World Bank Report Reveals China’s Bigger Troubles

Nov 27th, 2008 | By Irwin Greenstein | Category: Emerging Markets

While China made headlines with a historic interest rate cut this week, the World Bank weighed in with a gloomy prediction about China that received scant coverage. For emerging-market investors who missed the story, the World Bank’s assessment of China’s economic performance in 2009 could reshape their strategy for portfolio allocation.

That said, China’s economy is still on track to post impressive growth during a global financial crisis. Unfortunately, this growth won’t meet initial forecasts.

In its latest quarterly report, the World Bank revised China’s growth downward to 7.5% from an earlier projection of 9.2%. The change reflects the World Bank’s view that Beijing isn’t doing enough to shift the country’s reliance away from waning exports to more robust domestic growth.

The Chinese economy grew by 11.9% 2007, in what appears to be the peak in double-digit expansion since 2002. Now facing single-digit prospects in 2009, China’s slower-than-expected advance call into question the global economy overall.

While most pundits see diminished U.S. consumer spending impacting China’s exports, emerging markets worldwide contributed significantly to the export boom of the past few years.

Latin America, Eastern Europe, Russia, Southeast Asia and other regions able to cash in on skyrocketing prices of fossil fuels, metals and grains are themselves suffering from the market turmoil. As commodity prices plummet, the expanding middle classes of these emerging nations begin to contract - reducing spending on consumer goods coming into their countries from China.

Reading between the lines, the World Bank also seems to be saying that the worldwide recession will be here for years to come - further hampering China’s ability to stimulate its economy.

The World Bank’s report also challenges the effectiveness of China’s new $586 billion stimulus package announced earlier this month. The package called for a massive national infrastructure build-out. Given the World Bank’s view of China’s over-reliance on exports, the new stimulus plan could ultimately prove to be a “bridge to nowhere” with no substantial growth for the long-term returns that emerging markets count on for these massive projects.

Obviously, the much ballyhooed stimulus plan isn’t enough to carry the day in China.

The latest rate cut, to 5.58% for loans and 2.52% for deposits, was the fourth cut since September.

Now, potentially like the U.S., China’s lower growth rate next year would rely heavily on higher public spending, according to the World Bank report. This could be a harbinger of how the incoming Obama administration would attempt to fix the U.S. economy based on recent news stories.

Taking into account China’s stimulus plan and other domestic projects, Beijing’s spending would add 4 percentage points in 2009 to the economy compared with 1.5 percentage points in 2007.

Another drain on China’s coffers could be subsidies for the increasing ranks of unemployed factory workers. Shrinking exports mean lower demand for products.

The government has announced new measures to support the economy, out of fear that the crisis and growing unemployment could cause increased public protests, according to AsiaNews.

Facing an epidemic of protests, Public Safety minister Meng Jianzhu warned that local regulators could face “social problems affecting stability.” In particular, there is the danger that the slowdown in exports will cause widespread unemployment.

Gunagzhou province provides a snapshot of where unemployment is heading.

A recent Chinese media report cited data from the Guangzhou Train Station, which showed in early October that the number of departing passengers compared to the same period last year had increased by 128,000.

Guangzhou is one of China’s largest manufacturing export centers.

The biggest gains for the Dow Jones industrials

The biggest gains for the Dow Jones industrials
| 13 Oct 2008 | 07:28 PM ET
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NEW YORK - Here are the 10 largest point and percentage gains for the Dow Jones industrial average since the index launched in 1896:

Biggest Point Gains

Oct. 13, 2008: 936.42, or 11.08 percent, to 9,387.61

March 16, 2000: 499.19, or 4.93 percent, to 10,630.60

July 24, 2002: 488.95, or 6.35 percent, to 8,191.29

Sept. 30, 2008: 485.21, or 4.68 percent, to 10,850.66

July 29, 2002: 447.49, or 5.41 percent, to 8,711.88

March 18, 2008: 420.41, or 3.51 percent, to 12,392.66

March 11, 2008: 416.66, or 3.55 percent, to 12,156.81

Sept. 18, 2008: 410.03, or 3.86 percent, to 11,019.69

April 5, 2001: 402.63, or 4.23 percent, to 9,918.05

April 18, 2001: 399.10, or 3.91 percent, to 10,615.83

Biggest Percentage Gains

March 15, 1933: 8.26 points, or 15.34 percent, to 62.10

Oct. 6, 1931: 12.86, or 14.87 percent, to 99.34

Oct. 30, 1928: 28.40, or 12.34 percent, to 258.47

Sept. 21, 1932: 7.67, or 11.36 percent, to 75.16

Oct. 13, 2008: 936.42, or 11.08 percent, to 8,387.61

Oct. 21, 1987: 186.84, or 10.15 percent, to 2,027.85

August 3, 1932: 5.06, or 9.52 percent, to 57.22

Feb. 11, 1932: 6.80, or 9.47 percent, to 78.60

Nov. 14, 1929: 18.59, or 9.36 percent, to 217.28

Dec. 18, 1931: 6.90, or 9.35 percent, to 80.69.

Abu, this is a very important one for you to understand: All that money you've lost — where did it go?

All that money you've lost — where did it go?

| 11 Oct 2008 | 08:02 PM ET

Is it a matter of it all vanishing into thin air? Some would say yes

NEW YORK - Trillions in stock market value — gone. Trillions in retirement savings — gone. A huge chunk of the money you paid for your house, the money you're saving for college, the money your boss needs to make payroll — gone, gone, gone.

Whether you're a stock broker or Joe Six-pack, if you have a 401(k), a mutual fund or a college savings plan, tumbling stock markets and sagging home prices mean you've lost a whole lot of the money that was right there on your account statements just a few months ago.

But if you no longer have that money, who does? The fat cats on Wall Street? Some oil baron in Saudi Arabia? The government of China?

Or is it just — gone?

If you're looking to track down your missing money — figure out who has it now, maybe ask to have it back — you might be disappointed to learn that it was never really money in the first place.

Robert Shiller, an economist at Yale, puts it bluntly: The notion that you lose a pile of money whenever the stock market tanks is a "fallacy." He says the price of a stock has never been the same thing as money — it's simply the "best guess" of what the stock is worth.

"It's in people's minds," Shiller explains. "We're just recording a measure of what people think the stock market is worth. What the people who are willing to trade today — who are very, very few people — are actually trading at. So we're just extrapolating that and thinking, well, maybe that's what everyone thinks it's worth."

Shiller uses the example of an appraiser who values a house at $350,000, a week after saying it was worth $400,000.

"In a sense, $50,000 just disappeared when he said that," he said. "But it's all in the mind."

'A big mistake'
Though something, of course, is disappearing as markets and real estate values tumble. Even if a share of stock you own isn't a wad of bills in your wallet, even if the value of your home isn't something you can redeem at will, surely you can lose potential money — that is, the money that would be yours to spend if you sold your house or emptied out your mutual funds right now.

And if you're a few months away from retirement, or hoping to sell your house and buy a smaller one to help pay for your kid's college tuition, this "potential money" is something you're counting on to get by. For people who need cash and need it now, this is as real as money gets, whether or not it meets the technical definition of the word.

Still, you run into trouble when you think of that potential money as being the same thing as the cash in your purse or your checking account.

"That's a big mistake," says Dale Jorgenson, an economics professor at Harvard.

There's a key distinction here: While the money in your pocket is unlikely to just vanish into thin air, the money you could have had, if only you'd sold your house or drained your stock-heavy mutual funds a year ago, most certainly can.

"You can't enjoy the benefits of your 401(k) if it's disappeared," Jorgenson explains. "If you had it all in financial stocks and they've all gone down by 80 percent — sorry! That is a permanent loss because those folks aren't coming back. We're gonna have a huge shrinkage in the financial sector."

There was a time when nobody had to wonder what happened to the money they used to have. Until paper money was developed in China around the ninth century, money was something solid that had actual value — like a gold coin that was worth whatever that amount of gold was worth, according to Douglas Mudd, curator of the American Numismatic Association's Money Museum in Denver.

Back then, if the money you once had was suddenly gone, there was a simple reason — you spent it, someone stole it, you dropped it in a field somewhere, or maybe a tornado or some other disaster struck wherever you last put it down.

But these days, a lot of things that have monetary value can't be held in your hand.

If you choose, you can pour most of your money into stocks and track their value in real time on a computer screen, confident that you'll get good money for them when you decide to sell. And you won't be alone — staring at millions of computer screens are other investors who share your confidence that the value of their portfolios will hold up.

But that collective confidence, Jorgenson says, is gone. And when confidence is drained out of a financial system, a lot of investors will decide to sell at any price, and a big chunk of that money you thought your investments were worth simply goes away.

If you once thought your investment portfolio was as good as a suitcase full of twenties, you might suddenly suspect that it's not.

In the process, of course, you're losing wealth. But does that mean someone else must be gaining it? Does the world have some fixed amount of wealth that shifts between people, nations and institutions with the ebb and flow of the economy?

Jorgenson says no — the amount of wealth in the world "simply decreases in a situation like this." And he cautions against assuming that your investment losses mean a gain for someone else — like wealthy stock speculators who try to make money by betting that the market will drop.

"Those folks in general have been losing their shirts at a prodigious rate," he said. "They took a big risk and now they're suffering from the consequences."

"Of course, they had a great life, as long as it lasted."

China growth 2009

But for now, many economists believe that is unlikely, which means China looks set to remain the main driver for growth in commodities markets. Even with the U.S. and Europe in the doldrums, China's economy is expected to expand 9% or slightly more next year. Travel by air and road continues to expand. Oil imports in August jumped 11% from August 2007, according to Barclay's Capital.

Japan's Mitsubishi UFJ Financial Group Morgan Stanley

NEW YORK - Japan's Mitsubishi UFJ Financial Group says it is investing $9 billion in Morgan Stanley for a 21 percent stake in the U.S. investment bank.

Mitsubishi UFJ said Monday it will buy nearly 10 percent of Morgan Stanley's common stock for $3 billion, and $6 billion in preferred stock.

Morgan Stanley, along with Goldman Sachs Group Inc., had been one of the two remaining independent Wall Street investment banks until the two recently applied to become commercial banks that take deposits.

Wall Street is in a state of upheaval after poor investments in mortgage-backed securities that have led the U.S. government to propose a $700 billion rescue plan for the nation's banks.

Buffetts gamble

Buffett Drove Hard Bargain With Goldman

For six months, as the credit crisis deepened, billionaire investor Warren Buffett turned away a string of Wall Street firms that came hat in hand looking for help.

On Tuesday, Mr. Buffett says, he was sitting with his feet on his desk in Omaha, drinking a Cherry Coke and munching on mixed nuts, when he got an unusually candid call from a Goldman Sachs Group Inc. investment banker. Tell us what kind of investment you'd consider making in Goldman, the banker urged him, and the firm would try to hammer out a deal.

Warren Buffett

That midday call from Goldman's Byron Trott, who had done deals with Mr. Buffett for years, touched off a rapid chain of events. Within hours, Goldman had announced that Mr. Buffett's Berkshire Hathaway Inc. would invest $5 billion in Goldman -- a move viewed by many investors as a vote of confidence in the nation's reeling financial system.

The swiftness of the deal underscores the intense pressure now faced by Goldman, long regarded as one of the most financially secure firms on Wall Street. Over a 10-day stretch this month -- amid federal bailouts of Fannie Mae, Freddie Mac and American International Group and a bankruptcy filing by Lehman Brothers Holdings Inc. -- Goldman shares dropped 36%. Investors began asking questions about whether it had the capital to survive. On Sunday night, Goldman secured federal approval to become a bank holding company, ending 139 years as a securities firm.

On Wednesday, Goldman said it had completed a separate $5 billion stock offering, double the size of the offering announced on Tuesday. Its shares jumped $7.95 to $133 in 4 p.m. New York Stock Exchange trading, although they remain far below their 52-week high of more than $250. The deal with Mr. Buffett and the stock offering means Goldman shareholders could eventually have their stake diluted by as much as 20%.

Mr. Buffett's decision to invest now in Goldman gives an indication of how the famed investor believes the financial crisis might shake out. At a minimum, he regards Goldman as a survivor, although the firm's profits could be pinched as it adjusts to life as a banking holding company, taking fewer risks and facing heightened regulation.

In a telephone interview Wednesday morning from his office in Omaha, Mr. Buffett said he believes the proposed federal bailout will be approved by Congress and that it will succeed. "The government has a great opportunity," he says. "If they buy things at market prices with the government's cheap funding, they should make a lot of money."

If Congress fails to approve the bailout, Mr. Buffett says, all bets are off. His investment in Goldman will "get killed, and so will all our other investments."

electric car

http://www.cnbc.com/id/15840232?video=864784364

Wall Street as it has long been known will cease to exist

Goldman, Morgan Scrap Wall Street Model,
Become Banks in Bid to Ride Out Crisis
End of Traditional Investment Banking, as Storied Firms Face Closer Supervision and Stringent New Capital Requirements

By JON HILSENRATH, DAMIAN PALETTA and AARON LUCCHETTI

The Federal Reserve, in an attempt to prevent the crisis on Wall Street from infecting its two premier institutions, took the extraordinary measure on Sunday night of agreeing to convert investment banks Morgan Stanley and Goldman Sachs Group Inc. into traditional bank holding companies.

With the move, Wall Street as it has long been known -- a coterie of independent brokerage firms that buy and sell securities, advise clients and are less regulated than old-fashioned banks -- will cease to exist. Wall Street's two most prestigious institutions will come under the close supervision of national bank regulators, subjecting them to new capital requirements, additional oversight, and far less profitability than they have historically enjoyed.


Already, the biggest rivals of Goldman Sachs and Morgan Stanley -- Merrill Lynch & Co., Lehman Brothers and Bear Stearns Cos. -- have merged into larger banks or sought bankruptcy protection.

"This fundamentally alters the landscape," a Goldman Sachs spokesman said Sunday night. "By becoming a bank holding company and being regulated by the Federal Reserve, we have directly addressed issues that have become of mounting concern to market participants in recent weeks."

The rapid pace of change in recent weeks highlights the severity of the financial crisis, and suggests it is deeper than many on Wall Street were willing to admit. Some investors may view the move as a negative signal, for it suggests that Goldman and Morgan Stanley, two institutions who were once considered rock solid, may have been facing greater liquidity issues than was apparent.

Becoming a bank holding company can help both Morgan Stanley and Goldman organize their assets, and puts both in a much better position to be acquired, to merge or to acquire smaller companies with insured deposits. It also may allow Goldman and Morgan Stanley to avoid using of mark-to-market accounting -- which forces companies to value their assets based on the current market price. Instead, these firm may be able to classify assets as "held for investment," as many banks do.

The huge banking firms that have so far survived the credit-market turmoil -- Citigroup Inc., Bank of America Corp., J.P. Morgan Chase & Co., Wachovia Corp. and Wells Fargo & Co. -- each have bank holding companies overseen by the Fed, and national bank charters supervised by the Treasury Department's Office of the Comptroller of the Currency. They can count on their huge deposit bases to serve as an alternative source of funding to other, more unpredictable, liquidity sources.

"The Fed wanted to send a strong statement that they would not allow Goldman and Morgan Stanley to be 'Lehman-ized,'" said a person familiar with the discussions, referring to the bankruptcy of Lehman.

In the short term, the agreement with federal regulators is likely to place on hold Morgan Stanley's talks to merge with Wachovia Corp., the Charlotte, N.C.-based banking powerhouse.

As a bank-holding company, Goldman Sachs would become the fourth-largest such company in the U.S., behind Bank of America, J.P. Morgan Chase & Co. and Citigroup.

Morgan Stanley officials have been talking about this option internally for several months, and Fed officials have been stationed at the bank since the crisis intensified earlier this year. After last week's market crisis, Morgan Stanley officials asked the Fed to speed up its review and grant the bank designation sooner. "It became clear that the world had changed," said Morgan Stanley spokeswoman Jeanmarie McFadden.

She said that the firm would reduce its leverage ratios -- a measure of a firm's risk in relation to the equity on its balance sheet -- over the next few years from current levels to something more in line with that at commercial banks. Investment bank ratios now stand above 20, with commercial banks closer to 10.

The Fed said it would also extend additional lending to the broker-dealer arms of the two firms, as well as to that of Merrill Lynch, as they make the transition. The steps effectively mark the end of Wall Street as it's been known for decades. It also formalizes a quid-pro-quo that regulators have warned about in the months after Bear Stearns's near collapse -- that in return for access to the Fed's emergency lending facilities, the firms would need to subject themselves to more oversight.

The conversions of Goldman Sachs and Morgan Stanley to bank holding companies could deal a blow to Treasury Secretary Henry Paulson, who had tried to preserve the existing structure of financial institutions over the past several weeks. Now, the parent companies of almost all major U.S. financial institutions will be overseen by the Federal Reserve. Sunday night's development also further expedites the ascendancy of the Fed as universal supervisor, as it now has even more direct authority over nearly all big financial companies in the country.

These actions "constitute a powerful statement by the Federal Reserve as to its views on the safety and soundness of these institutions," said H. Rodgin Cohen, chairman of the Sullivan & Cromwell law firm and a top adviser to financial institutions.

Instead of being overseen just by the Securities and Exchange Commission, Goldman Sachs and Morgan Stanley will now face much stricter oversight from numerous federal agencies. The Federal Reserve will regulate the parent companies, the Comptroller of the Currency will oversee the national bank charters, and the Federal Deposit Insurance Corp. will likely play a bigger role because the companies are expected to seek much higher volumes of federally backed deposits.

It had become increasingly clear to Fed officials in recent days that the investment-banking model couldn't function in these markets. Investment banks depend on short-term money markets to fund themselves, but that had become increasingly difficult, particularly in the wake of the collapse of Lehman Brothers. As bank holding companies, Morgan Stanley and Goldman Sachs will be allowed to take customer deposits, potentially a more stable source of funding.

Officials held a series of talks with Morgan Stanley and Goldman Sachs executives over the weekend. While Fed Chairman Ben Bernanke stayed in Washington for meetings on Capitol Hill about the government's plan to buy hundreds of billions of dollars of distressed assets, Timothy Geithner, president of the Federal Reserve Bank of New York, and Kevin Warsh, a Fed governor and former Morgan Stanley executive, worked in New York to sort out the details with Goldman and Morgan Stanley.

Officials had become more alarmed about the positions of both firms as their share prices continued to fall in recent days. One person involved in the talks said last week's bankruptcy filing by Lehman Brothers, and Merrill Lynch's agreement to be sold to Bank of America Corp., served as a wakeup call to the two investment banks. One person involved in the talks said the two firms had been flirting with the idea of becoming bank holding companies for some time, and that took on a new urgency in recent weeks.


Getty Images
Lower Manhattan and the Financial District are seen from Brooklyn at sunset Sept. 19.
Morgan Stanley Chief Executive John Mack engaged in serious discussions with Wachovia Corp., whose new CEO, Robert Steel, recently left a top post at the Treasury Department to take the reins of the regional banking powerhouse.

Goldman -- and to a lesser extent, Morgan Stanley -- has maneuvered through the credit crisis better than other investment banks. But its business model, which relies on short-term funding, is under attack. Some stockholders worry that its strategy of making big investments with borrowed money will go wrong someday, which would make it more difficult for the firm to get favorable borrowing terms. Such problems could also prompt the firm's clients, including big hedge funds, to move their assets to other banks, including larger commercial players.

To many analysts and investors, Morgan Stanley and Goldman still depend too much on leverage, or the use of borrowed money, and don't set aside enough cash against the bets they make on everything from commercial mortgages to non-U.S. stocks.

"They've been so close to a near-death experience, something needs to change," says Glenn Schorr, a brokerage-industry analyst at UBS. Surviving as independent companies is possible only if their business models become less risky, he adds.

Lots of commercial banks also blundered on risky mortgages, including Citigroup, UBS AG and Wachovia. Their salvation has been their size and their ho-hum source of reliable funding -- bank deposits.

Goldman has expressed wariness about joining up with a big commercial bank. When asked about the idea on a conference call Tuesday, the firm's chief financial officer, David Viniar, downplayed the attractiveness of the idea. "It is not the business model, it is the performance that matters," he said.

The most fundamental problem is how to generate profit growth in a world that no longer tolerates high leverage. At Merrill Lynch, the leverage ratio soared to 28 last year, from 15 in 2003, according to UBS. Morgan Stanley's leverage ratio climbed to 33, while Goldman's hit 28.

When markets were booming, borrowed money fueled record earnings. Investors showed few signs of concern. The ugly flip side of leverage is now obvious, and massive write-downs have shattered confidence in Wall Street's risk-management machinery.

Morgan Stanley and Goldman have been taking steps to reduce their leverage, but that hasn't been easy in a market where prices are dropping for many assets. It has proved difficult to find buyers for many distressed real-estate assets.

In contrast, Bank of America and Wachovia had leverage ratios of 11 as of the second quarter, less than half the average of the four big investment banks. The profit upside isn't as high as it is on Wall Street, but the downside isn't as steep. If a bank loses $1 billion on a loan, it has twice the capital an investment bank might have to absorb it.

The ascendancy of commercial banks largely reflects their use of customer deposits to fund much of their business. Retail depositors tend not to yank their money out, even in turbulent times, thanks to backing by federal deposit insurance. Even at Washington Mutual Inc., a Seattle thrift-holding company battered by mortgage losses, deposit levels are basically unchanged so far this year.

Still, plain-vanilla banking isn't a cure-all for what ails Wall Street. Commercial banks also run securities units that are highly leveraged and that have little to do with bank deposits. Also, the track record of so-called financial supermarkets such as Citigroup is so-so.

"It's not obvious that there's a clear economic benefit" to investment banks merging with commercial banks, says Campbell Harvey, a finance professor at Duke University.

Not a crisis it's war

Worst Crisis Since '30s, With No End Yet in Sight

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.


Getty Images
Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.

Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.

"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."

Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.


s economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. 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, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."


"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.

Not Enough
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.

But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.

"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."

Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.

Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.

In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.

Taking Out the Playbook
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."

Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.

But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.

This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.

Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.

One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.

As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.

More on the Crisis

Mounting Fears Shake World Markets
Morgan Stanley in Talks With Wachovia
Unheard Pleas, Lost Chances for AIG
Complete Coverage: Wall Street in Crisis
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.

Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.

But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.

Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.

But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.

One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.

"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"

The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.

In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.

The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.

Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.

Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."

At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.

In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.

In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.

But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.

Oil Speculators Lose Backing, Market Exodus Could Ripple

As Oil Speculators Lose Backing, Market Exodus Could Ripple
By GREGORY MEYER
Evaporating access to credit and fears of an economic washout are taking a toll on oil prices, forcing speculators using borrowed money out of the market.

Lehman Brothers Holdings Inc.'s sudden bankruptcy filing and Merrill Lynch & Co.'s pending sale to Bank of America Corp. suggest big banks may be less willing or able to absorb debt to boost trading positions, with implications for the inherently leveraged oil-futures markets. Analysts believe that could have a ripple effect on other speculative investors in the market.

Widespread liquidation of futures contracts compounded fears of faltering oil demand in knocking oil down near $90 a barrel on Tuesday before rebounding to settle at $91.15 on the New York Mercantile Exchange. Some traders faced margin calls, or demands for more cash collateral, in other asset classes, market participants said. In a conference call with analysts, Goldman Sachs Group Inc.'s chief financial officer noted "deleveraging" among its clients, attributing it to "more fear than anything."

The potential for less leverage -- or borrowed money -- at play in the oil-futures market has already helped spark a sharp fall in oil prices, which have lost about 20% of their value this month. The drop has come amid a slew of factors that should support prices, including a production cut by the Organization of Petroleum Exporting Countries, renewed attacks in key crude-oil producer Nigeria and a major knock to gasoline output in the U.S. Gulf Coast in the wake of Hurricane Ike.

The duress suggests investment banks' own proprietary commodities trading could decline as banks think twice about how much debt they take on to fund risky positions. Banks' risk aversion could also drive their clients out of the oil market, which could continue to weigh on prices, with some analysts identifying this year's lows of $86 as a near-term floor. That would represent a 42% drop from a peak above $147 a barrel hit in July.

"Essentially, the big banks will be doing less prop trading," said Craig Pirrong, director of energy markets at the University of Houston's Global Energy Management Institute. "To the extent they have clients that want to do hedges and things of that nature, they'll still be there, though probably not on as favorable terms as before. As a result, some of their clients might be less willing to hedge." Mr. Pirrong sees banks raising collateral requirements for customers seeking to trade oil.

Oil and other commodities have offered a key profit alternative for large investment banks in the past year as the credit crunch spread to many other parts of their business. Besides handling large volumes of trades for clients via the opaque over-the-counter commodity-swaps markets, they are also large commodity traders in their own right. Goldman Sachs and Morgan Stanley, the two banks with the biggest commodity businesses, are obsessively watched by other traders.

Both Merrill and Lehman have significant energy-trading operations, too. Merrill re-entered the sector in 2004, when it bought the trading business of Entergy-Koch LP. Lehman established its energy trading business in 2005. Barclays PLC, whose investment bank is also a major force in energy markets, has reached an agreement to buy the Lehman's U.S. capital-markets businesses, which include commodities.

Lehman declined to comment on its commodities business.

Whatever Lehman's future, its collapse on the heels of the rapid takeover of Bear Stearns and now Merrill Lynch is already sparking questions about the implications for the oil-trading businesses of other major banks.

A big oil-market exodus wasn't in evidence Monday, as the number of Nymex crude contracts outstanding rose by nearly 18,000. But given the prevalence of trading on the vast over-the-counter swaps markets, it is difficult to get a one-day fix on traders' positions.

One executive involved in oil trading said brokerages have reduced or canceled lines of credit to traders, even telling customers they need to double the amount of margin required from last week.

"If they want to put a position on and their requirement was a million dollars Friday, now it's $2 million," the executive said. The Nymex margin requirement for crude is currently about $10,000 per 1,000-barrel contract, and brokerages typically tack additional margin onto that.

Philip Gotthelf, president of Equidex Brokerage Group Inc., said some brokerage houses "are at 150% of exchange margin. They're essentially shutting the little guy out completely." It is harder to buy or sell crude, because "there's less credit around to do it," he said.

Fewer investors in the market won't necessarily spell lower oil prices, as speculators can take bets with equal ease on price declines or gains. It could also lead to greater price swings.

"If a certain amount of market-making capacity leaves the market, you might have more volatility because they're not here to stabilize prices," said James Angel, an associate professor of finance and expert on exchanges at Georgetown University.

"For everybody in every asset class, risk aversion has gone up," said Michael Wittner, global head of oil research at Societe Generale. "When volumes get thinner, it always adds to volatility."