Four Essential Articles

As we head into the economic abyss (as the AP put it) and the Fed goes where it's never gone before (as BusinessWeek put it), we have to ask ourselves, what are the next shoes to drop? Here I've located what I think are the next two most likely shoes to drop.

Into the Economic Abyss

Understanding how things got so bad means rewinding to the start of the housing boom. Wall Street and the banks made it far easier for people with shaky credit to get a mortgage -- known as a subprime loan.
"This problem begins with the fact that we underwrote mortgages sloppily, which means no one really knows what those assets are worth," said Lyle Gramley, a former Federal Reserve governor and now an analyst with Stanford Financial Group. "That makes bankers very leery, and has resulted in a significant contraction in the availability of credit."
"I think the current financial crisis looks to me like the worst one since we got into the Depression," says Richard Sylla, who teaches the history of financial institutions at New York University's Stern School of Business.

A pretty interesting article from the AP, which is, in my opinion, among the worst (best?) at sugar-coating and downplaying the risks to the economy.

Where No Fed Has Gone Before

The Federal Reserve has stretched its mandate up, down, and sideways to prevent a financial market deluge. Now it appears to be stretching the English language a bit as well. What the Fed is calling a $29 billion "loan" to help finance JPMorgan Chase's (JPM) purchase of Bear Stearns (BSC) looks much more like a $29 billion investment in securities owned by Bear. Although the Fed insists that it isn't technically buying any assets, in practical terms it's doing exactly that. All this adds up to a big and unacknowledged step up in the central bank's financial intervention with Wall Street investment banks.

To understand what's going on, go back to the weekend of Mar. 15-16, when the Fed encouraged JPMorgan to buy Bear Stearns at a fire-sale price to keep Bear from going under and dragging other banks down with it. Even at $2 a share, JPMorgan wasn't willing to do the deal because lots of Bear's assets, despite having an investment-grade rating, were worth almost zero in the then-skittish marketplace.

So the Fed got creative. It set up an arcane arrangement that will give JPMorgan the full appraised value for some of Bear's assets if JPMorgan succeeds in acquiring Bear.

Here's how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear's new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there's money left over even after JPMorgan gets repaid, the Fed gets it all.

Well, isn't that interesting? I wondered how that $30 billion from the Fed got 'injected' in the BSC deal. In a cartoon-like fashion, I imagined that the Fed just wired the money over. Instead, they (very rapidly) created a separate holding corporation to receive both assets and liabilities and found a third party to run it. Nice work for a single weekend!

However, this tells us something very important: The Fed does not actually want to hold any of the truly rotten garbage in its own portfolio. This means the Fed is seeking to insulate itself. What does this tell us? Even the Fed does not have confidence in these assets, and the Fed is *not* willing to risk it all on this, or any other, rescue attempt.

Equity Loans as Next Round in Credit Crisis

Little by little, millions of Americans surrendered equity in their homes in recent years. Lulled by good times, they borrowed — sometimes heavily — against the roofs over their heads. Now the bill is coming due. As the housing market spirals downward, home equity loans, which turn home sweet home into cash sweet cash, are becoming the next flash point in the mortgage crisis. Americans owe a staggering $1.1 trillion on home equity loans — and banks are increasingly worried they may not get some of that money back.

The next shoe to drop. Too bad our economy looks like a tree festooned with the contents of Imelda Marcos' closet right now.

Mid-Atlantic banks face more loan losses

NEW YORK (Reuters) - Big Mid-Atlantic banks face more losses from the real estate slump, according to a report on Monday from a regional Federal Reserve that suggests the worst has not passed for the beleaguered banking sector.

Prospects of an ever-growing stockpile of bad loans on homes, office buildings and shopping malls will likely force banks to seek additional capital and/or to put aside more money to cover further losses, the Philadelphia Federal Reserve said.

While the latest study focused on banks the regional Fed oversees in three Mid-Atlantic states -- Pennsylvania, New Jersey and Delaware, many of them do business across the country.

Financial conditions at these large Mid-Atlantic banks worsened across the board in the last quarter of 2007, deteriorating to their weakest levels in 15 years by some measures, the Philadelphia Fed said.

The next, next shoe to drop. I wrote about this prospect about a year ago. The key here is to understand that it is primarily the mid-sized and regional banks that do the bulk of the Commercial & Industrial loaning. Which means they are the most heavily exposed to losses that might result from, oh, say, defaults by the developers of the ill-advised mall built on the outskirts near the empty, overpriced and unsold houses on the edge of town.

If these losses are in the hundreds of billions
(likely), then, statistically speaking, it is possible that nearly all of the capital of the mid-sized regional banks will be wiped out.

This is why I constantly caution you to pick your bank very carefully, and, even then, to keep your eye firmly focused on how your bank is doing.


This is a companion discussion topic for the original entry at