U.S. financial crisis spreads toward your wallet

Banking woes, rising debt levels, and unemployment will put consumers in greater trouble, economists say.

By David R. Francis

from the September 8, 2008 edition

In 2006, well before the financial crisis broke on the shores of the American economy, Ann Lee wrote a 22-page paper on "Wall Street's House of Cards." It warned of the danger to the nation from the sale of trillions of dollars of complex financial products called "structured credit derivatives."

She watched as investment banks constructed and sold these paper investments that were supposedly backed by loans on houses, cars, businesses, and credit cards.

"Complete vapor money," she calls many of the derivatives. "Pretty much worthless."

With a Harvard Business School degree and 10 years experience on Wall Street, she quit as a trader for a hedge fund, hoping to expose the financial folly. "I was so disgusted with what was going on," she says

Since then she has taught corporate finance at Pace University in New York and this fall at China's Peking University. The $5 billion hedge fund where Ms. Lee had worked, Ritchie Capital, is headquartered in Lisle, Ill. [Editor's note: The original version made an incorrect statement about Ritchie Capital.]

Seeking a reaction to her paper, she sent it to officials in Washington. Lee received an e-mail reply from Lawrence Lindsey, director of the National Economic Council under the first President Bush, who wrote that "both the practitioners and the regulators are well aware of the risks that are out there," including those in the subprime mortgage market. Mr. Lindsey held that the deregulated mortgage market was "much better" in early 2007 than the more regulated one in 1991, when there were also credit-market problems.

Lee's warning was not acted on. The credit markets froze in the summer of 2007. She figures Wall Street and other financial centers face more damage ahead that could hurt the general economy, not just the banking industry. "I don't think we are close to being done," she says.

Here she has company. A. Gary Schilling, an economic consultant in Springfield, N.J., suspects the financial unease and semi-freeze will spread to the "overleveraged household sector."

Consumers account for more than 70 percent of all spending in the United States. Since many families have relatively little savings and are deep in debt through credit cards, car loans, home-equity loans, etc., he foresees a cutback in spending. This will lead to a deep recession next year, one that will spread beyond US borders, he says.

Unemployment will exceed 6.5 percent by this time next year, predicts Harald Malmgren, a veteran Washington economic consultant.

Presently, consumers and banks are both trying to de-leverage, that is, reduce the amount of money borrowed in relation to their assets or income.

"It is going to get more painful," says Mr. Malmgren. "People will be more and more cautious." So will banks be in granting credit and loans.

So far, the world's bigger financial institutions have suffered losses or written down asset values on their books totalling some $500 billion, according to Bloomberg.com. To help bolster their financial position and continue lending, banks have raised $353 billion in new capital, but are having trouble rounding up more money.

About $43 billion of new capital for such major firms as Citigroup, Merrill Lynch, and Morgan Stanley, was provided by sovereign wealth funds. These are investment pools set up by oil-rich nations, such as Kuwait and The United Arab Emirates, and trade-surplus nations, such as China and Singapore. Last week, the Korea Development Bank was considering an investment in another troubled US investment bank, Lehman Brothers. In effect, foreigners are buying large chunks of the American financial industry.

So far, though, the investments of the sovereign wealth funds have done poorly, at least on paper. Mr. Shilling notes that the price of the stocks they bought is down between 21 and 55 percent.

To Shilling, Malmgren, and Lee more big losses can be anticipated.

In 2006, the Bank of International Settlements in Basel, Switzerland, a bank for the world's major central banks, put the value of financial derivatives at $26 trillion. That's almost twice the level of the US annual gross domestic product, that is, its total output of goods and services.

Lee suspects the nominal value of derivatives escalated to $100 trillion as banks raced for profits and fees by selling derivatives around the world. On top of these were derivatives on derivatives, up to 10 degrees removed from real loans, charges Lee. Investors were often ignorant of their nature.

"The construction and sales process for structured products is opaque, and no one really knows what credit risk is transferred to whom and who is left holding the credit risk bag," Lee wrote in 2006.

"We have been living in a phantom economy," she held last week.

Neither President Bush nor Congress is expected to tackle the financial mess, except maybe in the housing area, before the November election. So the problem will be left largely to a new president.

Lee hopes for a tougher regulatory system, reversing the deregulation trend during the Bush years.

"If we want to ensure financial market integrity and stability, then we should consider the ethical obligations to move beyond a system of self-regulation," she wrote. Since financial markets "always attract the foolish and the greedy," she notes that "no perfect solution exists."