Lenders and investors are pushing up the interest rates they
demand from financial institutions seen as solid just a few months ago, or
demanding that they sell assets and come up with cash. Banks and Wall Street
firms are so wary about each other that they're pulling back. Financial
markets, anticipating that the Fed will cut rates sharply on Tuesday to try
to limit the depth of a possible recession, are questioning the central
bank's commitment or ability to keep inflation from accelerating.
There are other symptoms of declining confidence. Gold, the
ultimate inflation hedge, is flirting with $1,000 an ounce. Standard &
Poor's Ratings Services, a unit of McGraw-Hill Cos., predicted Thursday that
large financial institutions still need to write down $135 billion in
subprime-related securities, on top of $150 billion in previous write-downs.
Ordinary Americans are worried: Only 20% think the country is generally
headed in the right direction, nearly as low as at any time in the Bush
presidency, according to the latest Wall
Street Journal/NBC News poll1.
"Clearly, the whole world is focused on the financial
crisis and the U.S. is
really the epicenter of the tension," says Carlos Asilis,
chief investment officer at Glovista Investments,
an advisory firm based in New
Jersey. "As a result, we're seeing capital
flow out of the U.S."
That is a troubling prospect for a savings-short, debt-heavy
economy that relies on $2 billion a day from abroad to finance investment. It
is raising the specter of the long-feared crash in the dollar that could
further rattle financial markets and boost U.S. interest rates.
Offsetting the Pain
Though the risks of an unpleasant outcome are worrisome, the
effects of Fed interest-rate cuts and fiscal stimulus have yet to be fully
felt by the U.S.
economy. Moreover, the combination of a weakening dollar -- which remains the
world's favorite currency -- and still-growing economies overseas is boosting
U.S.
exports and offsetting some of the pain of the housing bust and credit
crunch.
But while cash continues to pour into the U.S. from
abroad, this flow has been slowing. In 2007, foreigners' net acquisition of
long-term bonds and stocks in the U.S. was $596 billion, down from
$722 billion in 2006, according to Treasury Department data. Americans,
meanwhile, are investing more of their own money abroad.
Hopes are fading fast that the U.S. economy was suffering from a
thirst for liquidity that standard Fed remedies could quench. Former Treasury
Secretary Lawrence Summers, speaking in Washington yesterday, said he sees
"an increasing risk that the principal policy tool on which we have
relied -- the Federal Reserve lending to banks in one form or another"
-- is like "fighting a virus with antibiotics."
Bob Eisenbeis, a former executive
vice president of the Federal Reserve Bank of Atlanta, says the problem is more than an
inability to find ready buyers for assets. "It is time to step back and
recognize that the current situation isn't a liquidity issue and hasn't been
for some time now," said Mr. Eisenbeis, the
chief monetary economist for Cumberland Advisers. "Rather, there is
uncertainty about the underlying quality of assets -- which is a solvency
issue, driven by a breakdown in highly leveraged positions."
President Bush, speaking in New York and in a television interview
yesterday, showed little appetite for further action. Detailing the steps the
administration has already taken, the president in a speech knocked a couple
of pending proposals. "Government policy," he said, "is like a
person trying to drive a car on a rough patch. If you ever get stuck in a
situation like that, you know full well it's important not to overcorrect --
because when you overcorrect you end up in the ditch."
But few in markets and elsewhere are convinced that the worst
is over for the U.S.,
as each player moves to protect its own interests against potential
calamities seen as improbable just a few months ago. Bear Stearns reassured
investors earlier this week that it was solvent, but speculation that Bear
faced a liquidity crunch had some traders and hedge funds moving to limit
their exposure to it. Yesterday, J.P. Morgan Chase & Co. and the
Federal Reserve Bank of New York
offered emergency funds to keep the troubled investment bank afloat.![[One-two punch]](WSJUSReceivesMarginCall031408_files/image011.gif)
The loss of confidence is now spreading beyond the biggest
banks, with their well-publicized losses on subprime and other risky assets,
to regional and small banks. In the fourth quarter, U.S. banks
reported their smallest net income -- a total of $5.8 billion -- in 16 years,
according to the Federal Deposit Insurance Corp.
![[COnfidence]](WSJUSReceivesMarginCall031408_files/image012.gif)
There's
little sign yet that the worst is past. The "moment of recovery" is
when forecasters turn out to be too pessimistic, says Mr. Summers. That point
hasn't likely arrived. A Wall Street Journal survey of more than 50 economic
forecasters in early March found a profound shift toward pessimism: About 70%
say the U.S.
is currently in recession, and on average they put the odds that this
recession will be worse than the past two mild, short recessions at nearly
50%. Most expect house prices to decline into 2009 or 2010.
This couldn't come at a worse time for U.S.
homeowners. American household debt has more than doubled in a decade to
$13.8 trillion at the end of 2007 from $6.4 trillion in 1999, the vast
majority of it in mortgages and home equity lines, according to Fed data. But
the value of U.S.
householders' biggest asset -- their homes -- is now falling.
Federal Response
The response of the Republican White House,
Democratic Congress and Federal Reserve have been substantial.
President Bush and Congress, with remarkable speed, agreed to a $160 billion
fiscal-stimulus package that will put money in consumers' wallets soon. The
Fed already has cut interest rates by 1 1/4 percentage points this year, and
markets anticipate another 3/4 point cut on Tuesday. The Fed has moved to buy
$400 billion worth of mortgage-backed securities for its $800 billion total
securities portfolio in an effort to jolt that crucial market back to life
and prevent rising mortgage rates from further depressing the U.S. housing
market.
While there is continued debate about how to treat the current
disease, there is a consensus emerging on the causes. "Soaring
delinquencies on U.S.
subprime mortgages were the primary trigger," the heads of the Treasury,
Federal Reserve and Securities and Exchange Commission said in a
lessons-learned report. "However, that initial shock both uncovered and
exacerbated other weaknesses in the global financial system."
Kenneth Rogoff, a Harvard University
economist, says the current difficulty has many mothers -- the housing
bubble, the subprime problem and the fact that the value of U.S. imports
has long outstripped the value of exports. The current account deficit -- the
broadest measure of the trade deficit -- burgeoned, and the U.S. needed
to borrow ever larger amounts of cash from abroad to fund it.
For years, Mr. Rogoff and
like-minded economists harped that the U.S. current account deficit was
unsustainable. But despite the belief that it would necessarily reverse, it
kept growing through the first part of this decade, going from 3.6% of gross
domestic product at the end of 1999 to a record 6.8% at the end of 2005.
Lately, the deficit has seen a slight narrowing, but the combination of
credit crisis and the economic downturn may have proved the catalyst for a
faster, and potentially more dangerous, adjustment.
Pressures in one market spread rapidly to other, often more
distant markets. "The dollar and subprime -- they're two sides of the
same coin," says Princeton
University economist
Hyun Song Shin. Many U.S.
hedge funds and financial institutions were speculating in mortgage-related
securities with money that was ultimately borrowed in Japan, where
interest rates have been low for years. He notes foreign banks' net
liabilities in the yen interbank market surged between April 2006 and April
2007. As investments bought with money borrowed in Japan get sold and converted back
into yen, he says, "we see both a fall in asset prices and a fall in the
dollar."
Crossing a Line
The resulting blow to confidence threatens to further weaken
lending, borrowing, spending and investment in the U.S. economy. "Hedge fund
blowups have so far been one-off situations. One worry is that we'll cross
some line and there'll be a systemic wave of fund failures. It's a reason why
the market is so nervous," says John Tierney, credit derivatives
strategist at Deutsche Bank.
Banks also are increasing the collateral they demand when they
lend to hedge funds that hold municipal bonds. One hedge fund manager
described what appears to be a coordinated effort by big investment banks to
reduce their risk as they faced quarter-end pressures to cleanse their
balance sheets. Lenders declared "by fiat," he said, that
municipal-bond-fund managers needed to post more collateral to back their
borrowings.
As a result, funds run by Blue River Asset Management, 1861
Capital Management and others circulated lists of assets to raise cash. The
sell-off flooded the market with municipal bonds, making it more expensive
for municipalities to borrow and upending the traditional relationship
between tax-exempt municipal bonds and taxable U.S. Treasury bonds. For the
first time in memory, yields on tax-exempt municipal bonds jumped above
yields on taxable U.S. Treasury debt.
Now, many hedge fund managers say, access to borrowed money,
essential for many of their investment strategies to work, has become
virtually impossible.
Mohamed El-Erian, co-chief executive
officer of Allianz SE's Pacific Investment Management Co., says the
hedge-fund community is unwinding its leverage. "This will push more of
them into 'survival mode,' further accentuating distressed sales and
nervousness among the prime brokers," he wrote to his colleagues
Thursday morning. "In such a world, the quality of the assets matters
less than whether you can finance them [or] how liquid they are."
--Rick Brooks and Joanna Slater contributed to
this article.
Write to Liz Rappaport at liz.rappaport@wsj.com2 and
Justin Lahart at justin.lahart@wsj.com3
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