As we head into the economic abyss (as the AP
put it) and the Fed goes where it’s never gone before (as BusinessWeek
put it), we have to ask ourselves, what are the next shoes to drop?
Here I’ve located what I think are the next two most likely shoes to
Understanding how things got so bad means rewinding to the start of the
housing boom. Wall Street and the banks made it far easier for people
with shaky credit to get a mortgage — known as a subprime loan.
"This problem begins with the fact that we underwrote mortgages
sloppily, which means no one really knows what those assets are worth,"
said Lyle Gramley, a former Federal Reserve governor and now an analyst
with Stanford Financial Group. "That makes bankers very leery, and has
resulted in a significant contraction in the availability of credit."
"I think the current financial crisis looks to me like the worst one
since we got into the Depression," says Richard Sylla, who teaches the
history of financial institutions at New York University’s Stern School
A pretty interesting article from the AP, which is,
in my opinion, among the worst (best?) at sugar-coating and downplaying
the risks to the economy.
The Federal Reserve has stretched its mandate up, down, and sideways to
prevent a financial market deluge. Now it appears to be stretching the
English language a bit as well. What the Fed is calling a $29 billion
"loan" to help finance JPMorgan Chase’s (JPM) purchase of Bear Stearns
(BSC) looks much more like a $29 billion investment in securities owned
by Bear. Although the Fed insists that it isn’t technically buying any
assets, in practical terms it’s doing exactly that. All this adds up to
a big and unacknowledged step up in the central bank’s financial
intervention with Wall Street investment banks.
To understand what’s going on, go back to the weekend of Mar. 15-16,
when the Fed encouraged JPMorgan to buy Bear Stearns at a fire-sale
price to keep Bear from going under and dragging other banks down with
it. Even at $2 a share, JPMorgan wasn’t willing to do the deal because
lots of Bear’s assets, despite having an investment-grade rating, were
worth almost zero in the then-skittish marketplace.
So the Fed got creative. It set up an arcane arrangement that will give
JPMorgan the full appraised value for some of Bear’s assets if JPMorgan
succeeds in acquiring Bear.
Here’s how it works: A Delaware-based limited liability company will be
set up to receive, upon completion of the merger, $30 billion in
various Bear holdings, such as mortgage-backed securities. The Fed will
lend $29 billion to that company, which will pass all the money along
to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to
the Delaware company. The company, managed by BlackRock Financial
Management, will pay back the loans by gradually liquidating the
assets. As a protection for the Fed, it gets paid back fully before
JPMorgan gets back anything on its loan. The other sweetener for the
Fed is that if there’s money left over even after JPMorgan gets repaid,
the Fed gets it all.
Well, isn’t that interesting? I wondered how that $30 billion from the
Fed got ‘injected’ in the BSC deal. In a cartoon-like fashion, I
imagined that the Fed just wired the money over. Instead, they (very
rapidly) created a separate holding corporation to receive both assets
and liabilities and found a third party to run it. Nice work for a
However, this tells us something very important: The Fed does not
actually want to hold any of the truly rotten garbage in its own
portfolio. This means the Fed is seeking to insulate itself. What does
this tell us? Even the Fed does not have confidence in these assets,
and the Fed is *not* willing to risk it all on this, or any other,
Little by little, millions of Americans surrendered equity in their
homes in recent years. Lulled by good times, they borrowed — sometimes
heavily — against the roofs over their heads.
Now the bill is coming due. As the housing market spirals downward,
home equity loans, which turn home sweet home into cash sweet cash, are
becoming the next flash point in the mortgage crisis. Americans owe a
staggering $1.1 trillion on home equity loans — and banks are
increasingly worried they may not get some of that money back.
The next shoe to drop. Too bad our economy looks like a tree festooned with the contents of Imelda Marcos’ closet right now.
NEW YORK (Reuters) – Big Mid-Atlantic banks face
more losses from the real estate slump, according to a report on Monday
from a regional Federal Reserve that suggests the worst has not passed
for the beleaguered banking sector.
Prospects of an ever-growing stockpile of bad loans on homes,
office buildings and shopping malls will likely force banks to seek
additional capital and/or to put aside more money to cover further
losses, the Philadelphia Federal Reserve said.
While the latest study focused on banks the regional Fed oversees
in three Mid-Atlantic states — Pennsylvania, New Jersey and Delaware,
many of them do business across the country.
Financial conditions at these large Mid-Atlantic banks worsened
across the board in the last quarter of 2007, deteriorating to their
weakest levels in 15 years by some measures, the Philadelphia Fed said.
The next, next shoe to drop. I wrote about
this prospect about a year ago. The key here is to understand that it
is primarily the mid-sized and regional banks that do the bulk of the
Commercial & Industrial loaning. Which means they are the most
heavily exposed to losses that might result from, oh, say, defaults by
the developers of the ill-advised mall built on the outskirts near the
empty, overpriced and unsold houses on the edge of town.
If these losses are in the hundreds of billions (likely), then, statistically speaking, it is possible that nearly all of the capital of the mid-sized regional banks will be wiped out.
This is why I constantly caution you to pick your bank very
carefully, and, even then, to keep your eye firmly focused on how your
bank is doing.