It’s a really bad sign when even banks can’t secure a loan
As Congress wrestles with a $700-billion plan to buy up bad mortgages, many on Wall Street say the situation in the banking system has become desperate.
Credit -- the lifeblood of the economy -- has simply stopped flowing in many parts of the financial system over the last two weeks.
“Figuratively, institutions are putting money in a mattress,” said Bill Gross, the chief investment officer of money management giant Pimco in Newport Beach.
Many banks have stopped making short-term loans to other lenders. Big investors are hoarding cash, and the only IOUs some will accept are those of the U.S. Treasury. States and cities suddenly face crushingly high interest rates if they try to sell bonds to finance government operations. And for many businesses and consumers, credit is harder to get -- if it’s available at all.
The root of this crisis is the housing market’s collapse, but the shock waves are reaching well beyond the real estate market and are threatening to make a full-blown recession inevitable.
“If it keeps going and the authorities don’t find a way to stop the contagion, it will hit the economy harder than anything we’ve had to absorb in decades,” said Lou Crandall, chief economist at Wrightson ICAP, a research firm in Jersey City, N.J.
With nowhere else to turn, Wall Street and business executives are pressing Congress on the bailout plan, despite doubts that it will have the desired effect of quickly restoring confidence and spurring ailing financial institutions to lend again.
“Every day that it’s delayed, it hurts,” said John Castellani, president of the Business Roundtable, which represents large U.S. companies. “The credit markets are frozen, and the longer that happens the greater the damage to the economy.”
To many Americans, the scope of the now year-old U.S. financial crisis may be evident only when it shows up in a bad reaction in the stock market. Over the last two days, the market has rallied, yet the credit situation has remained dire.
“If the Dow goes down 1,000 points, you know exactly what that means,” said Michael Darda, chief economist at the investment firm MKM Partners in Greenwich, Conn.
“You’ll see it on the news and in your 401(k). It’s palpable and understandable. If the credit markets freeze, that hits the economy with a lag, but it’s just as powerful, maybe more so.”
The economy and banking system run on credit, much of it short-term in nature. Untold billions of dollars change hands each day to fund U.S. banks’ operations and the workings of companies and local governments.
If that money stops flowing, the economy loses the lubricant that keeps the gears turning.
In normal times, for example, one bank may have a large need for cash just for a day or two. Other banks may have excess cash and are happy to lend it to peers at relatively low interest rates.
In recent weeks, that back-and-forth flow of credit has been badly hampered as banks increasingly have been unwilling to lend to one another, fearful they won’t be repaid if financial conditions worsen.
“What credit really is is trust and faith,” said Pimco’s Gross. At the moment, he said, “there is no trust, there is no faith.”
Why now?
Soaring mortgage defaults and plummeting real estate prices have been rocking the financial system for the last year, resulting in massive loan losses for many banks and other institutions that fed the housing mania earlier this decade.
But the fallout from the mortgage debacle reached epic proportions this month, beginning with the government’s takeover of ailing mortgage-finance giants Fannie Mae and Freddie Mac on Sept. 7.
That was followed by the failure of brokerage Lehman Bros. Holdings Inc. on Sept. 14, and the Federal Reserve’s rescue of insurance titan American International Group on Sept. 16.
On Thursday, federal regulators seized Washington Mutual Inc. in the biggest bank failure in U.S. history.
And Friday, shares of Wachovia Corp., one of the nation’s biggest banks and mortgage lenders, dived 27% as many investors fled, fearing that it could be the next institution to fail.
“This is scary,” said 75-year-old Dan Fuss, who manages $110 billion in bonds for investment firm Loomis, Sayles & Co. in Boston. “Right now, when you think this through, any bank . . . is at risk” of the market’s instant judgment of which institutions are solvent and which are not, he said.
The Federal Reserve and other major central banks have flooded the global financial system with hundreds of billions of dollars in short-term credit this month, trying to calm nerves and get banks to begin lending to one another again.
But the Fed can’t force banks to extend credit, least of all when the most primal of instincts -- self-preservation -- rules the day.
In the last two weeks, fear also has gripped other parts of the credit markets.
Money market mutual funds, for example, normally buy short-term IOUs of companies, financial institutions and municipalities. But the $3.3-trillion money fund business has been upended since Sept. 16, when one of the oldest money funds revealed that it had lost 3% of its principal value because of losses on Lehman Bros. IOUs it held.
That marked only the second time in 38 years that a money fund had suffered a loss. The news triggered record outflows from the sector as nervous investors pulled their cash, which in turn drove many fund managers in recent days to stop buying corporate debt and instead load up on super-safe short-term U.S. Treasury bills.
Other big investors, spooked by what they see happening in the banking system, are shunning long-term bonds in favor of hoarding cash. That has stymied states and cities that need to borrow in the bond market to fund public works projects.
If the state of California were to try to issue a 20-year bond now, it would have to pay an annualized interest rate of about 5.4%, up from 4.84% just two weeks ago.
Of course, many consumers had already been facing tighter restrictions on credit.
Bert Boeckmann, who owns Galpin Motors in North Hills, said the credit crunch had made it tougher for all but “prime” borrowers to get car loans.
As for mortgages, Wells Fargo & Co. this week was charging 9.25% for “jumbo” 30-year loans -- those larger than about $730,000.
With the credit markets in a deep freeze, all eyes have turned to Washington and the bank bailout plan.
As proposed by the Bush administration, the Treasury would swap cash for up to $700 billion of banks’ troubled loans.
The assumption is that, by relieving the banks of a large chunk of bad assets -- and removing the possibility that the banks would suffer more losses on those loans -- the program would damp fears about the financial system and encourage banks to lend again, breaking the credit market logjam.
Many experts say that with the bailout already so anticipated, it would be a psychological blow to markets if Congress balks.
Particularly for foreign nations that provide much of the funding for the U.S. economy, the program “will show that the government is doing something” about the credit crisis, said Loomis Sayles’ Fuss.
But he and others say the only real solution for the nation’s financial woes is time -- time for banks to rebuild their finances, for housing prices to bottom and for investors to regain confidence.
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walter.hamilton@latimes.com
Times staff writer Peter Y. Hong contributed to this report.
