Looking for Footing on Shaky Ground

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By Steven Pearlstein
Saturday, August 11, 2007

Whew! What was that all about?

So much of what has been going on in financial markets has been so complicated, so distant, so hidden from view that it's easy to dismiss it as nothing more than a mud fight among the financial titans. After all, who cares if a couple of hedge funds go under or a bank in Germany needs to be rescued or that central banks have to inject $350 billion worth of "liquidity" into the financial system?

But as the Greeks understood, battles among the gods wind up having earthly reverberations. It's hard to say exactly how much or when, but the general direction isn't much in doubt. Over the next year or maybe longer, the value of your pension fund or your 401(k) is likely to decline, along with the value of your house, impressionist paintings and the cost of renting a house in the Hamptons.

It will be a bit harder and more expensive for most people to borrow money for a house or a car or keep an unpaid balance on a credit card. And as the economy slows, unemployment will rise, income growth will slow, personal and corporate bankruptcies will increase, and governments will face shortfalls in revenue.

Order of magnitude: something approximating the recent tech and telecom bust, only a bit worse. Stocks may fare better, but real estate, the credit markets and the economy will take serious blows.

What the week's turmoil reminds us is that the world of finance is, by its nature, something of a Ponzi scheme. That's not to say that it's fraudulent or abusive, though the behavior of some subprime mortgage brokers and their Wall Street enablers could certainly be characterized as such. But what it does mean is that the business of extending credit is fundamentally a confidence game that quickly degenerates when people start to become nervous about getting repaid. And in a world where money is mobile and financial institutions global, a crisis of confidence in one region or sector can spread faster than wildfire in a Malibu canyon.

Like most financial crises, this one has two distinct but related parts.

There is, first, the genuine credit crisis that is just beginning to unfold as homeowners find that they cannot make payments on the mortgage loans they should never have been given in the first place. In a matter of months, the number of mortgage loans in arrears has gone from historic lows to near historic highs, with the worst yet to come as teaser rates are reset.

This is a financial, economic and political time bomb that is likely to force families out of their homes; dump millions of houses and condos onto an already glutted market; and result in massive losses for mortgage lenders, hedge funds, banks, insurance companies and pension funds that hold securities backed by, or somehow tied to, these troubled mortgages. And despite the happy talk from Washington and Wall Street investment houses -- eerily reminiscent, by the way, of the early days of the savings-and-loan crisis of the late '80s -- these shocks will have serious consequences for an economy that will be lucky to avoid at least a mild recession.

Because this credit time bomb has a long, slow fuse, it can't fully explain why this week the major banks around the world and some of their biggest loan customers, the hedge funds, suddenly found themselves short of cash. And this brings us to the second component of the recent turmoil, the liquidity crisis.

Remember, the credit system is a confidence game that is very sensitive to changes in market psychology. And when that psychology shifts, and greed gives way to fear, the investment herd can stampede in the opposite direction.

That's what happened this week, when BNP Paribas announced that it was halting redemption in three hedge funds that stuffed their books with mortgage-backed securities such that they could no longer be priced because nobody want to buy them. People began to think, "If the largest bank in France is worried about a shortage of cash and the value of the assets on its balance sheets, what other banks and hedge funds are in a similar position?"

And suddenly, every bank was scrambling to build its cash reserves, either by selling what it could or by borrowing money from each other. And with everyone trying to sell and borrow at the same time, there were not enough buyers and lenders to meet their needs. That's when the central banks stepped in with freshly printed dollars and euros to lend and buy, "pumping liquidity into the system" until the crisis of confidence had passed and normal market operations could resume.

Obviously, there wouldn't have been a liquidity crisis in the first place if there were not an underlying credit crisis looming. And with more hedge funds starting to report big losses -- Goldman Sachs's $8 billion Global Alpha Fund is the latest -- there will be more stampedes to the exits in the weeks to come.

The big challenge for central bankers will be to figure out whether the market turmoil at any point is more of a liquidity crisis, requiring another temporary infusion of cash, or another step in the nasty repricing of financial assets that must be allowed to proceed if the market is to regain its equilibrium.

In the end, the question isn't whether lenders and borrowers will be spared the consequences of their bad decisions -- that's inevitable. The high-stakes question is whether that process will be orderly enough to avoid a full-blown credit crunch that causes unnecessary damage to the economy as a whole.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

© 2007 The Washington Post Company

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