This big rescue may be just the beginning

Throughout Wall Street’s history, major financial system upheavals often have culminated with the spectacular failure of a marquee name.

That was the case in December 1994, when Orange County filed for bankruptcy protection after getting caught on the wrong side of a sharp jump in interest rates.

In September 1998, the Federal Reserve helped arrange a bailout of the giant investment fund Long-Term Capital Management after it neared collapse from bad bets in wildly swinging markets.

In those and similar instances the big-name debacles marked the peak of the financial system crises, not the start of something worse.


But this time around, with Friday’s surprise announcement that the Fed would temporarily inject its own money into tottering brokerage giant Bear Stearns Cos., many Wall Street pros say they have little confidence that the move is a prelude to better times for beleaguered markets and the economy.

Indeed, some experts say Bear Stearns’ woes warn of potentially larger calamities that will severely test the Fed, the economy and, ultimately, taxpayers as the government gets more deeply involved in fixing the markets’ troubles.

“We will lose, in some form, several major financial institutions before this is over,” said veteran economist Allen Sinai of Decision Economics Inc. in New York.

The heart of the problem is that the nation is living through an unwinding of a 25-year-long, consumer-led borrowing binge. Bear Stearns was a key player in financing that binge, most notably in high-risk mortgages.


Wall Street in recent years designed ever more creative ways to transform loans into bonds and sell them to investors who were hungry for interest income. That alchemy reached its zenith with sub-prime mortgages -- loans to people with dubious credit.

Even as investors poured hundreds of billions of dollars into sub-prime-mortgage bonds from 2003 to 2006, there were ample warnings that many borrowers were vastly overstretched.

But it wasn’t until housing prices began to implode last year, and mortgage defaults rocketed, that banks, brokerages and investors came to realize they had gone too far.

Now, with the U.S. financial system already overburdened with debt, many investors simply don’t want to take a chance on owning more of it -- unless it’s the direct obligation of the U.S. Treasury.

In market parlance, debt is leverage.

“We have far too much leverage in the system, and we’re now in the process of de-leveraging,” said Tom Atteberry, a money manager at investment firm First Pacific Advisors in Los Angeles. “We think there’s a lot more to go.”

That mentality is widespread, and it is feeding on itself: Investors don’t want to pay current market prices for mortgage-backed bonds and other debt because they worry that more borrowers will have trouble making payments. That further shuts down lending, making credit tighter and squeezing more borrowers.

Banks and brokerages already have written down the value of many of the mortgage securities they hold, to account for rising delinquencies. But there still is no sense that the housing market has reached a bottom, so there is no way for investors to know how much worse delinquencies will get.


“The only true solution would be to get home prices up,” said Jeffrey Gundlach, chief investment officer of Los Angeles-based money manager TCW Group. “But the fundamentals are moving in the opposite direction.”

At times like this the focus for Wall Street firms primarily is on surviving. No bank or brokerage will lend to a peer, even in routine daily transactions, if there is any doubt at all that the borrower can repay. Failure then can become assured once rumors start about a firm.

In January, after rumors swirled that it was running out of capital, Countrywide Financial Corp., the largest U.S. mortgage lender, quickly struck a deal to sell itself to Bank of America Corp.

Wall Street’s propensity to abandon its own has sunk all sorts of financial institutions over the last century. In 1984 the government had to rescue Continental Illinois, then the seventh-largest bank, once creditors pulled the plug. Brokerage Drexel Burnham Lambert Inc. failed in 1990 after its funding lines were cut.

But the current crisis is far larger in scope than those. Because so many banks, brokerages and investors were involved in financing the recent real estate boom -- the biggest housing bubble ever, by many accounts -- the growing problem of mortgage defaults infects nearly every corner of the financial system.

By shaking markets’ confidence to the core, the housing bust also has made investors skittish about debt securities that have no direct connection to housing. In recent weeks, for example, demand has evaporated for certain kinds of municipal bonds.

What’s more, financial institutions are tied to one another in ways that didn’t exist 20 years ago. Using so-called derivative securities, banks, brokerages and investors in effect make bets with one another about each other’s solvency. Those particular contracts, known as credit-default swaps, often are used as insurance policies against market turmoil.

“These institutions all are linked by a derivatives market that none of us could map out on a piece of paper,” said Charles Geisst, a finance professor at Manhattan College and a Wall Street historian.


One ever-present risk is that the inability of one party in a credit-default swap to pay another could trigger a domino effect throughout the financial system.

Still, the primary concern at the moment remains the withering value of mortgage-backed bonds.

Gundlach, whose firm manages tens of billions of dollars in mortgage securities, estimates that losses on mortgage bonds across the economy might total $1 trillion by the time the delinquency wave has crested and lenders write down loans to levels borrowers can afford.

Although the Fed is almost certain to continue cutting short-term interest rates, that won’t fix the markets’ problems, Gundlach asserts. It might even make things worse: As the Fed’s cuts lower rates on adjustable-rate mortgages, he says, investors become less interested in buying bonds backed by those loans.

“So the bonds’ prices drop more,” Gundlach says, “because investors analyze the risk to be even higher.”

To be sure, some investors believe the extreme level of fear on Wall Street means there is tremendous long-term potential in lower-valued bonds and stocks.

“There are plenty of attractively priced opportunities” in markets, said Russell Read, chief investment officer at the $235-billion-asset California Public Employees’ Retirement System. “We’re not on the sidelines at all. We’re buying.”

But many other investors clearly are in no hurry to step up. And that raises the potential for more declines in markets and deeper troubles for financial institutions.

Across Wall Street, there is a widespread belief that the Fed’s use of its own capital to shore up Bear Stearns is just the first step toward an eventual government bailout of the housing market.

“The history of major financial crises is that the government is going to come in at some point,” said Richard Sylla, a professor of financial history at New York University.