Before economy stabilizes, housing must

John W. Schoen Senior producer • Profile • E-mail

The spectacular collapse of two big investment banks — and the scramble by a major insurance company to stay afloat — has many on Wall Street and Main Street wondering: Is this as bad as it gets?

The answer is that nobody knows — not the heads of surviving banks, Treasury officials or policymakers at the Federal Reserve. The reason is that the true value of the investments being held by banks and other financial institutions cannot be known until home prices stop declining and the job market stabilizes. Until that happens, more losses are inevitable.

“I do not understand how we got into this situation,” said New Jersey Gov. Jon  Corzine, a former chief executive of Goldman Sachs.

“You could have asked me two years ago, five years ago, would you ever see a day like this?," he told CNBC. "And I think, not just me, but most people would say: 'That's never going to happen.'"

The financial storm that swamped investment banking giants Lehman Bros. and Merrill Lynch over the weekend shows no signs of weakening. The Dow Jones industrial average lost more than 500 points Monday in its worst day since 2001. Insurance giant AIG, whose stock has been hammered by worries about its financial strength, was scrambling Monday to build its capital base and stabilize its stock price — which has lost more than 70 percent of its value in the past week.

Just as the bursting of the housing bubble destroyed hundreds of billions of dollars in phantom home equity built by an explosion of rogue lending, Wall Street is now suffering through its own evaporation of market value.

More than a year after the financial meltdown began in August 2007, Wall Street bankers are still uncovering more losses and working to raise more capital to cover their bad debts. Borrowing more money — from other investors or the government — won’t solve the problem.

When a financial firm's losses rise more quickly than it is able to raise fresh capital, the process can lead to a vicious downward spiral. Just like a credit card holder who spends beyond the limit, the outstanding balance is far too big to pay back all at once.

And Wall Street has a bigger problem than debt-strapped consumers. Financial company executives simply are not sure how big their debt is. Instead of getting one credit card statement, financial companies have hundreds of investors and “counterparties” — the holders of mortgage-related debt that has been sold and resold in private transactions.

“I don't think anybody has a handle on it,” said Corzine. "I have a feeling that people do not know all of the exposures they have to the entities that are troubled, and therefore causing additional problems that have to be adjusted, requiring even more capital and even greater shrinkage of balance sheets and other risk exposures.”

In the initial stages of the crisis, the Treasury and Federal Reserve were willing to pony up taxpayer capital to stop the bleeding for the most badly wounded firms, including government-sponsored mortgage brokers Fannie Mae and Freddie Mac.

But late last week the outlook for a broader financial turnaround became more uncertain when officials at both the Treasury and the Fed signaled an abrupt shift in policy, making clear they would not necessarily invest more capital in firms that had gotten into trouble.

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