The fundamental reason for the turmoil on Wall Street is simple: American people, companies and investment banks borrowed far more money than they could afford. Undoing this, as we’ve seen in recent days, will be difficult, painful and expensive.
The financial term for what is happening in the economic markets, worldwide, not just in the United States, is deleveraging, or the undoing of debt. With so much debt being deleveraged now, investment values have plummeted, causing the collapse of financial giants such as Bear Stearns and Lehman Bros.
In a comprehensive assessment of what it calls the “worst crisis since ’30s, with no end in sight,” Thursday’s Wall Street Journal reported household borrowing grew an average of 11 percent per year between 2002 and 2006. Borrowing by financial institutions grew by 10 percent a year. Because these rates far outpaced economic and income growth, this was not sustainable.
Much of the household debt is in the form of mortgages or home equity loans. When housing prices fell, many borrowers were unable to repay, sending ripples through the financial markets, which developed increasingly complex investment vehicles to finance, swap and even bet against such debt.
The Journal identified three things that must happen for the deleveraging to end. “Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions.”
Government bailouts and financing, a mix of which has happened in recent months, only delays the need to fess up to mistakes.
New York Times financial columnist David Leonhardt compares the government’s recent assistance to AIG, the country’s largest insurance company, and mortgage giants Fannie Mae and Freddie Mac to the 1979 bailout of Chrysler. The 10th largest company in the U.S. at the time, the company was near financial ruin because its gas-guzzling vehicles lost popularity as oil prices rose. The company argued that its failure would damage the U.S. economy. It got more than $1 billion in subsidized loans.
The bailout saved the company, but it didn’t halt the decline of U.S. automaking. Instead, Barry Ritholtz, who is working on a book called “Bailout Nation,” argues that the bailout prolonged the problem. If Chrysler had failed, it would have forced other U.S. automakers to rethink things such as fuel efficiency and quality. If these companies had changed their strategy rather than continuing to do business as usual, they may not have seen their share of new vehicle sales in the U.S. drop by almost half.
As The Wall Street Journal reported, there are no easy solutions to the current crisis. So, as happened during the Great Depression and after the Asian market crash in the 1990s, governments “experiment with solutions with varying degrees of success.” The experimentation this time has included outright bailouts, government loans and injecting more money into the economy through the sale of Treasury bills. Expect more experimentation including the creation of an entity like the Resolution Trust Corp., which sold the assets of failed savings and loans in the early 1990s, to recoup some of the taxpayer money now being used to prop up financial institutions.
Expect more bad news before the situation improves.