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The meltdown is real, but its impact beyond finance is still unclear.
There has never been a week like this!" "There is no playbook!" "The worst financial crisis since the Great Depression!" These phrases and others of equal hyperbole were repeated any number of times on Wall Street these past weeks. No doubt the drama has been spectacular. In the space of ten days, the U.S. government took over two mortgage-bond behemoths, Fannie Mae and Freddie Mac, and assumed de facto control of one of the world's largest insurance companies, AIG. Two of the oldest and most renowned investment banks, Lehman Brothers and Merrill Lynch, came to an end; Merrill was acquired by Bank of America for about $50 billion; and Lehman was forced into bankruptcy, with some of its more-valuable assets and employees picked up for pennies by Britain's Barclays Bank. Morgan Stanley and Goldman Sachs saw their stocks plummet and then boomerang back up. Global stock indices lost and then gained trillions in value, and central banks injected hundreds of billions to prevent the global economic system from freezing. To cap it off, the U.S. government announced a far-reaching plan to assume responsibility for the bad mortgages that triggered all this in the first place.
When someone shouts "Fire" in a crowded theater, the person who stands up and asks for calm usually get knocked down. That doesn't make him wrong. The suggestion that the current crisis may not be quite so critical isn't finding much traction these days, but that doesn't make it false.
The meltdown of Wall Street and the resulting government intervention are real and will reshape the industry. But it's much less apparent what the ramifications are beyond the financial industry. The link between Main Street and Wall Street has always been mysterious. There have been Wall Street crises that barely touched the broader economy (think the Panic of 1907 and the implosion of Long Term Capital Management in 1998), and there have been Main Street downturns that have only marginally hurt Wall Street (the 1981-82 recession). Many people say that today's crisis on Wall Street will have dire effects on the "real" economy, but for now, at least, those assertions are just that. The U.S. economy, at least as measured by GDP, has shown surprising growth through the first six months of the year, up 3.3 percent in the second quarter alone. Consumer spending has flattened but not collapsed under the weight of higher gas and food prices and tighter credit. Stocks are down, but in the last presidential election year of 2004, the only real gains in the market happened between late October and the end of the year. On Main Street, there may not be much to celebrate, but it's a far cry from what's happening on Wall Street.
And it's not even happening everywhere on Wall Street. Trillion-dollar asset-management companies such as Fidelity and Vanguard, for instance, are doing fine, though the decline in stock prices is a negative for them. Companies that make money processing transactions, ranging from massive banks like State Street and Bank of New York, haven't imploded. Credit-card companies like Capital One, and Visa (which had one of the most successful initial public offerings in years earlier this summer) have not seen the consumer defaults that the dire rhetoric would suggest. In free-fall are investment banks and anyone involved in mortgages and their many derivatives, but parts of Wall Street are business as normal, though you'd never know that judging from the mood. After all, Bank of America—flush with consumer deposits from Main Street—actually had $50 billion to buy Merrill Lynch.
Even the absolute size of the problems isn't as dire as depicted. Lehman Brothers just before it went bankrupt had a market value of $2.9 billion and about 25,000 employees. Most of its value is now wiped out, though 10,000 of those workers will find new jobs at Barclays. But even at its height, it was far smaller than hundreds of companies that get less press. Take a company called Polycom, which makes teleconferencing equipment; you've probably seen their triangle-shaped units in some office or another. It had a market value of about $2.4 billion. If Polycom were, hypothetically, to go bankrupt tomorrow, would people be tearing their hair out about the end of teleconferencing? Doubtful.
Of course, unlike the Polycoms of the world, investment banks and insurers like AIG have trillions of dollars in outstanding assets, obligations, and contracts. But that doesn't mean trillions of dollars in losses. Only a portion of their business is tied up with mortgages and derivatives, and while some of those might be worthless, most aren't. We know that because even in a terrible, dysfunctional market, they have been purchased.
The derivatives built around mortgages ultimately rest on underlying assets, namely homes. Even as those homes decline in value—whether in the United States, or the U.K., or Spain—they are still worth something. Most home price decreases are in the range of 10 percent to 20 percent, and most mortgages are not in default. As a result, other financial institutions have been buying the "paper" of distressed financial companies for 60 cents to 80 cents on the dollar. Earlier this year, Merrill Lynch sold some of its worst assets for about 30 cents on the dollar, but those were the lowest of the low and represented a small portion of the company's holdings. Accounting rules passed in the wake of Enron, however, force companies to mark down these derivatives even when markets are spiraling downward and there are no buyers. And when there are no buyers, even things of value can be worth nothing.
The fear is that the system unravels rapidly, triggering virtual runs on the banks that leave them unable to meet the demands for payment. Some of that has already happened inside Wall Street. The fear that the contagion was about to spread to Main Street was stoked when a $60 billion money-market fund run by Reserve Trust halted redemptions, and its shares started trading at 97 cents on the dollar. Yet the government quickly provided $180 billion in backing, and here as well, the problem was panic—after all, few people's lives would be completely ruined losing 3 cents on a dollar.
Swift government action also separates the current financial implosion from Great Depression-like meltdowns. The U.S. government spent a trillion dollars on Iraq in the past five years—though that money will never yield a penny. With the U.S. economy generating $14 trillion every year, the government is more than able to provide a several hundred billion dollar backstop to bad mortgages, if that proves necessary to halt the rippling panic on Wall Street or contain the next bank failure, whether it is Washington Mutual or someone else. Not a great outcome, but not the sum of our fears.
The conventional wisdom is that Wall Street is the center of the global financial system, the axis around which all revolves, and if it breaks, if the current government bailout fails to stem the bleeding, the entire world is imperiled. Short-term, there's some truth in that: the world needs liquidity (cash) just as the body needs water. But the world needs a lot of things: electricity and transportation, for instance. In 2002, the global airline industry imploded in the wake of 9/11. Globally, 150,000 people lost their jobs—more than the dire projections of job losses this year on Wall Street. The U.S. government provided $15 billion in bailout funds to airlines in November 2002 alone. In 2008, faced with sharply higher fuel costs, the U.S. airline industry has already shed 22,000 jobs, and has notched tens of billions in losses. Yet the collapse of the airline industry in both 2002 and 2008 did not lead to claims that global travel was imperiled or that the system as we know it was teetering on the brink.
The bottom line—there's clearly an echo-chamber problem here. The people who report on Wall Street by and large live in the same place as the people who work on Wall Street. A similar problem exists in London with the City and Fleet Street. The analysts who assess what is happening on behalf of investors are employed by the same companies that they are supposed to be analyzing objectively. The agencies that rate the bonds of companies are part of the same nexus. And of course the traders who buy and sell are intertwined as well. Expecting any of these to have perspective is a bit like asking someone in the eye of a storm what they feel about wind and rain. Rumors spread easily, and fear can get stoked to wildfire intensity in a matter of days. The 24/7 news cycle doesn't help; drama and crisis are good for ratings.
But Wall Street is not the world. It is an industry that is central to the world, but it is one input rather than the input. In the past five years, it has lost much of its centrality. For much of the second part of the 20th century, Wall Street was a major source of global capital. Today, it needs to look elsewhere for capital. In the past five years alone, there has been a massive wealth transfer away from the United States and in both the oil-producing regions such as the Gulf and goods-producing regions such as China. At least $7 trillion sits in the sovereign wealth funds and central banks of countries ranging from China to Dubai. The total market cap of the five independent U.S. investment banks at their height: less than $500 billion.
While this shift may signify a relative decrease in U.S. power, it provides a cushion for the global economic system, a system that most U.S. companies and consumers are enmeshed in. Global capital may not flow exactly where it is needed exactly when it is needed, but it changes the equation. There may not be enough capital on Wall Street to float ailing investment banks. There is more than enough capital globally to do that many times over. Sovereign wealth funds already helped Citibank through some of its trouble at the end of 2007; China's SWF just took a larger stake in Morgan Stanley; and they could very well step in again if needed.
Finally, there is the tricky question of Main Street. The more than 400 publicly-traded companies of the S&P 500 that have nothing to do with mortgages and don't make cars have been doing quite well. Earnings of financial companies were down more than 100 percent for the first six months of 2008; the rest saw their earnings up nearly 10 percent, with many individual companies like Google up substantially more. True, these companies function in a global marketplace that is expanding more quickly than Europe or the United States, especially China. They can squeeze more efficiency (fewer workers, more technology) out of their business. But they are also doing well because people and companies outside of Wall Street are simply going about their business.
On Main Street, cell-phone stores are selling iPhones; electronics stores are selling flat screens and game consoles; nail parlors are cutting nails; fast food is selling fast; and medical-equipment companies are making artificial joints, bandages and pacemakers. Ask the average person in Houston or Omaha what they think about Lehman Brothers or AIG, and most of them would probably say they've never heard of either. And for good reason: those companies don't impact their lives meaningfully.
Dark days on Wall Street for sure, but catastrophe for society, that is a stretch. As stock markets continue their wild gyrations, pension plans and retirees who need the cash now are pressured, yet stocks go up just as quickly as they go down. Others will continue to put money in their retirement plans and may find years from now that those investments performed spectacularly. Wall Street will consolidate, and some firms will thrive and profit having picked up solid franchises of imploding companies. And then some other crisis will occur, unexpected, and people will once again say that it's the worst they've ever seen, and life will go on.
Karabell is president of RiverTwice Research and senior adviser to Business for Social Responsibility.
© 2008
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