As Economic Leaders Meet, Subprime Woes Look Done But Not So Other Crises
Is the worst over? That will be a big talking point when finance ministers, bankers and central bankers gather in Washington this weekend for meetings of the International Monetary Fund and Group of Seven industrial nations.
The answer to the question depends on which crisis one is talking about. If it is risky subprime mortgages, the answer probably is yes. If it is the broader economy, the damage has barely started. As for the turmoil in the banking sector, we may be over the hump but it would be foolish to count on it.
Look, first, at the U.S. subprime crisis. The IMF calculates banks have recognized roughly two-thirds of their expected losses from U.S. residential mortgage lending to risky borrowers, and a somewhat smaller portion of expected losses from commercial real estate and loans for leveraged buyouts.
Getting this far has been painful. It has forced several financial institutions to the brink, notably Bear Stearns. But the
U.S. Federal Reserve stepped in to prevent a catastrophe, in the process throwing its protective mantle around pretty much the whole investment-banking industry.
What is more, banks are coming. to terms with their problems. The writedowns haven't come as fast as a purist would like. Still, they have come a lot faster than, say, in Japan in the 1990s. Banks also have started to repair their tattered balance sheets, most recently Washington Mutual with its $7 billion of new capital.
So the subprime crisis probably is about halfway over. Still, this chapter won't be closed until dodgy assets start trading smoothly-and that isn't happening yet. Wall Street no longer is churning out new, trashy paper; but the old inventory is still semi-stuck. Even headline-grabbing deals like Citigroup's proposed sale of $12 billion in leveraged loans aren't quite what they seem. In a round-robin deal, the bank is set to lend the buyers three-quarters of the cash they need to buy the assets.
Although some assets now appear cheap, nobody wants to call the bottom. Morgan Stanley boss John Mack this week said he was keeping his powder dry. Another Wall Street titan was even blunter in private: He still is looking to cut debt. No wonder banks and brokers seem to be falling over themselves to tap central-bank lending facilities on both sides of the Atlantic and that the gap between interbank interest rates and base rates still is exceptionally high.
Now look at the broader economy. Many observers think the U.S. already is in a recession and that the pace of European economic growth is slowing rapidly. But financial pain from the higher unemployment and increase in bankruptcies that typically mark recessions has yet to be felt.
Much of the focus, again, will be housing-albeit no longer loans that started out as subprime. House prices already have fallen sharply in the U.S. and'have started to decline in other markets, such as Britain. But they could fall a lot more. The sharp rise in defaults in the past few months presages a further decline of 14% in average house prices, according to a Goldman Sachs Group analysis of historical patterns.
Further declines in house prices will cause consumers to tighten their belts, creating more of a drag on the economy. That, in turn, will provoke a new rash of loan losses for banks. Given the wounds they already have suffered, they may not be well placed to take much more pain.
Would the losses be enough to provoke a new chapter in the banking crisis? The central bankers converging on Washington this weekend will certainly hope not. Still, they should realize that they, especially the 'Fed, have exhausted a lot of their firepower by slashing rates and pumping cash into the markets in recent months.
The authorities should use the current breathing space to redouble their pressure on banks to raise more capital. That way, if another tsunami hits, there is less risk of everybody being swept away.
By: Hugo Dixon and Edward Hadas
Wall Street Journal; April 11, 2008
