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Letter to the editor

Caught in a downdraft and starting to panic

By STEVEN PEARLSTEIN, Washington Post
Published January 18, 2008

Are we having fun yet?

Okay, so maybe the economy has fallen into recession. Maybe house prices are going to decline 12 percent by the time it's all done, as Fannie Mae's CEO said last week. Maybe this won't be the year for that 13 percent stock-price rebound that Goldman Sachs's crack investment strategist, Abby Joseph Cohen, predicted only last month. Maybe nearly a million workers were added to the unemployment rolls in the past nine months and a million more will be added before it's all over. And maybe there's really not much that the Federal Reserve can - or should - do to prevent this painful adjustment.

But look on the bright side: The country and Wall Street have made great progress in the stages of economic grief:

- Willful blindness. ("Bubble, what bubble?")

- Denial. ("House prices never fall. It's only those speculators in Las Vegas and the Gulf Coast.")

- Rationalization. ("Maybe subprime did get out of hand, but it's really a small part of the market.")

- Fantasy. ("Things should be pretty much back to normal by the second half of '08.")

- Anger. ("If it weren't for those yahoos in structured finance ... ")

- Capitulation. ("We might as well take these write-downs now and get it over with.")

- Depression. ("This is going to get worse before it gets better.")

Now we're entering a new stage: Panic. Hedge funds scrambling to actually hedge their positions. Central banks throwing money at money-center banks. Huge financial institutions raising capital from foreign investors on concessionary terms. Gold prices heading toward $1,000 an ounce, with record lows on the dollar.

The most eye-popping figuring in this week's report from Citigroup wasn't the $18-billion in write-downs on its subprime mortgage investments, but the $5.2-billion reserve it was setting aside for losses on its vanilla-variety home equity loans, auto loans and credit card loans.

If that weren't enough, many banks face the prospect that developers will be unable to find permanent financing for office buildings and shopping centers whose construction has been financed with short-term bank loans. With investors unwilling to buy newly securitized packages of commercial real estate loans, the only source of such financing is insurance companies and pension funds, which are demanding that developers and investors cover 20 percent of project costs.

In the best case, that would blow investors' promised returns. In the worst, it would mean some banks end up as part-owners of half-empty buildings worth less than it cost to build them.

The final phase of this unraveling is likely to implicate the market in credit-default swaps. Those swaps are essentially contracts that allow investors to bet on whether a company, a government entity, or even a securitized package of loans will default. They can place bets whether they own the underlying security or not.

Because these contracts trade on unregulated derivatives markets, no one knows who holds the losing side. But it's a good guess that if defaults rise to historically normal levels, highly leveraged hedge funds will take a big hit.

The credit-default swap has become so central to global finance that its size is estimated at $43-trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a chain reaction that could easily rival the subprime debacle.

[Last modified January 18, 2008, 00:20:47]