Is economy sliding into abyss?
NEW YORK–For months, Americans have been subjected to a sort of economic water torture – a maddening drip of bad news about jobs, gas prices, sagging home values, creeping inflation, a slouching dollar and a stock market in bumpy descent.
Then came Bear Stearns. One of the five largest U.S. investment banks nearly collapsed in a single day before the government propped it up by backing emergency loans and a rival stepped in to buy it.
To the drumbeat of signs that seemed to foretell a traditional recession, this added a nightmarish spectre – an old-style run on the bank, customers clamouring to pull their cash, a stately Wall Street firm brought to its knees.
The combination has forced the economy to the forefront of the national conversation in a way it has not been since the go-go 1990s, and for entirely opposite reasons.
As economists and Wall Street types grope for historical perspective – another way of saying a road map out of this mess – Americans are nervously wondering about retirement savings, interest rates, jobs that had seemed safe.
They are surveying the economic landscape and asking: Just how bad is it? They are peering over the edge and asking: How far down?
And the scariest part of all? No one can say for sure.
Even before the crippling of Bear Stearns, the U.S. economy was acting as a slowly tightening vise – an interconnected web of factors combining to squeeze Americans.
Take Jaci Rae of Salinas, Calif. She runs Luco Sport, a company that sells golf bags and accessories. Merchandise is made with foam, which is based on petroleum, so record oil prices have taken a heavy toll.
Her clients are feeling the pinch, too, and cutting back. Sales to retail clients are an eighth of what they were a year ago. So, Rae had to cut loose five of her 20 employees.
Now the company isn’t buying products as far in advance. With gas prices running high, she waits for shipping firms to pick up products from her headquarters instead of having an employee drop them off.
She is nickel-and-diming expenses at home, too. She eats in every night, has stopped going on road trips to visit her family, dropped her satellite dish and cancelled her monthly Blockbuster movie rental.
"I want to make sure I have enough money to feed my family," Rae says.
On top of an economy that was already groaning under the weight of a downturn, Bear Stearns came down like an anvil. It tied together so much of what’s wrong with today’s economy – the housing crash, the credit crunch and a loss of consumer and investor confidence.
Understanding how things got so bad means rewinding to the start of the housing boom. Wall Street and the banks made it far easier for people with shaky credit to get a mortgage – known as a subprime loan.
Investors wanted a piece of the fast-growing mortgage pie, so plenty of money was sloshing around the market to pay for the loans.
Financial firms sliced up the mortgages and sold them as complex investments to pension funds, hedge funds and others who were chasing higher returns and willing to overlook risks.
As long as house prices went up, the strategy worked. As they began to fall, so did financial stability.
The same people who made a financial stretch to buy their homes are now defaulting on the loans at alarming rates. Many are "upside down" on loans – owing more on a mortgage than their home’s worth.
Nearly 9 million households now have upside-down mortgages, and for the first time ever, aggregate mortgage debt is bigger than the total value of homeowner equity – bigger by $836 billion (U.S.), according to Merrill Lynch research.
The housing problem set off the dominoes: Surging defaults meant mortgage-backed securities plunged in value cash advance. That dried up the money to fund new home loans. Lenders everywhere became tighter with credit.
Bear Stearns found itself in the crosshairs. Market rumours began to swirl about the size of its exposure to mortgage securities, whether it had ample reserves to cover potential losses. Clients and investors began to demand their money back.
"This problem begins with the fact we underwrote mortgages sloppily, which means no one really knows what those assets are worth," said Lyle Gramley, a former Federal Reserve governor and now an analyst with Stanford Financial Group. "That makes bankers very leery, and has resulted in a significant contraction in the availability of credit.”
The credit crunch means corporations can’t borrow as easily, so they are delaying big projects, which cuts into the job market. And many of the same companies were already smarting from the downturn in housing, which has made many Americans uneasy about their household wealth and caused them to scrimp on spending.
The last time the U.S. economy tilted into recession was 2001.
Investors bore the brunt of that downturn as the stock market shook off the excesses of the late-’90s technology boom.
Encouraged by their government – and fortified with tax rebates in their pockets – Americans kept spending.
There was no reason for anyone to doubt the stability of the financial system.
This time around, no one has declared a recession just yet: By the generally accepted rule, that takes two consecutive quarters of shrinking economic activity. The economy came close to stalling late last year but eked out small growth.
"I think the current financial crisis looks to me like the worst one since we got into the Depression," says Richard Sylla, who teaches the history of financial institutions at New York University’s Stern School of Business.
Which is not to say this time will be anywhere near as bad – partly because, economists note, Federal Reserve chair Ben Bernanke is a student of the Depression and appears to be steering the Fed toward avoiding the mistakes of back then.
That may be why the Fed moved quickly to back up JPMorgan Chase & Co.’s lifeline loan to Bear Stearns when it neared collapse.
The Fed dusted off other Depression-era tools, too. It allowed securities dealers to borrow directly from the Fed, a privilege once restricted to commercial banks. And it announced it would lend up to $200 billion to investment banks in exchange for the banks’ beaten-up mortgage-backed securities.
The idea is to maintain confidence in the U.S. banking system. If that fails, it could gum up the entire economy, historians note.
"No one would trust anybody else, no one would be willing to do business," said Charles Jones, a finance professor at Columbia Business School. "And if that happens, the economy would feel that right away. So, the Fed is doing what it can."
Filed under: online by TheDoor