Into The Economic Abyss: How Deep Will It Go?

Source : The Straits Times, Mar 24, 2008

NEW YORK - FOR months, Americans have been subjected to a sort of economic water torture - a maddening drip of bad news about jobs, gas prices, sagging home values, creeping inflation, the slouching dollar and a stock market in bumpy descent.

Then came Bear Stearns. One of the five largest US investment banks nearly collapsed in a single day before the government propped it up by backing emergency loans and a rival stepped in to buy it for a paltry US$2 (S$2.75) per share.

To the drumbeat of signs that seemed to foretell a traditional recession, this added a nightmarish specter - an old-style run on the bank, customers clamoring to pull their cash, a stately Wall Street firm brought to its knees.

The combination has forced the economy to the forefront of the national conversation in a way it has not been since the go-go 1990s, and for entirely opposite reasons.

As economists and Wall Street types grope for historical perspective - which is another way of saying a road map out of this mess - Americans are nervously wondering about retirement savings, interest rates, jobs that had seemed safe.

They are surveying the economic landscape and asking: Just how bad is it? They are peering over the edge and asking: How far down? And the scariest part of all? No one can say for sure.

Economy acting as slowly tightening vice

Even before the crippling of Bear Stearns, the US economy was acting as a slowly tightening vice - an interconnected web of factors combining to squeeze Americans from all sides.

Take Ms Jaci Rae of Salinas, California. She runs a company, Luco Sport, that sells golf bags and accessories. The merchandise is made with foam, which is based on petroleum, so record oil prices have taken a heavy toll.

On the other end, her clients are feeling the pinch, too, and cutting back. Sales to retail clients are an eighth of what they were a year ago. So Ms Rae had to cut five of her 20 employees loose.

Now the company isn't buying products as far in advance. With gas prices running high, she waits for shipping companies to pick up products from her headquarters instead of having an employee drop them off.

She is nickel-and-diming expenses at home, too. She eats in every night, has stopped going on road trips to visit her family, dropped her satellite dish and canceled her monthly Blockbuster movie rental.

'I want to make sure I have enough money to feed my family,' Ms Rae says.

Signs of pinch showing up everywhere

Signs of the pinch are showing up everywhere: -By the end of 2007, 36 per cent of consumers' disposable income went to food, energy and medical care, a bigger chunk of income than at any time since records were first kept in 1960, according to Merrill Lynch.

-People are treating themselves less often. The National Restaurant Association says 54 per cent of restaurants reported declining traffic in January, and the government says eating at home increased last year for the first time since 2001.

-Financial planners say that more than ever, parents are calling for advice on how to deal with grown children who have moved back in with Mom and Dad after losing a job or just to save money.

-Less trash is being set on the curbs of Mesa, Arizona, where surging home foreclosures are leaving more houses empty. That means fewer homeowners paying the city US$22.60 a month for pickup.

And Mr William Black, the city's solid-waste management director, says people are not throwing out as many appliances and bulk items, like furniture. They're sticking with what they have.

On top of an economy that was already groaning under the weight of a downturn, Bear Stearns came down like an anvil.

Housing crash, credit crunch

It tied together so much of what's wrong with today's economy - the housing crash, the credit crunch and a loss of confidence among investors and consumers alike.

Understanding how things got so bad means rewinding to the start of the housing boom. Wall Street and the banks made it far easier for people with shaky credit to get a mortgage - known as a subprime loan.

Investors wanted a piece of the fast-growing mortgage pie, so there was plenty of money sloshing around the market to pay for the loans.

Financial firms sliced up the mortgages and sold them as complex investments, finding eager buyers among pension funds, hedge funds and more who were chasing higher returns and willing to overlook risks.

As long as housing prices went up, the strategy worked. When they began to crumble, so did financial stability.

The same people who made a financial stretch to buy their homes are now defaulting on the loans at alarming rates. Many are 'upside down' on their loans, meaning they owe more on their mortgages than their homes are worth.

Nearly 9 million households now have upside-down mortgages, and for the first time ever, aggregate mortgage debt is bigger than the total value of homeowner equity - bigger by US$836 billion, according to research by Merrill Lynch.

Domino effect

The housing problem set off the dominoes: Surging defaults meant the mortgage-backed securities plunged in value. That dried up the money to fund new home loans, and lenders everywhere became tighter with credit.

Bear Stearns found itself in the cross hairs. Market rumors began to swirl about the size of its exposure to mortgage securities, whether it had ample reserves to cover potential losses. Clients and investors began to demand their money back.

'This problem begins with the fact that we underwrote mortgages sloppily, which means no one really knows what those assets are worth,' said Lyle Gramley, a former Federal Reserve governor and now an analyst with Stanford Financial Group. 'That makes bankers very leery, and has resulted in a significant contraction in the availability of credit.'

The credit crunch means corporations can't borrow as easily, so they are delaying big projects, which cuts into the job market. And many of the same companies were already smarting from the downturn in housing, which has made many Americans uneasy about their household wealth and caused them to scrimp on spending.

The last time the US economy tilted into recession was 2001. And it was an entirely different animal.

Investors bore the brunt of that downturn as the stock market shook off the excesses of the late-'90s technology boom. Encouraged by their government - and fortified with tax rebates in their pockets - Americans kept spending.

Perhaps most importantly, there was no reason for anyone to doubt the stability of the financial system. There was no credit crisis to speak of, and the housing boom had yet to begin.

Recession not declared yet

This time around, no one has declared a recession just yet: By the generally accepted rule, that takes two consecutive quarters of shrinking economic activity. The economy came close to stalling late last year but eked out small growth.

But the lack of an official declaration makes the pain no less real.

'I think the current financial crisis looks to me like the worst one since we got into the Depression,' says Mr Richard Sylla, who teaches the history of financial institutions at New York University's Stern School of Business.

Which is not to say this time will be anywhere near as bad - partly because, economists note, Federal Reserve Chairman Ben Bernanke is a student of the Depression and appears to be steering the Fed toward avoiding the mistakes of back then.

That may be why the Fed moved quickly to back up JPMorgan Chase & Co.'s lifeline loan to Bear Stearns when it neared collapse.

The Fed dusted off other Depression-era tools, too. It allowed securities dealers to borrow directly from the Fed, a privilege once restricted to commercial banks. And it announced it would lend up to US$200 billion to investment banks in exchange for the banks' beaten-up mortgage-backed securities.

The idea is to maintain confidence in the American banking system. If that fails - if more Bear Stearns episodes emerge - it could gum up the entire economy, historians note.

'No one would trust anybody else, no one would be willing to do business,' said Prof Charles Jones, a finance professor at Columbia Business School. 'And if that happens, the economy would feel that right away. So the Fed is doing what it can.'

US just a piece of a complex global economy

Another key difference: Today, the United States is just one piece of a complex global economy. A century ago, an American financial crisis was America's problem. Today, emerging economies provide an extra layer of insulation.

'People are still going to eat in China and India. They're going to be buying clothes and cars and airplanes,' says Prof Robert A. Howell, a distinguished visiting professor of business administration at Dartmouth. 'So I think it's a whole different ballgame.'

A better comparison might be the economic downturn that gripped the United States in the early 1970s, a time now widely remembered for long lines at the pump. Today gas is plentiful, but summer drivers face the scary prospect of paying US$4 a gallon.

And as Mr David Rosenberg, chief North American economist for Merrill Lynch, pointed out in an analysis this week, the parallels to the 1970s go much deeper than just the shock of record oil prices, which tripled during the 1973-1975 recession and have seen a similar rise in recent years.

Then as now, food prices rose along with energy. Then as now, declining home prices gave homeowners ulcers over equity. And the dollar, which held up fine in the 2001 recession, is falling now even more than it did in the early '70s - 9 per cent then on a trade-weighted basis, 14 per cent in the last year, according to the Federal Reserve.

The 1970s

One other interesting difference: In the downturns between the '70s and today, the baby boomers used their massive buying power to help spend the nation out of the slump. In the 1970s, they were too young. Today, they are focusing on retirement.

'The mid-1970s is the best template,' Mr Rosenberg wrote, 'if there is any.'

If the 1970s truly are a guide, there's a lot farther to fall.

Back then, the Standard & Poor's 500 index fell 36 per cent from its peak to its trough. Right now, the S&P 500 has only lost 15 per cent from its record highs of October 2007.

Finding shelter from this downturn is not as easy as you might think. So-called private label products - no-name cereal or crackers usually far cheaper than brand names - are less of a deal because of soaring commodity prices.

Nearly 90 per cent of chief financial officers of global public companies do not see an economic recovery coming until 2009, according to a new survey by Duke University/CFO Magazine.

And that is more than just crystal-ball gazing: If companies see a sluggish recovery, they will not be taking any steps to build their payrolls soon and will remain cautious in how they allocate capital.

So what's the way out? Former Fed chair Alan Greenspan wrote in the Financial Times last week that the financial crisis - which he said would likely be the 'most wrenching' in the United States since World War II - would end only when housing prices stabilise.

Interest rates slashed

Already, the Fed has slashed interest rates. It has cut the closely watched federal funds rate, the overnight lending rate for banks, six times since September, from 5.25 per cent to 2.25 per cent - two-thirds of the cut coming in the last two months alone.

But the Fed can't work alone. Upcoming tax rebates for millions of people and tax breaks for businesses may give a little relief, but economists think that something will have to be done soon to slow down the number of foreclosures, a cornerstone of the economy's woes.

'We can't have financial institutions not providing credit to the economy,' said Prof Eugene White, a professor of economics at Rutgers University. 'We have to stop that if we want to avoid a deep recession.'

Economists and market historians seem to agree that this is more than a typical, cyclical slump. And the X-factor that sets it apart - determining how deep the wounds from the mortgage mess really are - also makes it impossible to map the path of the downturn.

'Financial crises happen, but they always do blow over,' Mr Sylla says. 'It's a question of how long.' So in the meantime, Americans like Ms Monica Nakamine are planning for a long road ahead.

The 37-year-old took a higher-paying job at a Los Angeles architectural firm, but has been putting the difference in her earnings right into savings. These days she's dyeing her own hair, picking through sales racks when she shops and washing her dog herself, rather than getting him groomed.

And she's considering some drastic actions in case things get worse - like moving to a cheaper city such as Austin, Texas, and getting rid of her gas-guzzling SUV for a hybrid sedan.

'Certainly I don't want it to get any worse,' Ms Nakamine said, 'but I know it can.' -- AP