The weather in Brunswick is outrageously gorgeous today, and good spirits are easy to find. It seems that the case is the same on Wall St. Over the past few weeks, the mood on the Street seems to have taken a turn towards optimism. Many CEOs of the top banks--with the notable exception of Jamie Dimon at JPMorgan, have expressed a belief that "the worse is over." A favorable earnings season, especially for technology companies, has contributed to this sentiment. But, with credit spreads still high, it is clear that not all share this view. There are many reasons for continued pessimism--not least of which is the fact that systemic leverage has not down nearly enough to be realigned with historical averages. If consumers are forced to unwind, they spending will abate, with negative consequences for corporations, especially those burdened with considerable debt. Is the crisis near its end? Or has it barely begun? Time will tell...
Bill Gross, chief investment officer of Pimco, the world's largest bond fund, has in recent years become famous for issuing downbeat warnings about the credit world. This month, however, his tone has turned positively apocalyptic.
"We haven't faced a downturn like this since the Depression," he observed to reporters when talking about the US housing sector and its impact. The debt market's "effect on consumption, its effect on future lending attitudes, could bring [America] close to the zero line in terms of economic growth", he said. "It does keep me up at night."
By Wall Street standards, such sentiments still sound extreme: in public, at least, most financiers are still anxious to avoid any comparisons with the terrible 1930s. Nevertheless, behind the scenes a mood of gloom is spreading across Wall Street and other parts of the financial world.
Until quite recently, many bankers and policymakers hoped that this summer's credit squeeze would prove short-lived. But as winter draws in, bankers and regulators are coming to recognise that the shock that arrived in August could be merely the first chapter in a saga of pain that could last years.
As a result, investor confidence is slipping and, with banks wary of lending to each other, borrowing costs in the money markets are on the rise (see chart). While these price swings may be exaggerated by the looming turn of the year – a period when banks typically hoard cash to flatter their annual accounts – the underlying trend is clearly alarming the authorities. In recent days the European Central Bank, the Bank of Canada and the US Federal Reserve have all acted to pump liquidity into the interbank market in an effort to keep that crucial corner of the financial system from seizing up.
"The liquidity stresses in global money markets are palpable," says Donal O'Mahony, analyst at Davy, the Irish stockbroker. Or as John Hurley, a member of the ECB's governing council, observed on Tuesday: "Recent developments have not been favourable and increase the risk of a more significant spillover from financial markets to broader economic activity." Markets may therefore "continue to remain fragile" for some time.
This climate of fear reflects four inter-related problems. First, projected losses from this year's credit turmoil are continuing to rise. When it first became clear that US homeowners were defaulting on their mortgages, particularly in the so-called subprime category of borrowers with a poor credit history, Ben Bernanke, the Fed chairman, suggested this would create $50bn (£24.1bn, €33.6bn) in losses. But this month he raised the projected loss to $150bn – and many investment banks fear it will be at least twice this size.
That is partly because house prices are falling faster than economists expected but also because lending standards had been far more lax than previously thought. Indeed, standards were so loose that Goldman Sachs analysts now think that total losses on US subprime mortgages issued in 2006 and early 2007 will be as high as 22 cents in the dollar.
If that projection is bad, however, there is worse. As defaults rise on subprime mortgages, other types of debt, such as on credit cards and in car loans, also begin to face defaults. "Investors are now starting to worry that the subprime crisis will broaden out into other forms of consumer and real estate lending," notes Goldman Sachs in a recent research report, which estimates that in a worst-case scenario non-subprime losses could eventually rise as high as $445bn.
If so, this would imply America could be heading for a total credit hit of $700bn or so – and that is without taking account of any losses that might occur if risky corporate loans turn sour too. This is a dramatically bigger shock than investors expected back in August and much larger than the losses in America's last banking shock, the savings and loans crisis of the 1980s. The Goldman team's worst case is not far from the scale of losses produced by Japan's 1990s banking crisis, where bad loans were estimated at $800bn-$1,000bn.
A blow of this scale could take years to absorb. But aside from its size, there is a second feature of the credit crisis now spooking investors: uncertainty about how the credit pain will affect the financial system as a whole. In previous crises, credit losses were usually relatively well contained: in the S&L debacle, for example, bad loans were held by a limited group of US banks, which were well known to regulators.
But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans.
Sectors that had been widely ignored in recent years because they seemed utterly safe and dull – such as bond insurers, money market funds and structured investment vehicles – are also beset by a loss of confidence.
The revelations are making investors fearful about the potential for unexpected chain reactions to develop as complex interlinkages break down in poorly understood corners of the financial world. "Grenades keep going off in the system and nobody quite knows what to think or expect," says one policymaker. "There is a fear of the unknown [risks]."
Aside from this abstract fear, there is also a very tangible concern about which institutions are suffering subprime pain. In recent weeks, large western banks and other financial institutions have written off about $50bn of credit losses. But analysts fear that the coming year-end statements from US banks – and future reports from European banks – could reveal more bad news. Many also suspect that non-bank institutions, such as insurance companies and asset managers, are also holding large losses that have yet to appear. "If mortgage-related losses are $400bn-plus, then banks probably only have a portion," says Geraud Charpin at UBS.
These financial interlinkages, in turn, are fuelling a third concern: the knock-on impact of the credit turmoil on the "real" economy. When the credit crisis first emerged this summer, many economists initially thought it would have limited impact on US growth. Some cited parallels with the events of 1998 surrounding Long Term Capital Management, a hedge fund that imploded: that an event shocked Wall Street but barely affected the wider American economy, let alone that of the world.
But it is now clear that the 2007 credit shock has implications that extend well beyond hedge funds or Wall Street. As the credit losses pile up, the banks' capital resources are being squeezed – and that is forcing them to cut lending, particularly to riskier companies and consumers.
If the process intensifies – and many analysts fear it will – that would undermine economic growth. In turn, this could unleash a second, more pernicious phase of the credit shock: defaults in the corporate arena of the type that have not been seen in the credit squeeze so far. That could, moreover, generate a further round of losses on credit instruments and thus more pain for banks and other investors.
"Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth," Lawrence Summers, former US Treasury secretary, wrote in the Financial Times this week. However, "the odds now favour a US recession that slows growth significantly on a global basis".
Not everybody accepts this downbeat scenario. After all, one mitigating feature of the current market turmoil is that it is occurring after a period of strong global growth – and, in particular, at a time when regions outside the US, such as the emerging economies, continue to boom.
Corporate earnings in the US and Europe remain strong and American consumers do not appear to be panicking: though housing activity is weak, retail sales last Friday – the bellwether post-Thanksgiving shopping day – were relatively strong. For October they were up 5.2 per cent year-on-year.
Many investors also take comfort from a hope that the Fed will slash interest rates to offset any risk of a serious economic downturn. The US bond market, for example, is trading at levels that assume several more rate cuts – totalling at least a full percentage point – before next autumn. "We expect the US and global economy to slow but avoid a serious downturn," say economists at Lehman Brothers, who argue that a recession will be avoided "by central banks changing course".
Nevertheless, the longer the credit squeeze lasts, the greater the risk that the pain will spread from Wall Street to Main Street. If such contagion does occur, there is a fourth problem increasingly alarming investors: a dawning realisation that western authorities have few policy tools with which to resist this spreading financial shock.
Indeed, in the current environment the Fed appears distinctly reluctant to cut rates to the degree that the bond market expects, because inflation pressures are rising. Data on Wednesday are expected to show that inflationary pressures are rising in Europe too, which could also stay the ECB's hand on rates. Even if central banks do eventually throw caution to the winds and slash rates, this may not be enough to ease the problems of the markets. "Rate cuts are part of the solution but probably only just a part of it," observes UBS's Mr Charpin.
That is because this year's shock has, in essence, shattered investor faith in the innovative techniques that have enabled the global banking system to create a wave of cheap credit in recent years.
Investor trust is likely to return only once there is real transparency about existing problems – and when a rethink has taken place of the way that 21st-century finance is done.
At the best of times, these would appear to be difficult tasks; in the current, panicky climate they seem doubly hard – and the steps needed to rebuild investor faith cannot be implemented quickly, however desperately the market might be clamouring for comfort.
"I think we are going to go through next year, certainly the first half of next year, with considerable traumas," Peter Sutherland, chairman of both Goldman Sachs International and BP, said this week. "It is a dangerous period for the world."
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