Financial Fear & Loathing

By Robert Samuelson

WASHINGTON -- It's now said that we're in the worst financial crisis since the Great Depression, but that judgment seems premature. In the 1980s, most of the savings and loan industry, then the largest source of home mortgage loans, was wiped out. At that decade's end, commercial banks faced huge losses on loans to developing countries and for commercial real estate and energy projects. From 1988 to 1992, 905 banks failed, the most since the 1930s. The 1997-98 Asian financial crisis involved more bad lending -- mainly by U.S., Japanese and European banks -- that sent Thailand, South Korea and other nations careening from boom to bust.

What distinguishes this crisis is that it involves the entire financial system, not just depository institutions. Previous financial crises so weakened the banks and S&Ls that they lost their primacy. As recently as 1980, they supplied almost half of all lending -- to companies, consumers and homebuyers. Now their share is less than 30 percent. The gap has been filled by "securitization": the bundling of mortgages, credit card debt and other loans into bond-like instruments that are sold to all manner of investors (banks themselves, pension funds, hedge funds, insurance companies).

As a result, the nature of financial crises changed. With a traditional "bank run," the object was to reassure the public. The central bank -- the Federal Reserve in the United States -- lent cash to solvent banks so that they could repay worried depositors and pre-empt a panic that would spread to more and more banks and would ultimately deprive the economy of credit. But now the fear and uncertainty center on the value of highly complex, opaque securities and the myriad financial institutions that hold them.

At the epicenter of the crisis are the now-notorious "subprime" mortgages made to weaker borrowers and subsequently "securitized." On paper, the financial system seems to have ample resources to absorb losses. Commercial banks have $1.3 trillion in capital; U.S. investment banks in 2006 had an estimated $280 billion in capital -- and other investors, including foreigners, may hold half or more of subprime loans. But no one knows who or how much. Recent estimates of subprime losses range from $285 billion to $400 billion. They might go higher. Ignorance breeds caution and fear.

The stunning fall of Bear Stearns reflects these realities. It was not a traditional commercial bank that took deposits from the public but America's fifth-largest investment bank that funded most of its operations with borrowed money ("leverage"). On average, the ratio of borrowed money to underlying capital for investment banks and hedge funds is about 32-1, according to a recent study. Many of these loans -- commercial paper, "repurchase agreements," bank credits -- are backed by the securities owned by the borrowing financial institutions.

What this means is that if lenders became worried about the worth of these securities, they might ask for more collateral or pull their loans. In effect, that's what happened to Bear Stearns. Deprived of its credit lifeblood, Bear Stearns either had to collapse or be purchased by someone with credit. J.P. Morgan Chase bought Bear for almost nothing: $236 million for a firm valued at $20 billion in January of 2007.

Whether Bear Stearns was the victim of unfounded rumor or of genuine rot in its securities portfolio is unclear. But the very uncertainty defines the nature of the modern financial crisis -- and the difficulties facing the Fed in trying to contain it. Financial institutions (banks, investment banks, hedge funds, and others) are interconnected through networks of buying, selling, borrowing and lending. These require confidence that commitments made will be commitments honored. If the confidence collapses, the processes of extending credit for the economy and of trading -- for stocks, bonds, foreign exchange -- may also collapse.

The Fed can no longer instill confidence by lending to besieged but sound banks. Somehow it must reassure the broader market that there are backup sources of credit and that the failure of any major financial institution won't trigger a chain reaction of failures, as firms refuse to deal with each other and dump stocks, bonds and other securities onto the market. That's why the Fed was eager to see Bear Stearns continue operations by being purchased and why it has, in the past six months, introduced more and more ways for financial institutions to borrow from the Fed itself.

So far, panic has been avoided, though some observers think the Fed's frantic efforts have actually undermined confidence. Meanwhile, the real economy of production and jobs, though weakening, is not yet in dire straits. In February, manufacturing output dropped 0.2 percent: bad news but hardly a calamity. But in trying to calm financial markets, the Fed has spewed out enormous amounts of money and credit that have depressed the dollar's exchange rate and could aggravate inflation. The effort to fix one problem may lead to others.