A New Direction on Wall Street

Panic and uncertainty have sent markets reeling.

On Wall Street, they're calling it the Great Unwind. Trillions of dollars of interlaced leverage and debt is now being removed around the globe after years of steady economic growth and record low interest rates encouraged investors and speculators, including scores of American financial institutions, to take unprecedented risk. Today, it's clear that those bets were made on a now collapsed foundation of greed and overly optimistic economic assumptions. And anyone with a dollar at risk is looking at mathematical models or even Ouija boards to figure out what happens next.

The job of keeping the Great Unwind from turning into another Great Depression has now fallen to Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson. In a mere two weeks, Paulson and Bernanke have transformed American capitalism, as they mount a high-stakes commando operation to head off the worst financial crisis since the '30s. After a dizzying fortnight of near-death experiences, the U.S. government now effectively owns the world's biggest insurance company, American International Group, and has approved up to$85 billion in loans from the American taxpayers to prevent a bankruptcy filing and a deeper market meltdown. The feds are now deeply into the mortgage business, too, thanks to a $200 billion commitment to Fannie Mae and Freddie Mac, which fund three quarters of all home mortgages being written today. "Who would have thought that the United States would nationalize its financial assets?" asks economist James Barth of the nonprofit Milken Institute.

Global gloom. And it's not just an American crisis. Central banks worldwide have been forced to pony up a collective $200 billion plus to unplug the clogged drains of the global credit markets. Russia, recently celebrating its newfound oil wealth, suddenly found its stock market dysfunctional. And China, everyone's great financial superpower of tomorrow, moved to buy up shares in its banks. But not everybody is getting a bailout. When Richard Fuld, CEO of Lehman Brothers, came hat in hand, the feds said no, and Lehman declared bankruptcy virtually overnight. The once venerable Merrill Lynch didn't even wait to be turned down: It rushed into the arms of Bank of America, creating a new, if fragile, financial titan.

At the center of these troubles is America's housing boom and now bust. As the Fed poured cheap money into the system in the past decade to prevent a financial shock after the dot-com bust, interest rates plunged and home prices soared. That fired up the market for mortgage-backed securities. Mortgage brokers lent as much money as they could to hopeful homeowners—even if it meant shaky or even fraudulent loans—since they didn't have to hold the loans themselves. They just passed it along to Wall Street through a process called securitization. Most of the world's major financial institutions ended up with a portfolio of mortgage-backed securities that turned out to be much riskier than any of them or their fancy computer models anticipated.

The whole rickety scheme began to unravel in 2006, when overpriced homes began to fall in value and refinancing became a lot tougher. Then, foreclosures skyrocketed, and mortgage-backed securities began to blow up like time bombs. Investing firms hold very little cash (unlike their commercial bank colleagues) and borrow much of the money they invest. Lehman, for instance, had as little as $1 in cash on hand for every $30 it borrowed. As worried creditors started calling in their loans, the whole show looked like a cat with a ball of string. First to fall was Bear Stearns, which was forced into a shotgun marriage with JPMorgan Chase, with the feds providing a $29 billion dowry.

So far, the government (i.e., the taxpaying public) could be on the hook for more than $300 billion in guarantees and loans. The betting in Washington is that's preferable to a full-scale meltdown that could take an already ailing economy with it. But at some point, the bill has to be paid, and already the critics are wondering whether the bailouts are a placebo treatment that's losing effect. Instead of taking comfort from last week's AIG deal, for instance, the markets plummeted, fearing more devastation ahead. "The feds have exhausted a lot of policy initiatives," UBS executive Mike Dion warned clients. "This may be the deepest crisis in 50 or 100 years, but we'll only know a couple of years from now."

Meanwhile, credit markets are now as jittery as they have ever been. The TED spread, a closely watched gauge of credit risk that measures the spread between three-month treasuries and the London interbank lending rate, has soared to nearly 5 percentage points. That's more than double the spread at any other time during this credit crisis and a big reason why the Fed and other central banks chose to pump more dollars into the system. The actions also serve as a handy metaphor for the Great Unwind: Every apparent answer or solution seems only to raise more questions or reveal more problems lurking beneath. In the meantime, the average American (or Chinese, for that matter) is left to wonder:

If housing is the core problem, when do home prices turn around?

The housing bottom seems to be perpetually just around the corner. Current economic consensus is for the U.S. housing market to finally bottom in mid to late 2009 with price increases coming a year after that. Mark Zandi, chief economist at Moody's Economy.com, guesstimates home prices still have another 5 to 10 percent to fall from current levels. But even after leveling off, home values won't actually begin increasing until the fall of 2010, Zandi says. "We need to get rid of all the excess inventory before prices start rising."

Healthy housing markets have a five to six month supply of unsold homes. The current level in the United States is 11.2 months. But "if [employment] weakens more than I expect—which is very, very possible—then the bottom in prices is further into the future and the day when they start to rise is well into the next decade," Zandi adds.

Is a bigger bailout coming, or is this it?

For all of the government's rescues so far—and there may be more—what's missing is an organized framework for dealing with the crisis. The best precedent for a federal bailout agency is the Resolution Trust Corp., which the government established in 1989 to deal with hundreds of insolvent thrifts that weren't covered by FDIC insurance. The RTC was generally successful: It assumed the powers of a ganglion of predecessor agencies and eventually helped dispose of more than 1,000 troubled thrifts while protecting most of the depositors.

An RTC-like agency that would buy bad debt or even entire institutions may make sense today, by bringing order to what seems like an ad hoc rescue. "It's ironic to say that AIG is too big or too interconnected to fail but then approve Bank of America's acquisition of Merrill Lynch," says Barth of the Milken Institute. "Doesn't that make Bank of America even bigger and more interconnected?" With its hands full, the Bush administration is likely to defer such thorny questions to the next president, though there is plenty of talk now in Congress about just such a plan.

Will the financial mess cause a severe recession . . . or worse?

Bold bailout moves by the Treasury and Federal Reserve may help stop the slide, but don't expect a quick return to normal economic conditions. "It's preventing a broader collapse but doesn't necessarily mean we'll turn around and start growing like mad because all our problems are over. It just prevents a much broader downturn," said Scott Brown, chief economist with Raymond James.

Despite surprisingly robust economic growth of 3.3 percent during the second quarter and help from lower energy prices in the third—which frees up spending money for consumers—economists were already anticipating growth would slow through the end of the year. Job losses, the defining figure in any economic slump, are worsening. In September, the jobless rate jumped to 6.1 percent from 4.7 percent a year ago. The economy has shed more than 600,000 jobs in the past eight months. At the same time, corporate profits are still under pressure, and the factory sector is struggling. Faster economic growth makes the crisis less severe, but right now that seems as unlikely as getting a subprime loan.

What will Wall Street look like a year from now?

Investors spooked by the financial sector in general have been dumping shares of Wall Street's last two big investment banks, Morgan Stanley and Goldman Sachs. But unlike their now defunct competitors, Morgan and Goldman are both still profitable, with some cash to ride out tough times. "I think we've seen the worst institutional failures we're likely to see," says David Beim of Columbia Business School.

But the shakeout of the securities industry is likely to continue. Since the repeal of the Depression-era Glass-Steagall Act in 1999, investment banks that cater to corporations and wealthy investors have been merging with commercial banks that take deposits from ordinary consumers, and that's likely to continue. The Bank of America—Merrill Lynch deal may prove to be a tipping point, and both Morgan and Goldman may end up in the arms of a bank—or vice versa. Such a linkup gives the investment bank access to the vast reserves provided by depositors, and—theoretically—makes the overall enterprise more stable, since there's more cash available to back up investments that Wall Street has been accustomed to financing with debt.

Whether or not more firms merge on their own, it seems certain that the recent generation of a freewheeling Wall Street is ending. Washington will subject more financial firms to the same kinds of regulations that now apply to regular banks—especially if they're taking advantage of cheap federal loans or other government largesse.

In the end, what does the credit crisis mean to the average person?

There is a smidgen of good news here. Those who invest regularly through retirement accounts are now getting deals on shares that were pricier before, albeit after having seen their nest eggs decline by double-digit amounts, says Brad Sorensen of the Schwab Center for Financial Research.

What's more, mortgage rates have also dropped; the average 30-year fixed mortgage rate fell to 5.78 percent last week from 6.52 percent in August, according to Freddie Mac. That is prompting a rash of refinancing. As investors searching for safe havens in a rough market turn to "quality" vehicles such as treasury securities, the yield on 10-year notes has gone down. Since 30-year mortgage rates tend to follow the yield of 10-year treasury notes, they have also fallen, explains banking consultant Bert Ely. But whether this will last depends as much on overall confidence in the market as much as the economic fundamentals.

At the same time, credit card, auto loan, and mortgage lenders are increasingly picky about their borrowers after being forced to write off an increasing number of consumer loans. So while consumers with good credit can borrow money more cheaply, those with sketchier credit histories are finding it more expensive—if they can get approved at all.

Picky lenders. Higher rates. Hard-to-get credit. It's a scenario that Wall Street understands all too well these days.