest rates are reset daily, weekly or monthly based on the outcome of regular auctions.
In the case of student loans, it was surprising because the federal government guarantees most of the loans -- meaning there was almost no chance that lenders would get stuck with losses if borrowers failed to repay.
Nevertheless, major lenders suddenly retreated from the $330-billion auction-rate market, forcing several states to suspend building projects and delay offering student loans.
The economy has survived such batterings repeatedly over the course of the nation’s history and has almost always come back to prosper, said Moss of Harvard University.
“At the moment, the crisis feels like it’s everywhere,” Moss said. “But that’s not that unusual. Crises seem to go away and then pop back up again” before finally ending, he said.