More Room to Fall

Steven Pearlstein
Tuesday, January 22, 2008

With the explosive growth in developing countries such as China and India, and a modest revival of business in Europe, economists have begun to suggest that the global economy is no longer so reliant on the United States.

But judging from yesterday's global stock market meltdown, all this talk of "decoupling" may have been a bit premature. For though it may no longer be true that a healthy U.S. economy can single-handedly keep the global economy humming, it still looks to be a necessary ingredient to global prosperity.

As markets open this morning, investors will be desperate for some signal from economic policymakers that they share their concern about the global impact of a U.S. recession. Trading in U.S. stock futures yesterday suggested that the Dow Jones industrial average would fall more than 500 points at the opening bell, while in Tokyo this morning, early trading put the Nikkei average down almost 4 percent. Those developments increased the possibility that the Federal Reserve, European Central Bank, Bank of England and Bank of Canada might respond with a coordinated cut in interest rates.

Central bankers still have real concerns about too-high inflation and the appearance that they are being railroaded by investors demanding a return to the days of cheap money. But they may conclude that the greater danger lies in a disorderly unwinding of the global credit bubble that could spiral out of control.

Moreover, in yesterday's stampede out of stocks, investors sought refuge in the safety of government bonds, which had the effect of driving down interest rates. A rate cut would merely confirm what the markets have already concluded and the quiet criticism that the central banks have been "behind the curve."

During the financial market disturbance last summer, economic policymakers were mostly concerned about liquidity -- the availability of short-term money as banks husband their cash rather than lend to one another. But after aggressive efforts by the central banks to make hundreds of billions of dollars available to banks on easy terms, the liquidity crisis has largely abated.

The problem now is a more serious one -- a credit crisis in which commercial banks, investment banks, insurance companies and hedge funds all around the world are being forced to write off billions of dollars from American subprime mortgages and more exotic securities. The stronger ones have enough capital, or can raise it, so that their viability is not jeopardized by these losses. But if even a few of the weaker ones collapse and are unable to repay loans or make good on their commitments, it would have a domino effect that could threaten still more institutions and trigger another wave of panicked selling.

It is those considerations, as much as a sudden realization over the weekend that the U.S. economy was tipping into recession, that drove yesterday's sell-off. Leading the way down were shares of big banks and insurance companies, which fell 6 to 10 percent.

While most of the big U.S. financial institutions have acknowledged major write-offs, most European banks have not, and rumors of what's in store have just begun.

In Germany, where the DAX index fell by more than 7 percent, Hypo Real Estate Holding, a relatively obscure lender, shocked markets last week with news that it had lost $570 million on its holdings of collateralized debt obligations. Its shares fell 33 percent. Yesterday, WestLB, Germany's third-biggest lender, said it would post a $1.45 billion loss after suffering trading losses on subprime mortgage securities.

Here in the United States, the spotlight is on a group of firms that traded heavily in what are called credit default swaps -- contracts that, in effect, offer to insure corporate bonds, takeover loans and asset-backed securities against default. The buyers of these insurance contracts included banks, pension funds, hedge funds and investment houses that used the swaps to hedge their bets or construct elaborate, computer-driven trading strategies. Now, the prospect that one or more of the insurers may not be able to make good on the insurance has rattled their customers and their lenders, who in some cases are one and the same.

One of those insurers, ACA, is effectively under the receivership of Maryland's insurance commissioner after losing more than $1 billion in the third quarter and seeing its credit rating drop from AAA to CCC in a single move. Merrill Lynch has been forced to write down $1.9 billion to reflect the likelihood of an ACA default, while the Canadian Imperial Bank of Commerce said it would have to issue $2.75 billion in additional stock to offset losses it thought it had insured against with ACA.

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