Wall Street scrambles to avert a meltdown

By Lee Sustar

THE WORLD financial system is out of control--and the crisis is only beginning. That's the growing consensus of economists, stockbrokers and bankers in the wake of the collapse of the investment bank Bear Stearns, the fifth-largest firm on Wall Street.

"We have all been talking about a 1970s-style crisis, but as each day goes by, this looks more like the 1930s," Michael Taylor of Lombard, the British economic consulting company, told the Independent newspaper. "No one has any clue as to where this is going to end; it's a self-feeding disaster."

The U.S. stock market stabilized at the beginning of the week after the Federal Reserve Bank stepped in with an emergency bailout of Bear Stearns and arranged its takeover by rival J.P. Morgan Chase--at the price of just $2 per share for a company that not long ago claimed a book value of $80 per share.

The Fed went much further, invoking a Depression-era law to announce that it would make emergency loans available directly to investment banks, as well as to commercial banks, in order to maintain the flow of credit between financial institutions.

What else to read

For more background on the worsening state of the economy, see Joel Geier's "More than a recession: An economic model unravels," published in the International Socialist Review.

In an interview with Fortune magazine, headlined "How bad is the mortgage crisis going to get?" economist and New York Times columnist Paul Krugman talks about the scale of the housing crisis and the impact of Wall Street's financial turmoil on the economy.

For a closer look at the mortgage and housing crisis, see Petrino DiLeo's "Housing bubble deflates," in the ISR last year.

As New York Times financial columnist Floyd Norris pointed out, it was the 11th step taken by the Fed since August to bail out the financial system, including cuts in interest rates and loans that make it easier for the banks to borrow money.

A 12th measure by the Fed--another cut in interest rates--was expected as Socialist Worker went to press. But these repeated attempt to inject capital into the banking system haven't prevented the recurrence of a credit crunch that first emerged last summer.

Despite the lower rates and expanded lending from the Fed, banks are reluctant to lend to one another, either because they need to preserve capital to absorb expected losses, or because they don't trust their counterparties to be able to repay them.

"The Fed can do no good at all if they effectively print money and give it to the banks, and the banks dig a hole in the ground and put it in there," Donald Brownstein, a hedge fund manager, told the New York Times.

- - - - - - - - - - - - - - - -

IF BEAR Stearns was the first Wall Street titan to fall, it's because it was among the most aggressive purveyors of mortgage-backed securities--financial instruments tied to the repayment of mortgages. When sub-prime mortgages began to go bad in mid-2007, Bear Stearns saw two of its hedge funds, or specialized investment vehicles, collapse.

Other big-name banks have had to turn to "sovereign investment funds" run by foreign governments to cover their own losses in mortgage-backed securities and related investments. Singapore's government fund invested $9.7 billion in UBS, and the China Investment Corporation handed $5 billion to Morgan Stanley. Citigroup was forced to sell a $7.5 billion share of the company to the Abu Dhabi Investment Authority, giving it a 5 percent stake in the mega-bank.

Those are big sums, but they pale in comparison to the scale of the crisis. Overall, the collapse in value of mortgage-backed securities has forced banks worldwide to write off more than $150 billion in losses. As the Bear Stearns collapse portends, many more losses are still to come: the credit crisis has spilled beyond mortgages into virtually every corner of the credit market, from auto and student loans for consumers to obscure business-to-business markets.

For example, the so-called auction-rate securities market has ceased to function entirely. Once regarded as an investment so safe that it was like holding cash, the market allowed government agencies and not-for-profit institutions to borrow easily at low interest rates that were set in weekly auctions. But earlier this year, bids dried up, forcing interest rates up.

Hedge funds, the specialized investment vehicles for wealthy investors, have also been hit with huge losses. Carlyle Capital, a spinoff of the private investment fund the Carlyle Group, was unable to repay its creditors. Its assets were seized this month.

The same pattern can be seen in other credit markets worldwide. "The U.S. is at the receiving end of a massive margin call," wrote Liz Rappaport and Justin Lahart of the Wall Street Journal, using the term for when investors are required to put up cash or securities to cover money they had borrowed. "Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts."

It's that dynamic that took down Bear Stearns--its creditors essentially demanded that it pay off debts, and it didn't have the money to do it. The Fed agreed to accept Bear's radioactive mortgage-backed securities as collateral for an emergency loan made to the investment bank by J.P. Morgan. If the securities decline in value, the Fed--and U.S. taxpayers--will take the loss, not J.P. Morgan.

In fact, a week before the Bear Stearns debacle, the Fed had already announced that it would accept mortgage-backed securities as collateral for special loans to banks--another way of pumping cash into the system, but in exchange for securities so troubled that they can't be sold on the open market.

Thus, while the Bush administration abandons victims of mortgage fraud to the fate of foreclosure, it has given a green light to Fed Chair Ben Bernanke to rescue Wall Street at any cost.

Those costs are likely to be heavy. Already, the Fed's repeated interest rate cuts have compelled international investors to sell dollars, driving the value of the currency to new lows against the euro and the Japanese yen. This is adding to the international financial instability.

"In the credit market panic that began in August, we have now reached the point of maximum danger: A global run on the dollar that could become a rout," a Wall Street Journal editorial declared.

"The Fed's main achievement so far has been to stir a global lack of confidence in the greenback. By every available indicator, investors are fleeing the dollar for other currencies and such traditional safe havens as gold and commodities. Oil has surged to $110 a barrel, up from under $70 as recently as September. Gold is above $1,000 an ounce, up from $700 in September, and food prices are soaring across the board...

"The flight from the dollar has made U.S.-based investments less attractive, at a time when the U.S. financial system urgently needs to raise capital."

New York Times business columnist Gretchen Morgenson also sounded the alarm. "What are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in?" she wrote.

"Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year? Or all of the above? Stick around, because we'll soon find out. And it's not going to be pretty."

- - - - - - - - - - - - - - - -

IN FACT, it's plenty ugly already. According to the Commerce Department, the U.S. economy slowed to a rate of 0.6 percent growth in the fourth quarter of 2007. The financial crisis will almost certainly restrict growth even further as debt-burdened businesses fail and even profitable companies cut back because of a lack of credit. Thus, the financial crisis will be a dead weight on the real economy as well.

The signs of a further slowdown are already apparent. The government's February jobs report showed a loss of 63,000 jobs, the second consecutive month of decline and the third consecutive month of job losses in the private sector. While mass layoffs have not yet taken place, employers are on a virtual hiring strike.

While the unemployment rate is still relatively low at 4.8 percent, the overall figure doesn't reflect the rise in long-term joblessness and the fact that millions have dropped out of the active labor market because of poor job prospects.

Plus, real wages--pay after taking inflation into account--are dropping. "Inflation...driven up by higher energy prices, is growing about twice as fast as was the case one year ago," the Economic Policy Institute's Jared Bernstein noted. "This combination has led to the dramatic shift in the buying power of workers' paychecks. A year ago, real hourly and weekly earnings grew on a yearly basis by over 2 percent; this January, they are both down by about 1 percent."

Further, because work hours are being cut due to the slowing economy, weekly paychecks are shrinking even faster, Bernstein noted.

To rising joblessness and declining wages, add the continuing negative impact of the housing crisis. According to the Federal Reserve, net household wealth declined by $900 billion in the fourth quarter of 2007 due to falling house prices.

That decline in house prices also meant that--for the first time in history--homeowners' equity in their homes fell below 50 percent. Some 30 percent of all homes bought in 2005 and 2006 are now worth less than what their owners owe on their mortgages. The inevitable result is that the rate of foreclosures--already at a record 7.9 percent--will go even higher.

The Bush administration promises that the recent $168 billion economic stimulus package will avert a recession. Behind the scenes, policymakers are thrashing about for a solution.

While there is no coherent plan, some elements of a White House plan are coming into view: stick taxpayers with the cost of bailing out Wall Street, abandon millions of homeowners to foreclosure, cut real wages by allowing inflation to eat up workers' paychecks, and hope the tax rebates in the stimulus plan will keep the economy moving until things somehow get better.

It's impossible to predict the depth and length of the recession. But what is already clear is that the problems that it is creating go far beyond the policy proposals not only of the Bush administration, but the Democratic presidential candidates as well.