Fallout From Credit Crunch Creates Another One

Source: Washington Post | Tuesday, November 20, 2007

The credit crunch is back.

After improving in September and early October, markets in a wide variety of debt -- including for home mortgages, consumer loans, and corporate buyouts -- have sharply deteriorated in recent weeks. Investors view much of this debt as riskier than they did even at the height of the August credit crisis and are requiring higher interest rates as compensation.

While markets are behaving in a more orderly fashion than they were in August, many on Wall Street fear that the situation will get worse before it gets better. "This is just dragging on longer," said Axel Merk, a portfolio manager for Merk Hard Currency Fund. "We're very early in this."

Economists increasingly worry that banks are suffering such massive losses that they will be forced to cut back their lending to consumers and businesses. That would slow the economy, much as the savings and loan crisis did in the early 1990s. Yesterday, an analyst predicted that Citigroup, the world's biggest financial services company, would suffer another $15 billion in losses in the coming six months from its exposure to exotic types of debt.

That prediction, along with fresh negative data about the housing market, drove the Dow Jones industrial average down 218 points, or 1.7 percent. Financial markets are pointing to a strong possibility of even more bad news.

For example, futures markets indicate that there is a 20 percent chance that the Federal Reserve will cut interest rates by half a percentage point or more at its next policy meeting Dec. 11, even though it is widely understood that the central bank would do so only if there were highly negative economic news between now and then. An index measuring the cost of insuring against credit losses on 125 financially sound companies reached an all-time high yesterday. And the market for securities backed by commercial real estate loans, which had been little affected through the August crunch, is showing strain.

In August, as investors concluded that defaults on U.S. mortgage loans would cause massive losses, worldwide markets for a variety of complicated securities all but shut down. But what is happening now is different. The markets are working reasonably well, with transactions taking place. But investors have had time to digest just how great the losses may be, and how widely the impact may ripple, and they do not like what they see.

The direct losses from mortgage foreclosures will be about $400 billion, economists at Goldman Sachs estimated in a report last week. If that were the extent of the losses, the financial system could easily absorb them. But because of the way banks and other institutions work, the losses could spread far more widely.

Banks are required to keep capital on hand so they can weather losses. The mortgage-related losses are cutting into their capital and thus could cause a commensurate drop in how much they can loan. Taking into account that "multiplier" effect, the mortgage problems could reduce by $2 trillion the credit available to consumers and businesses, Goldman estimated in the report.

"The implications are that it will be harder for ordinary people to get loans," said Jan Hatzius, chief economist at the investment firm. "That's true not just in mortgage land but also for consumer loans, for corporate loans, for commercial real estate."

There are tentative signs that credit is becoming less available. In October, 28 percent of senior loan officers surveyed by the Federal Reserve said their banks had tightened lending standards for consumer loans; 2 percent had loosened them.

If banks severely curtail lending, the situation could mirror that of nearly 20 years ago, when bad loans in commercial real estate and other sectors led to massive losses by savings and loans. They then cut back on lending, a major cause of the 1990 recession. But Hatzius notes that such a dire situation could be avoided if the institutions affected raise more capital through other means.

Parts of the market for packages of loans are functioning reasonably well; almost none were in August. Now buyers and sellers are both at the table. However, investors have concluded that many debt securities are riskier than they thought then, and they are requiring higher interest rates as compensation.

And it's not only in the troubled home mortgage sector. For example, packages of high-quality loans for office buildings and other commercial properties had interest rates 0.7 percentage points higher than comparable Treasury bonds earlier this year, according to a Morgan Stanley index for commercial mortgage-backed securities.

During the August credit crunch, that premium rose to 1.5 percentage points before dropping in September and early October. But yesterday, investors required an interest rate premium of 1.7 percentage points to take on the risk of lending for commercial real estate.

"People are looking at things and saying, 'Hey, I'm going to price the market according to what I expect will happen, not what I currently see happening,' " said Alan Todd, head of commercial mortgage-backed securities at J.P. Morgan, who noted that delinquencies on commercial mortgages are starting to pick up from historic lows.

Another example of the spreading sense of worry: Wall Street is closely watching the rash of bad news from bond insurers, who guaranteed complicated securities that are now going bad in portfolios across the globe.

"Will they be able to pay up on the claims as these defaults and foreclosures roll in on the underlying mortgages?" said Ed Rombach, senior derivatives analyst at Thomson Financial. "If they can't, there's going to be hell to pay. It's going to lead to a whole new round of downgrades of these securities. Those downgrades will lead to a whole new round of write-offs for Citigroup and investment banks and commercial banks and hedge funds."

Yesterday, insurance giant Swiss Reinsurance took a $1 billion write-down of losses on complicated securities tied to home mortgages, another example of how the problems tied to the U.S. housing market have spread widely and unpredictably -- and of how companies are still coming to terms with the scope of the losses.

Economists speak of "tail risks," meaning events that are unlikely to happen but would cause major disturbances if they did. And in recent weeks, many analysts think that the likelihood of these risks, while low, has risen.

Laurence H. Meyer, a former Federal Reserve governor, described three such risks in a note to clients of his forecasting firm, Macroeconomic Advisers. A major financial institution could fail or come close to failing. Government-sponsored housing-finance companies Fannie Mae and Freddie Mac could find they are more exposed to the mortgage problems than investors have factored into their stock and bond prices. And the market could lose faith in the companies that insure debt against credit losses.

"The general point is that the current circumstances are marked by sizable loses on credit positions, with no one quite sure of what the eventual magnitude of those losses will be or where they are located," Meyer wrote. "That raises the possibility of financial markets becoming more turbulent."

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