The spectacular collapse of two big investment banks — and the scramble by a major insurance company to stay afloat — has many on Wall Street and Main Street wondering: Is this as bad as it gets?
The answer is that nobody knows — not the heads of surviving banks, Treasury officials or policymakers at the Federal Reserve. The reason is that the true value of the investments being held by banks and other financial institutions cannot be known until home prices stop declining and the job market stabilizes. Until that happens, more losses are inevitable.
“I do not understand how we got into this situation,” said New Jersey Gov. Jon Corzine, a former chief executive of Goldman Sachs.
“You could have asked me two years ago, five years ago, would you ever see a day like this?," he told CNBC. "And I think, not just me, but most people would say: 'That's never going to happen.'"
The financial storm that swamped investment banking giants Lehman Bros. and Merrill Lynch over the weekend shows no signs of weakening. The Dow Jones industrial average lost more than 500 points Monday in its worst day since 2001. Insurance giant AIG, whose stock has been hammered by worries about its financial strength, was scrambling Monday to build its capital base and stabilize its stock price — which has lost more than 70 percent of its value in the past week.
Just as the bursting of the housing bubble destroyed hundreds of billions of dollars in phantom home equity built by an explosion of rogue lending, Wall Street is now suffering through its own evaporation of market value.
More than a year after the financial meltdown began in August 2007, Wall Street bankers are still uncovering more losses and working to raise more capital to cover their bad debts. Borrowing more money — from other investors or the government — won’t solve the problem.
When a financial firm's losses rise more quickly than it is able to raise fresh capital, the process can lead to a vicious downward spiral. Just like a credit card holder who spends beyond the limit, the outstanding balance is far too big to pay back all at once.
And Wall Street has a bigger problem than debt-strapped consumers. Financial company executives simply are not sure how big their debt is. Instead of getting one credit card statement, financial companies have hundreds of investors and “counterparties” — the holders of mortgage-related debt that has been sold and resold in private transactions.
“I don't think anybody has a handle on it,” said Corzine. "I have a feeling that people do not know all of the exposures they have to the entities that are troubled, and therefore causing additional problems that have to be adjusted, requiring even more capital and even greater shrinkage of balance sheets and other risk exposures.”
In the initial stages of the crisis, the Treasury and Federal Reserve were willing to pony up taxpayer capital to stop the bleeding for the most badly wounded firms, including government-sponsored mortgage brokers Fannie Mae and Freddie Mac.
But late last week the outlook for a broader financial turnaround became more uncertain when officials at both the Treasury and the Fed signaled an abrupt shift in policy, making clear they would not necessarily invest more capital in firms that had gotten into trouble.
Since the Fed-engineered sale of Bear Stearns in March and the Treasury’s takeover of Fannie Mae and Freddie Mac, opposition has been growing to taxpayer-funded rescues of private enterprises. Last week auto industry executives appeared on Capitol Hill explaining their desire for government financial help, raising fresh concerns about the costs of an open-ended policy to backstop big private companies.
The decision to allow Lehman Bros. to fail follows a fierce debate in Washington during the past year over the causes of the ongoing financial meltdown. The prevailing view in Washington argued against bailing out homeowners who made bad financial decisions, buying houses they couldn’t afford, or the lenders who wrote those loans.
The biggest government rescue plan applied to Fannie and Freddie, which did not offer mortgages directly but relaxed underwriting standards, allowing lenders to offer mortgages that made little sense for borrowers.
With the collapse of so many giant financial institutions, it has become clear that bankers acted imprudently, leaving them stuck with too much debt and not enough capital. Just like homeowners who took on mortgages they were unable to afford, commercial and investment banks that took on too much debt are now facing "foreclosure."
One critical question remains: How many more banks face the ultimate penalty? The answer depends on two huge unknowns.
First: When will home prices stop falling? The value of trillions of dollars of assets held by big investors — both here and around the world — is pegged to the underlying value of the real estate on which those assets are based. Every quarter that home prices fall, those assets have to be marked down further.
Second: When will the foreclosure rate stop rising and stabilize? As of the end of June, some 9 percent of all Americans holding a mortgage were either late on their monthly payments or in foreclosure. Those foreclosures add to the backlog of bank-owned properties that go onto the market, putting further downward pressure on home prices.
It’s unlikely the government can slow that downward spiral. Aggressive measures on Capitol Hill to slow mortgage defaults and home foreclosure rates were largely abandoned in the final version of the housing relief bill passed this summer, due largely to the prevailing view that homeowners should not be “bailed out.”
Until recently, the main cause of the spike in foreclosures was overreaching by borrowers — some of whom fell prey to questionable lending practices to take on loans they could not afford. More recently the deterioration of the job market has meant more homeowners are falling behind in their payments due to unemployment. If the job market continues to weaken, that will add further pressure to the housing market.
Corzine says these problems are being ignored in the recent “weekend work sessions” over what to do about Fannie and Freddie, Lehman and Merrill and AIG.
“The core problem that we have is the economy,” he said. ”There are two things here that are very disturbing and not addressed. One, there is no major infusion of new capital into the system. We are doing more financial engineering to solve problems. Second of all, and much more important, is the fundamental economy is in very bad shape and the problems are growing."