More Room to Fall

Steven Pearlstein
Tuesday, January 22, 2008; 10:41 AM

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 the global stock market meltdown of the last two days, all this talk of "decoupling" may have been a bit premature. Although 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.

That realization has now driven the Federal Reserve, in an unusual move between its scheduled meetings, to cut interest rates by three-quarters of a percentage point. The Fed, like other central bankers, still has real concerns about too-high inflation and the appearance that it is being railroaded by investors demanding a return to the days of cheap money. But faced this morning with a second wave of round-the-world selling, the Fed obviously concluded 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 merely confirms what the markets have already concluded while quieting criticism that the central banks have been "behind the curve."

True to form, some Wall Street traders complained this morning that the Fed move was too little, too late. But clearly the bigger disappointment was that the Fed was not joined by either the Bank of Japan or the European Central Bank in a coordinated move to ease credit conditions that would have acknowledged the increasing interdependence of global economies and financial markets. Both central banks are now likely to come under increasing political pressure at home to respond to the market meltdown and gathering recession threat.

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.

Even the Bank of China, one of that country's biggest, announced this week that it was taking a $2 billion write-off for securities backed by U.S. mortgages.

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.

Over the weekend, ACA reached a standstill agreement with creditors and counterparties who agreed to give it 30 days to raise additional capital or unwind its $60 billion in credit default swaps.

Also facing possible ratings downgrades -- and with that, the increased possibility of default -- are ACA's largest rivals, MBIA and Ambac. Together, those firms insure more than $2 trillion in loans, bonds and other securities. Because the credit-default-swaps market is almost completely unregulated, it's anyone's guess who is at the other end of those swaps.

Although most of the focus has been on the unwinding of the credit bubble here in the United States, there are problems with bubbles in other parts of the world. Those, too, played a role in yesterday's stock market rout.

In India, for example, demand for shares has been so frenzied that last week's initial public offering by Reliance Power had 10 investors clamoring for each share that was offered. Not surprisingly, Reliance was one of the biggest losers in yesterday's rout as selling shaved 7.4 percent from the Bombay Stock Exchange's benchmark index of 30 companies.

In China, where demand for shares is so brisk that the Shanghai stock index has more than doubled in each of the past two years, officials recently concluded that one way to cool things down was to increase the supply of shares being traded. It may have been no coincidence, then, that yesterday's 5.14 percent plunge came on the same day that three major share offerings were announced, including $20 billion by Pinan, the insurer.

Stock markets in Russia and Brazil too were hit hard yesterday, each falling by about 7 percent.

This kind of contagion is rarely a one-off event. Indeed, in Europe and Japan, yesterday's rout was merely an acceleration of a sell-off that began months ago. It's unlikely that the bottom has been reached.

As Bill Conway, a founder of the Carlyle Group and the investment guru of the private-equity firm, told The Post's Thomas Heath last week: "We are nearer the beginning than we are the end . . . The economy is going to be relatively weaker, at least for another year, than it has been the last five years. There are very significant problems ahead."

Steven Pearlstein can be reached

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