A lot of smart people have tried to call the bottom on Wall Street this year.
So far, they have all been wrong.
Since the financial crisis first hit in August 2007, markets — and the financial industry — have gone through a series of swoons, each more dizzying than the last. Last week, the crisis reached a new pitch, as Lehman Brothers, the fourth-largest United States investment bank, struggled to avoid joining Bear Stearns on the trash heap, and Washington Mutual, the largest savings and loan, saw its shares briefly fall below $2.
Now even Wall Street’s professional optimists have given up predicting exactly when their industry might stabilize. One senior executive at a top investment bank, speaking anonymously so he could speak freely, recently observed that the crisis was entering its “19th inning,” with no ending in sight.
Until now, the cataclysm in the banking and securities industry has damaged but not derailed the rest of the economy and the Fed and the Treasury signalled last week that they were not ready to bail out Lehman Brothers with taxpayer money. Economists generally predict that the United States will grow slowly over the next few months but avoid a deep recession, especially if oil prices fall further, easing pressure on consumers, and exports remain strong.
But as the Wall Street crisis moves into its second year, the risks to the overall economy are increasing. While the economy grew during the first half of the year, businesses are cutting jobs and consumers reducing spending. In August, the unemployment rate reached 6.1 percent, compared with 4.7 percent less than a year ago.
Until the worst turmoil on Wall Street ends, the economy will struggle, said Sung Won Sohn, an economist at California State University, Channel Islands, who studies financial markets.
“Until and unless we have financial markets stabilize, I don’t think we will see a meaningful recovery in housing, and therefore in the economy,” Dr. Sohn said. He said he expected economic growth to remain close to zero through the middle of 2009 before finally beginning to accelerate.
Steven Wieting, the United States economist for Citigroup, said: “We’re describing the U.S. economy as recessionary.”
Unfortunately, Mr. Wieting — and other economists — say that the Federal Reserve and the government have few good options left to ease the pressure on financial firms or the economy. The Fed has already cut short-term interest rates to 2 percent, below the rate of inflation, and the government has offered consumers and businesses $150 billion in tax rebates and cuts this year.
The Fed has also taken several measures to buoy the financial industry, such as allowing more banks access to low-interest, short-term loans. Yet Wall Street continues to struggle through the aftereffects of the biggest speculative bubble in history.
Financial services companies have cut more than 100,000 jobs this year, according to Challenger, Gray & Christmas, an executive placement firm, and deeper layoffs may come this fall.
Yet the picture may not be entirely bleak. When the chaos finally ends, Wall Street will almost certainly be smaller and more risk-averse. That change could eventually put the economy on firmer footing.
This year’s crisis appears to mark the end of a bubble in the financial markets that has lasted nearly two decades. The speculation began in technology stocks in the 1990s and turned to real estate, commodities and private equity buyouts this decade. Along the way it powered the New York City economy and helped drive income inequality nationally.
While the stock market has not been as frenzied this decade as it was at the end of the 1990s, rampant speculation took over many other financial markets, Mr. Wieting said. “In the last couple of years, financial activity became less related than we’ve seen before to real economic developments,” he said.
Now Wall Street is reeling, as a significant fraction of the speculative real estate loans that banks made during the boom years are underwater. Because banks have limited capital to absorb losses, investors worry that those losses will overwhelm them.
The problem has been worsened by the financial instruments that banks and hedge funds and insurance companies have created to swap loans and risk with each other. In theory, those products can help investors and companies diversify risk, but they are nearly impossible to value.
“Investors just don’t know what these assets are worth,” said Ed Yardeni, president of Yardeni Research. “There’s no transparency. It’s totally up to management to decide what these assets are worth and tell their accountants.”
For example, Lehman said last week that it had $20 billion in tangible equity— money that would theoretically be available to its shareholders if Lehman had to be liquidated. But those same shareholders valued Lehman at only $2 billion as of Friday, proof that they do not have confidence in the way Lehman has calculated its assets.
Now investors are demanding that banks like Lehman and Washington Mutual raise capital or sell their assets to raise cash and prove that they are solvent. But when banks are under pressure, they cannot easily find new investors or purchasers for their assets. It is as if a family were told to sell their home overnight, for cash, or lose it. They would surely receive a far lower price than the property would generate in a more orderly sale.
So, one by one, the banks that took on the most risk are facing the real possibility of going under. Those with stronger balance sheets, such as Morgan Stanley and Goldman Sachs and JPMorgan Chase, are suffering much less.
For Wall Street, the lesson has been sobering — and unlikely to be forgotten for several years, said Dr. Sohn, the California State economist.
“The restraint in the credit markets will last quite some time,” Dr. Sohn said. In the mortgage business, which saw the worst excesses, loan practices may remain stricter for at least a decade, he said. The results will be both positive and negative, he said.
The speculation that has produced wide swings in commodities prices and vacant subdivisions across California and Florida may become less prominent. But people who want to buy homes may continue to struggle to get mortgages, even if they have excellent credit. Companies who need loans to expand, or just to survive rough economic patches, will also have a harder time finding financing.
“We went overboard,” Dr. Sohn said. “As a result, the financial market is imposing some discipline on our behavior, and it’s painful. But that’s how the system works.”
Jared Bernstein, senior economist at the Economic Policy Institute, a liberal research group in Washington, said that, in a best-case scenario, greater risk aversion in the financial markets might eventually encourage the United States to rely less on bubbles and speculative lending to drive economic growth.
Instead, the government could pursue policies designed to drive wages higher for middle- and lower-class Americans, he said, allowing them to buy homes and cars without taking on ruinous debt.
“We have to find a new way — or maybe it’s an old way — to stimulate enough demand for the economy to do what it’s supposed to do without speculative excess,” Mr. Bernstein said. “A recovery that’s driven by more broadly shared prosperity, where consumption is fairly evenly shared through the economy, that kind of growth is more sustainable.”
Even so, Mr. Bernstein said he was not cheering Wall Street’s deep struggles. “The financials are the heart of the credit system, and credit is the lifeblood of our economy,” he said. “There’s no question that we will pay a cost in terms of much diminished growth if this continues.”