No Time To Sit and Watch

By Steven Pearlstein
Friday, August 17, 2007

You know that something is up when Hollywood studios can't get financing for their next movies.

What we have on our hands here, folks, is a full-blown, global financial crisis comparable to the junk bond collapse of 1987, the S&L crisis of 1990 or the Asian financial crisis of the late '90s.

On major stock exchanges, stock prices have fallen roughly 10 percent in a matter of weeks in volatile, high-volume trading. And in the past days, the sell-off has been extended to developing markets, where the declines have been even steeper.

Commodity prices have begun to tumble in anticipation of a global economic slowdown.

The yen has recorded its biggest jump against the dollar since 1998 as traders unwind a massive "carry trade" that for five years had allowed them to profit by borrowing at 2 percent in Japan and lending at higher rates in places like the United States or Australia. Meanwhile, the Australian dollar recorded the sharpest declines since it started trading freely in 1983, forcing the central bank Friday morning to intervene in markets to stabilize the currency.

And so many investors are flocking to the safety of the U.S. Treasury that the yield on the three-month bill has fallen nearly three-quarters of a percentage point in just two days, the sharpest decline since the October 1987 stock market crash.

In Canada, a group of banks have gotten together to provide short-term credit to business after the freeze-up in the market for commercial paper.

And here at home, Countrywide Financial, the country's largest mortgage lender, was forced to draw down nearly $12 billion from its existing lines of credit to reassure customers, shareholders and bondholders.

KKR, the onetime king of private equity, reported that its real estate unit faced losses of $300 million in trying to unload the $10 billion worth of mortgages and mortgage-backed securities on its book.

It's to the point that, according to the Financial Times, Goldman Sachs and Deutsche Bank have withdrawn their offer to raise $1 billion for MGM studios to finance production of films including "The Hobbit" and the next "Terminator" and James Bond movies.

Against this backdrop, it was curious to hear Bill Poole, the president of the Federal Reserve Bank of St. Louis, tell Bloomberg News that it would only "upset the market" if the Fed were to "change course in any fundamental way" before there was proof that market turmoil was actually having an impact on the real economy.

Dr. Poole is a stridently right-wing academic who hasn't noticed yet that financial markets now drive the real economy every bit as much as economic factors drive financial markets. His prescription -- that policymakers sit on their hands until economic data confirms a drop in business investment or household consumption -- is akin to a doctor telling his patient not to worry about that spot of lung cancer until it begins to affect his breathing.

Unfortunately, Poole is not the only policymaker who can't seem to get past ideology and outdated economic nostrums.

Although the problem in credit markets has spread well beyond the housing finance market, the inability to sell or borrow against anything associated with mortgages is causing the biggest problems. And yet the Bush administration still stubbornly refuses to allow Fannie Mae and Freddie Mac the latitude to fulfill their core mission and provide liquidity to these markets when private lenders and investors retreat.

With the stroke of a pen, James B. Lockhart, director of the inelegantly named Office of Federal Housing Enterprise Oversight, could free Fan and Fred to borrow more money and buy up more mortgages at a time when rising rates for even prime borrowers are putting extra burdens on a housing market already struggling with excess inventory, declining sales and falling prices.

Instead, Locky thinks it's much more important for Fan and Fred to finish cleaning up their books and continue doing penance for their questionable accounting. After all, why deal with a real-life threat to the safety and soundness of the global financial system when you can focus on the theoretical safety and soundness problem that might arise if Fan and Fred were allowed to temporarily grow their balance sheets.

It is true, as Locky noted in his letter to Fan and Fred, that their legislative charter prevents them from participating in several segments of the mortgage market that are experiencing problems, particularly the market for "jumbo" loans over $417,000. But given the severity of the mortgage meltdown and its knock-on effects throughout the credit markets, it is fair to ask why the Bush administration hasn't worked a deal with congressional leaders to put a pending Fannie-Freddie reform bill first on the agenda when Congress returns after Labor Day. Such an announcement would probably go a long way to calming housing finance markets.

What is not helpful is for the White House and the Treasury to keep repeating the silly line that there's nothing to worry about because the "economic fundamentals" are so strong.

A quick check reveals that, back in 1989, when the S&L crisis was unfolding, the U.S. economy was growing at a healthy 3.5 percent, with unemployment at a comfortable 5.3 percent. In 2000, as the tech and telecom bust was getting underway, annual economic growth was running at 3.7 percent and the jobless rate was at a post-war low of 4 percent.

In both cases, it quickly became apparent that the good "fundamentals" weren't really so fundamental, owing much to an asset bubble that was bound to burst. And in each case, the economy deteriorated so quickly that it caught the Fed and other policymakers flat-footed.

There's no need to make the same mistake again. Now is the moment for the Fed, in concert with other central banks, to use its powers to restore order to financial markets.

That could mean strategically selling dollars and buying yen, for example, to offset the sudden impact of the unwinding of the carry trade.

It could mean lowering the Fed's discount rate, which it charges banks for overnight loans, and opening the discount windows to a wider group of financial institutions.

And it certainly wouldn't hurt if the Fed and the European Central Bank would announce together that, in the face of changing circumstances, they are as worried about too little economic growth as too much inflation.

That seemingly minor tweak to their most recent policy statements would go a long way to calming markets by suggesting that a broader rate cut could be in the offing. More importantly, it would reassure uneasy businesses and consumers that economic policymakers are not so intent on "punishing" investors and lenders for their bad bets that they are willing to force billions of innocent bystanders to suffer as well.

Steven Pearlstein can be reached atpearlsteins@washpost.com.