America's Economic Meltdown

US Financial Woes

March 22nd 2008.

It was announced Monday that one of the world's largest securities firms, Bear Stearns & Co. Inc., had effectively gone bankrupt. And that, in a most unusual step, the U.S. Federal Reserve had hastily arranged a forced marriage between Bear Stearns and the larger JP Morgan Chase & Co., America's third-largest bank. Stock markets worldwide plunged in response.

The week ended with traumatized speculation about which illustrious bank or brokerage would be next to go toes up, and whether the Fed, other central bankers worldwide, and cool heads at the financial institutions themselves had the collective wit to stave off a meltdown in the global financial system.

Oh, and the United States is heading into the worst recession in a generation.

There was at least one sanguine voice this week, that of U.S. President George W. Bush. Against the backdrop of the global credit crisis, a greenback plunging to a new record low against the euro, a housing collapse, a looming bear market for stocks and mounting joblessness, Bush took a brief moment between Florida fundraisers to tell the world that its biggest consumer economy remained "fundamentally sound."

The same day Bush spoke, Representative Louise Slaughter (D-NY), surveying the layoffs, plant closings and other economic wreckage in her western New York district, had a different take on economic conditions. She called them "terrifying."

Most of Bear Stearns' 14,000 employees will lose their jobs and began early in the week calling recruiters. Even before the Bear Stearns collapse, the Bank of Canada had warned that the U.S. downturn is likely to inflict considerable damage on Canada.

The latest conventional wisdom has the rest of the world "decoupling" from the U.S., what with China, India and Europe emerging as rival economic superpowers. But we're not nearly there yet.

The effective demise of Bear Stearns sent stocks tumbling on exchanges worldwide, including Toronto, and European stock values fell back to 2005 levels. U.S. and European employers began warning that their financial outlook for 2008 and even 2009 had turned cloudy, and many large firms announced layoffs to shore up their finances.

The damage would have been far worse save for a residual faith – hope? – that the Fed and other central bankers worldwide can prevent more linchpins of the global financial system from coming loose.

And that recent efforts by the Bush administration and the U.S. Congress to assist the jobless and those still facing foreclosure – and the Harper government's effort last month to assist distressed regions – will prevent a "hard" landing for the economy.

And that bargain-hunters will emerge soon to snap up battered stocks, putting a floor, finally, under sagging prices that are eroding the middle-class nest eggs of mutual-fund owners.

So, how worried should we be? Worried enough, at least, to batten the hatches. Consider:

1. TANKING COMMODITIES WILL HURT CANADA TOO

In his maiden speech last week as governor of the Bank of Canada, Mark Carney was the bearer of bad news. The high commodity prices for everything from oil to wheat that have largely insulated Canada from the early phases of the U.S. economic slowdown are due for a fall, pulling down Canada's economic growth rate in 2008.

By the reckoning of some economists, Canadian GDP growth might clock in at zero this year, which means some economic sectors actually will shrink, resulting in job loss and punishing declines in personal income.

The slide in commodity prices has already begun, with crude oil slipping 4.5 per cent Wednesday, its biggest one-day drop in 17 years, and gold falling below $1,000 an ounce the same day in its biggest single-day decline since 2006.

World currency markets reacted to the blows to the Canadian resource economy by selling off the loonie, which fell below 99 cents (U.S.) on Wednesday, its sharpest one-day drop in 47 years.

Demand for Canadian oil and natural gas, base metals, canola and soybeans – all of which have touched record highs of late – will decline as the year progresses. U.S. demand for our goods will fall, but so will demand from China, India and other developing-world economies.

Determined, finally, to rein in runaway inflation, China is targeting lower growth of 8 per cent this year, compared with 11 per cent in 2007, which will reduce China's role in driving up global prices for Canada's food, fuel and metals. Chinese exports to the United States, like Canada's, are expected to take a hit from a U.S. slowdown.

"The big fall is coming," London investment counsellor David Roche of Independent Strategies wrote this week. In 2007, as financial and real-estate investments soured, speculators seeking refuge in gold, copper, uranium and other raw materials Canada produces in abundance came to account for more than half of all commodities trading.

But the speculators' ardour for nickel and soybeans will decline sharply as China finally pulls back on its GDP growth, creating big world surpluses – and price declines – in everything from zinc to cold-rolled steel. Roche forecasts a 30 per cent price drop in refined oil in 2008, and a decline of 20 per cent to 30 per cent for base metals.

Lest anyone think of this as a strictly Western Canadian setback, note that the Western oil patch in good years spends tens of millions of dollars annually on extraction equipment made in Ontario and Quebec.

2. BANK PARALYSIS DRIES UP CREDIT

The global financial system is in the sick bay. And there's no confident prognosis of when recovery can be expected.

Many global lenders' capital bases are in danger – the factor that caused Bear Stearns' collapse. Since January of last year, the world's largest banks and brokerages have suffered a collective loss of $181 billion (U.S.) on loan losses and reserves set aside for bad loans. Those losses have so severely depleted the treasuries of Citigroup Inc., Merrill Lynch Inc. and Swiss banking giant UBS AG, the largest bank in Europe, that all three have secured Red Cross injections of capital from state-owned investment funds and other investors in the Middle East and Asia.

The capital shortage at financial institutions has been worsened by the moribund condition of the markets for takeovers and initial public offerings (IPOs), depriving the banks and brokers of lucrative fees just when they need them.

Then again, overpriced, highly leveraged takeovers made at the height of acquisition exuberance in 2005 to 2007 are yet another source of the banks' current woes. Worldwide, banks, brokerages, hedge funds and even municipal pension-fund plans are on the hook for more than $1 trillion (U.S.) worth of buyout debt.

This is debt that private equity deal makers piled onto Chrysler LLC's balance sheet, and intend to burden Ma Bell parent BCE Inc. with so that those takeover targets can be made to pay the cost of their own acquisition.

Three New York-based banks and brokers alone, including Lehman Brothers Holdings Inc. (the subject of bankruptcy rumours this week), are saddled with more than $300 billion (U.S.) in private equity debt.

Contemplating such losses from at least some of the takeovers they financed, along with the near certainty of a wave of consumer-credit defaults on car, credit-card and other borrowing as the U.S. recession deepens, bankers are especially tight with money these days. That would be the case even if they weren't girding for further losses from the bursting of the $8 trillion (U.S.) housing bubble.

That's why banks worldwide have been hoarding cash by raising their lending rates – both to dissuade borrowers and to strengthen their balance sheets with higher rates imposed on their most creditworthy customers – even as the U.S. Fed slashed rates by 0.75 percentage points this week in still another bid to stimulate the economy.

If the bankers and the Fed appear to be acting at cross-purposes, so be it: The banks are being extra cautious for fear of being next on the list of lenders forcibly merged out of existence. The resulting capital drought is yet another drag on an already anemic U.S. economy.

3. LOSS OF TRUST

As of March 13, Bear Stearns was telling anyone who asked that it was in fine shape. Next day, it told Washington it was on death's door. Northern Rock PLC, Britain's largest mortgage lender and the first government-bailout casualty, was similarly sanguine about its prospects until a sudden bank run brought it to its knees.

As of late last year, Fed chair Ben Bernanke was insisting the crisis in subprime-mortgage defaults would not migrate into the larger U.S. economy, much less the global one.

Before he became a big investor in Wells Fargo & Co., the biggest bank on the U.S. West Coast, Warren Buffett counselled investors against banks. They can too easily hide their problems, he warned.

Bankers know that better than anyone, which is why they exhibited more than the usual suspicion this week in lending to each other – an essential function of modern global banking that keeps the system liquid. Interbank loans are cut off – as happened to Bear Stearns March 13 – when fellow banks and brokers abruptly cease lending to a peer they fear will not be good for the money.

The bankers and the Fed and other U.S. financial regulators have themselves to blame for the trust deficit that has grown since the credit crisis began seven months ago. That's when Bear Stearns found it could not recapitalize two of its hedge funds stuffed with "subprime" mortgages, the toxic instruments at the heart of the global credit crisis.

Earlier this decade, millions of low-income Americans, often making no down payment and offering no collateral, were induced to buy homes they couldn't afford, lured by low, "teaser" rates that currently are "resetting" at often usurious levels.

The premise was that home prices nationwide had never fallen, and that people who took out these junk or "wishful thinking" mortgages, as New York Times financial columnist David Leonhardt has called them, would be able to renegotiate their mortgages later at more favourable rates.

All the additional home-buying did ignite a boom in U.S. home prices, but this classic South Sea bubble burst last year, with prices falling between 30 per cent and 50 per cent.

With the regulators' after-the-fact approval, the world financial system was tricked up with a proliferation of devices for disguising "bundles" of subprime mortgages and other junk. These convoluted "innovations" included "structured investment vehicles" (SIVs), "collateralized debt obligations" (CDOs) and "asset-backed commercial paper" (ABCP), stuff that bank CEOs didn't understand or even know were in the bank's portfolio.

In a game of hot potato, banks unloaded this junk far and wide in bundles stamped with triple-A creditworthiness stickers, the recipients raking off their fees only to flip the package again until a $475,000 split-level in suburban Toledo whose low-income subprime mortgagee could no longer make the payments had found its way into the portfolio of a municipal employees pension plan in Hamburg or, remarkably, enough, an agency of the Ontario Treasurer.

About two years ago, Ed Clark, CEO of Toronto Dominion Bank, stumbled across an operation within his bank engaged in trading this unfamiliar exotica.

On discovering that the junior-ranking staff playing with the new toys could not explain how they worked, Clark demanded the stuff be immediately dumped (near the top of the market, as good luck would have it).

The Bear Stearns debacle and its aftershocks "stems from a loss of trust in the whole system of modern finance, with all its complex slicing and dicing or risk into ever more opaque forms," veteran financial markets columnist Gillian Tett wrote this week in the U.K. Financial Times.

"This trend is not just damaging the credibility of banks, but the aura of omnipotence that has enveloped institutions such as the U.S. Federal Reserve in recent years."

RECESSION SURVIVAL GUIDE Stay (or get) liquid. Pay with cash or debit. Avoid using credit cards and keep a zero balance. Retire the gas-guzzler and consider a smaller car or a hybrid. Diversify your stock portfolio. Don't put all your eggs in one basket. Exploit current low rates to lock in a long-term mortgage. See the United States and Canada first. Travelling to Europe can wait.

4. CORPORATE EXPANSION STALLS

As long as the credit crunch persists, consumer and corporate borrowing will be constrained. Which means a longer-than-usual wait for that car loan and the small-business start-up loan. Also jeopardized are routine lines of credit by which enterprises simply keep the lights on, along with more substantial loans for corporate expansion that creates jobs, new product lines and new geographic markets.

Corporate strategies are on hold across North America. Western Canadian pipeline projects await financing, and branch-plant operations as varied as Home Depot Inc. and Sears Canada have Canadian expansion plans on hold. Consumer-products giant Procter & Gamble Co. can't jettison its pet food business or Braun small-appliances unit for lack of credible buyers. Venerable enterprises like apparel retailer Talbots Inc. and struggling newcomers such as Internet phone provider Vonage Holdings Corp. are equally stymied in obtaining credit.

"Getting the financing done, whether on our side or the other, is impossible," Gary Rodkin, chief executive of U.S. consumer food giant ConAgra Foods Inc., told the Wall Street Journal this week. "It's crystal clear: Financing is almost nonexistent."

5. U.S. CONSUMER FATIGUE

As a U.S. recession deepens, its effects will be felt ever more widely in Canada. In slower sales of the minivans that roll off Chrysler's immense plant in Windsor, for instance – almost all destined for the U.S. market. Or at Waterloo's Research In Motion Ltd. if Wall Street steps up its tradition during slumps of laying off tens of thousands of white-collar BlackBerry addicts.

The entire B.C. economy is reliant on timber sales to a barely breathing U.S. new-house market.

It's said that the burgeoning middle class in China and India are developing a taste for North American goods. And it's true that Buicks that can't be given away in North America have lately become status symbols in Shanghai and Nanjing.

For all that, though, China boasts a consumer economy of about $1 trillion and India of a mere $600 million.

In the U.S., where shopping is famously referred to as "retail therapy," the consumer economy rings up about $9 trillion in annual sales.

Without robust American spending on Canadian goods, including patronage of our huge tourism sector, many Canadians will feel the pain. Bank of Canada governor Mark Carney was right, up to a point, that Canada benefits from "strength in domestic demand. We have a number of very strong fundamentals – corporate balance sheets, bank balance sheets, household balance sheets."

But our GDP is more export-oriented than most G-7 countries, and the bulk of those exports still head south. This is going to be, to say the least, a challenging next two years for Canadian exporters and for Canadian firms like TD Bank, Manulife Financial Inc., Tim Hortons Inc. and Alimentation Couche-Tard Ltée., which have aggressive growth plans in the U.S. in banking, insurance, fast food and convenience-store retailing, respectively. They'll be on the front lines as Americans cope with spending within their means.

CEO Howard Schwartz, as if he didn't have enough of a challenge in attempting a turnaround at struggling Starbucks Corp., told shareholders Wednesday at the coffee chain's annual meeting that, "You have an economy that really is in a tailspin, and many would say the consumer is in a recession. We're dealing with things we haven't seen before in terms of how people are responding to how tough it is."

With so many U.S. financiers "staring into the jaws of hell," as one New York analyst put it last week, a best-case scenario can't be ruled out. Lenders are newly cautious. There's still a lot of restless money out there in Asian and Middle Eastern "sovereign wealth funds" and traditional North American and European asset-management funds.

If worst comes to worst, the United States may end up creating a state agency to relieve troubled lenders of their junk – which the Fed effectively began to do by accepting a liberal definition of collateral in return for emergency bank financing.

It would be a costly gambit, reminiscent of Resolution Trust Corp., which picked up the pieces after the U.S. savings and loan disaster of the 1980s, whose total cost, while enormous by contemporary standards, would seem like chicken feed compared to this catastrophe.

Better that, though, than a great unwinding of the global financial system – although there's room to wonder if America, facing a $3 trillion debt in Iraq and Afghanistan, can resort to a rescue for the ages without resorting to printing the currency to fund it.