Caught in a Downdraft and Starting to Panic

By Steven Pearlstein
Wednesday, January 16, 2008

Are we having fun yet?

Okay, so maybe the economy has fallen into recession. Maybe house prices are going to decline 12 percent by the time it's all done, as Fannie Mae's chief executive said last week. Maybe this won't be the year for that 13 percent stock-price rebound that Goldman Sachs's crack investment strategist, Abby Joseph Cohen, predicted only last month. Maybe nearly a million workers were added to the unemployment rolls in the past nine months and a million more will be added before it's all over. And maybe there's really not much that the Federal Reserve can -- or should -- do to prevent this painful adjustment.

But, hey, look on the bright side: The country and Wall Street have already made great progress in moving through the stages of economic grief:

¿ Willful blindness. ("Bubble, what bubble?")

¿ Denial. ("House prices never fall. It's only those speculators in Las Vegas and the Gulf Coast.")

¿ Rationalization. ("Maybe subprime did get out of hand, but it's really a small part of the market.")

¿ Fantasy. ("Things should be pretty much back to normal by the second half of '08.")

¿ Anger. ("If it weren't for those yahoos up in structured finance . . . ")

¿ Capitulation. ("We might as well take these write-downs now and get it over with.")

¿ Depression. ("This is going to get worse before it gets better.")

Now we're entering a new stage: Panic.

Hedge funds scrambling to actually hedge their positions. Central banks throwing money at money-center banks. Huge financial institutions desperately raising capital from foreign investors on concessionary terms. Day after day of triple-digit declines on the Dow. Gold prices heading toward $1,000 an ounce, with record lows on the dollar. Policymakers and politicians tripping over one another to offer economic-stimulus plans.

To give you a sense of just how dramatically the tide has turned, consider what's happened to the Blackstone Group since those heady days after the private-equity firm decided to take itself public back in June. Six months later, its shares are selling for less than $20, about half their post-IPO peak.

Or how about Harman International, which in April struck a deal to sell itself to KKR for $120 a share? Harman closed yesterday at $40.30 after KKR walked away from the deal and Harman was forced to acknowledge that maybe its prospects weren't as bright as it once thought.

And how about Sallie Mae, another corporate bride left at the altar? In July, Sallie was valued at $60 a share by a buyout consortium led by J.C. Flowers. Now it is trading at less than $20.

The downdraft is getting so strong that even China is becoming nervous about throwing good money after bad. Having lost money on recent investments in Blackstone, Bear Sterns and Barclays, the government rejected a proposal by China's Development Bank to join the Citigroup rescue effort.

Despite the brave exhortations from the CNBC Squawk Box, we are nowhere near the end of the financial unraveling that is necessary for an economic bottom to be reached.

The most eye-popping figuring in yesterday's report from Citigroup wasn't the cumulative $18 billion in write-downs on its subprime mortgage investments, but the $5.2 billion reserve it was setting aside for losses on its vanilla-variety home equity loans, auto loans and credit card loans -- five times the loss reserve last year, when delinquencies were at historic lows. If other lenders are experiencing similar increases -- recent reports from American Express and Capital One suggest it -- then even banks that never heard of structured finance are in for a rough ride.

If that weren't enough, many of those same banks face the prospect that developers will be unable to find permanent financing for the office buildings and shopping centers whose construction has been financed with short-term bank loans. With investors still unwilling to buy newly securitized packages of commercial real estate loans, the only source of permanent financing is insurance companies and pension funds, which are demanding that developers and their investors cover 20 percent of project costs with their own money.

In the best case, that would pretty much blow any chance for investors to earn those double-digit returns they were promised. In the worst case, it would mean that some banks may end up as part-owners of half-empty office buildings and shopping centers that are now worth less than it cost to build them.

Looking ahead, the final phase of this unraveling is likely to implicate the giant market in credit-default swaps. Those swaps are essentially contracts that allow sophisticated investors to bet on whether a company, a government entity, or even a securitized package of loans will default on its debt obligations. And they can place these bets whether they own the underlying security or not.

Because these contracts trade on unregulated derivatives markets, nobody knows who holds the losing side of the bets. But it's a good guess that if defaults rise even to historically normal levels, a big hit will be taken by highly leveraged hedge funds, some of which may be unable to pay off on their bets and simply collapse. That, in turn, would trigger even further losses by banks and other investors that, unlike pure speculators, rely on those instruments to insure against default.

The credit-default swap has become so central to modern global finance that its size -- the amount insured, in effect -- is estimated at $43 trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a financial chain reaction that could easily rival the subprime debacle.