By John W. Schoen Senior producer
msnbc.com
updated 9/29/2008 9:30:26 PM ET 2008-09-30T01:30:26
ANALYSIS

The failure of a massive $700 billion bailout financial plan Monday removes a critical firewall intended to keep the credit market collapse from spilling over into the global economy.

Major Market Indices

But even if the plan is somehow revived, cracks are beginning to widen in the foundations of the global banking system.

Aftershocks from the ongoing credit crisis struck again Monday, with the forced marriage of Wachovia and Citigroup and the nationalization of several European banks.

The latest reverberations come just days after regulators seized the assets of Washington Mutual, which was losing ground to mounting writedowns on mortgage-related investments, and found a buyer in JPMorgan Chase. It was the largest bank failure in U.S. history.

To try to calm the waters Monday, central banks around the world said they were offering up billions of dollars in fresh capital to help banks here and abroad as they struggle to stay afloat in the worsening credit crisis. The Federal Reserve said it will make a total of $620 billion available to other central banks, swapping dollars for foreign currencies. That’s more than double the cash pile already provided by the Fed.

The global effort, involving central banks around the world, is yet another indication that the credit crisis that began in the U.S. mortgage market has tainted the river of capital that flows through the global economy. Until recently, the problem had been limited to a handful of British banks.

“We've seen a sharp increase in funding costs over the past two, three weeks overseas ,” said Alex Patelis, head of international economics with Merrill Lynch. “That's bringing the weaker players in the banking sector down. We've seen a number of issues with banks down throughout Europe today.”

As the banking crisis threatens to spill over, the worry is that bankers have been underestimating the potential impact on their holdings from ongoing losses related to mortgage defaults and foreclosures.

Slideshow: Red zone The problem bankers and the financial markets face are fairly straightforward. As the multitrillion-dollar mortgage lending spree now unwinds, there’s no way to know how many more potential shocks are out there. It all depends on how much longer house prices keep falling.

Since no one knows the answer, banks have to guess when to mark down the value of all those mortgage-related investments. The further house prices fall, the more they have to mark them down.

Meredith Whitney, head of stock research at Oppenheimer, figures that from the peak of the housing bubble to the trough when prices finally recover, home prices will have fallen by some 40 percent. She thinks banks have been slow to book those losses — which means bigger markdowns lay ahead.

“Wachovia, which had 60 percent of its portfolio in Florida and California, only assumed 21 percent peak-to-trough declines,” she said. “So there are going to be real (markdowns) that Citibank is going to have to take. They are both going to have to take markdowns, and they have to raise capital to these (markdowns.)”

With mortgage-backed securities infecting the global credit system, banks around the world
are not only raising cash — they’re hoarding it to protect against the rising tide of losses they may face in the near future.  With widespread uncertainly about which banks will survive and which ones will go under, bankers are also fearful of lending money to another bank that may end up on the list of those that fail.

That slowdown in lending between banks is moving down the chain as banks hoard cash that their business customers need to fund day-to-day operations.

The cycle will be difficult to break until the markets see some indication that home prices are stabilizing. For that to happen, the rate of mortgage defaults and foreclosures will have to peak and begin to subside.

So far, the most problematic loans have been adjustable mortgages armed with low “teaser” rates to qualify borrowers into loans they couldn’t afford. After two- and three-year delays, defaults from those who couldn't afford payments when teaser rates ended are now working their way through the system,

But there is a more ominous problem with a class of loan that became popular at the tail end of the housing boom. These so-called "pay-option ARMS" allow homeowners to choose among different monthly payments. The complexity of these loans makes it difficult to forecast how many borrowers ultimately will default.

“That's the biggest problem out there right now, especially with the pay-option ARMs: how to value these (loans),” said Mark Hanson, a California-based mortgage consultant at the Field Check Group. “This is toxic not only for the bank's balance sheets but also the consumer balance sheets because the principle balance keeps rising on 80 percent of the people that don't make the fully indexed payment, until they get to a point where they just implode.”

It can take years for that implosion to happen. Analysts at several major Wall Street firms have estimated that — unless these toxic loans are defused in the next 18 months — these pay-option ARMs will begin imploding in 2010 and 2011. That would bring on another wave of foreclosures, just as defaults from ARMs with two- and three- year “resets” have begun to work their way through the system.

Those estimates could be made worse by continued rise in unemployment. Homeowners who might otherwise be able to afford their mortgages face a much tougher time when they lose a steady paycheck.

As banks work to mark down their debts and raise more capital, consumer households face the same painful transition. After years of easy credit, households are already finding loans harder to get. That means they, too, will have to try to raise cash and cut their existing debts.
One way they can do that is to cut spending.

On Monday, the government released fresh data showing that consumer spending stalled in August as the impact of the tax rebate stimulus plan began to fade.

"Consumers seem to have hit the foxholes," said Joel Naroff, president of Naroff Economic Advisors Inc. in Holland, Pennsylvania.

As the credit crisis spills over to the broader economy, a further slowdown in consumer spending would weigh even more heavily on the economy — about two-thirds of which relies on purchases of goods and services.

"It looks like we are poised to see a real-term decline in personal consumption and that will likely result in a negative GDP number in the third quarter," said James O'Sullivan, economist at UBS Securities in Stamford, Conn.

Reuters contributed to this report.

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