Will the Leak Ruin the Engine?

By Steven Pearlstein
Friday, July 27, 2007

It's not just about subprime mortgages anymore.

The turmoil we're witnessing in global financial markets is nothing less than the popping of an enormous credit bubble that built up over the past five years, artificially inflating the market prices of stocks, bonds and real estate. It created a bonanza for Wall Street investment houses and private-equity funds and fueled the longest and strongest period of global economic growth in modern history.

The only question now is whether the bubble will deflate slowly enough to allow an orderly repricing of those assets, or whether a broad loss of confidence by investors will create a vicious cycle in which selling begets more selling, markets freeze up for lack of buyers, and a credit crunch ensues.

The air began leaking out of the credit bubble several months ago, when troubles surfaced in the market for subprime mortgages -- home loans made to people with poor credit scores that were packaged into pools and sold to investors.

At first, industry officials and regulators assured us that the problems were manageable and limited to the subprime market. But in recent days, industry executives began warning of similar problems with home-equity loans and mortgages made to borrowers with good credit histories, even as projections climbed for defaults by subprime borrowers.

Banks and credit-card companies have begun to report noticeable increases in delinquencies on consumer debt.

And now, investment banks are having serious trouble raising money to finance corporate takeovers and stock buybacks. A record flow of those deals fueled a year-long stock market rally that, only a week ago, pushed the Dow Jones industrial average past 14,000. Yesterday, the Dow closed at 13,473.57, down more than 300 points.

High-profile deals left hanging by this week's turmoil include the big buyout of Chrysler by Cerberus Capital Management, KKR's purchase of British retailer Alliance Boots and Citigroup's purchase of Allison Transmission. Barry Diller was forced to trim the stock buyback through which he hoped to take Expedia private. And there were reports that the sale of Cadbury Schweppes's drink business, which was being shopped around, will be delayed for months.

The move down in stock prices yesterday was led by shares of big Wall Street banks, which will now have to finance many of those deals with their own funds rather than sell them in pieces to investors and other banks.

The altered fortunes of the big Wall Street firms could also be measured yesterday in the humiliating 25 percent increase in the cost of insuring their own bonds against default. And investors who rushed to buy shares in Blackstone Group, the world's largest private-equity firm, when they were issued last month have watched the value of their stakes fall by 17 percent.

The nature of credit bubbles is that the difference in interest rates paid by risky borrowers and safe borrowers narrows. Never in history were they as narrow as they were just a few weeks ago.

But recently, banks and investors have sold their risky loans and fled to the safety of U.S. Treasury bonds. Spreads on everything from consumer loans to Argentine sovereign bonds have widened considerably, with no sign of stabilizing anytime soon. Just yesterday, the spread on both investment-grade and junk bonds jumped the most since the days of the telecom bankruptcies in 2002.

A credit bubble develops when there's too much money to lend and too few places to lend it. A world capital glut has been created by the impending retirement of the baby-boom generation and the globalization of finance, which has made the savings of billions of people in developing countries available for investment overseas.

It would be comforting to believe that the availability of all this money precipitated a deterioration of lending standards in only a few credit markets, such as subprime mortgages. But in an efficient global financial market in which money flows toward the best return, it is more likely that loosey-goosey lending anywhere is a symptom of loosey-goosey lending everywhere. If so, it's likely that this credit correction has only just begun.

A turning point was certainly the demise this month of two hedge funds run by Bear Stearns, a highly respected Wall Street firm. What was noteworthy was not only the speed of the collapse, but also that some of the assets in the funds carried AA and even AAA credit ratings, meaning they were supposed to be safe investments.

In the wake of such developments, S&P, Moody's and Fitch have downgraded the ratings of billions of dollars in outstanding bonds and warned of possible downgrades in tens of billions of dollars more. Such downgrades would force banks and investment funds to mark down the value of their holdings. More ominously, such downgrades could trigger another round of forced sales as hedge funds and other investors scramble to meet margin calls by lenders whose collateral is no longer valuable enough to cover outstanding loans.

In truth, nobody knows how all this will play out. Many of the newfangled financial instruments at the heart of today's credit system have never been fully tested in a market panic. And for all their claims to rationality, financial markets are still driven by the emotions of greed and fear that cause markets to overshoot on the way up as well as on the way down.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

© 2007 The Washington Post Company