Page last updated at 18:53 GMT, Tuesday, 18 March 2008

The crunch bites deeper in the US

By Stephanie Flanders
Economics editor, BBC News

A glut of unsold homes is depressing US house prices
A glut of unsold homes is depressing US house prices

The credit crunch has hit the US economy hard. From Wall Street to Main Street, loans that looked rock-solid a year ago now look shaky.

And the US central bank, the Federal Reserve, is throwing away the rule book to contain the effects.

Kevin Logan of Dresdner Kleinwort, one of the less gloomy New York economists, summarises the state of play as the credit crunch has spread to different types of assets as follows: "We're all sub-prime now".

We're all sub-prime now
Kevin Logan, Dresdner Kleinwort

The Fed did cut its main interest rate on Tuesday for the sixth time since September - by three quarters of one percentage point, to 2.25%.

This means that interest rates are now very close to going negative in real terms - once inflation is taken into account.

But amid the drama of the past few weeks, it almost seems par for the course.

Whether it's rate cuts or special funding arrangements for Wall Street, the more the Fed does, the more the markets seem to need.

Bernanke's problems

Ben Bernanke
Ben Bernanke wants to reassure the financial markets

America's chief economic fire-fighter, Fed boss Ben Bernanke, faces two core problems.

There's the slide in the real economy, which many now think fell into recession in February.

But there's also the crunch in the financial system, which rate cuts alone cannot cure.

The fact that banks are wary of lending even to each other and are desperate to offload their debt is as much about confidence as it is about interest rates.

These two crises are distinct.

But they stem from the same fundamental cause - the fact that US house prices have fallen nationwide for the first time since the Great Depression in the 1930s.

Housing problems

Foreclosures are spreading to areas like Los Angeles, depressing prices
The fear is that falling prices will undermine banks and squeeze credit

Across the US economy, everyone from homeowners to hedge funds has borrowed literally trillions of dollars on the assumption that such a fall could never happen.

Now that house prices have dropped by 10%, a lot of those borrowers, small and large, are turning out to have very little room for shocks.

Consider the homeowners first.

Back in 1976, the average down-payment for a first-time buyer in the US was 18%.

But between mid-2005 and mid-2006, almost half of first-time buyers put down nothing at all, according to the National Association of Realtors.

If house prices had fallen 10% in the 1970s, most of those first-time buyers would still have been OK.

Now, if they are in negative equity, they look like borrowers who have every reason to walk away from their mortgages.

Uncertain losses

 Bear Stearns
How many other banks are sitting on worthless assets?

The investors and financial institutions that are sitting on assets linked to those mortgages don't know how many of those loans will end up in default.

They do know it's a scary number and it's going up.

Every time they revise their guesstimates, the price of those mortgage-linked assets goes down further.

And the losses multiply for hedge funds and others who bet a lot more than the average homeowner on house prices continuing to go up.

The Carlyle Capital Corporation, the investment fund connected to the Carlyle private equity group that defaulted on $17bn (8.5bn) of debt last week, had $31 in debt for every $1 invested.

Moral hazard

There are some who say that the Fed should let all these institutions suffer the consequences - to the point of bankruptcy if need be.

The trouble is, the Fed Chairman, Ben Bernanke, knows that financial markets are now all too interconnected.

In less turbulent times he might have been able to afford to let a Bear Stearns go under.

Now it risks a domino effect in the markets and possible blame for a Japan-style economic "lost decade".

Everyone in the markets knows that the Fed is absolutely determined to avoid the mistakes of Japan in the 1990s, when the Bank of Japan failed to prevent a financial crisis sinking the real economy.

That's a large part of the reason why the dollar is falling and the gold price is reaching record high.

Self-fullfilling prophecy

In essence, traders around the world have concluded that the Fed now thinks that inflation would be a nice kind of problem to have, because inflation would tell you that the US was not going the way of Japan.

Even if supply limits keep the oil price at a high level over the next year, inflation is not going to be the Fed's core problem if the downward spiral in the markets gets out of hand.

The big fear is that in over-estimating the losses out there in the housing market, the financial institutions will make those estimates a self-fulfilling prophesy.

That is because the more mortgage assets get marked down, the greater the hit to banks' balance sheets, and the less they can lend to firms and households at decent rates.

That reduction in lending would take house prices down further, leading to more losses and the whole vicious cycle starting again.

Ben Bernanke is looking for the magic solution that will stop that dangerous dynamic taking hold.

He hasn't found it yet.

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