January 16, 2008 1:05PM

Muddling through the gloom

By Elizabeth MacDonald

With the unremitting negative headlines, it sure sounds like we should all be slamming our doors shut and getting out the nail guns. Here though are some points to ponder as we move from what economists call the Great Moderation (a period of low inflation) to the Great Unwind (the housing meltdown).

1. Learn from history: To get a read for how long we may be stuck wandering around in this Stygian gloom, check out this interesting study of 18 past banking crises co-authored by a professor at Harvard University and a professor at the University of Maryland that was released at a recent meeting of the American Economics Association. The study, which included analysis of the meltdown in Japan’s banking system in the ‘90s, sheds some light. The report found that in 18 prior banking-led crises, it took an average two years for economic growth to stabilize. The average drop in the growth of gross domestic product was two percentage points. For the five worst crises, GDP growth tumbled on average five percentage points from the top, and it took more than three years to unwind the mess. Other studies found housing-led crises last twice as long as equity busts—five years versus two, with output losses twice as large, 8% of GDP. The academics’ study also found a swift monetary policy response helps limit the pain—Fed chair Ben Bernanke is well aware of this fact, being a student of the severe monetary contraction that was partly to blame, along with the disastrous Smoot Hawley tariffs, for the Great Depression.

2. But how badly will the banks suffer?: To date banks, brokerages and financial services firms have written off $107.8 billion from their balance sheets, writedowns that have carved the same sum out of their net worth and vaporized assets that won’t deliver cash in the future. Say all of the $1.3 trillion in subprime mortgages defaults, and just half is recovered, amounting to $650 billion in losses. To be sure, a number of banks and bond insurers would be taken out. The professors’ study found that losses would amount to about 5% of GDP. Compare that to the 8% of GDP noted above in other housing-led downturns. That 5% is somewhat on a par with the five big crises, they aver. By way of comparison, the total losses from the S&L crisis as well as the related commercial lending mess from 1986 to 1995 amounted to about $189 billion, or 3.2% of GDP in that period. But here’s the figure to grab onto: Economists and housing pros are buzzing that home prices will have to fall 20% to 30% to come down to reality. That could amount to a loss of wealth in the U.S. of–deep breath–$4 trillion to $6 trillion, some estimates show.

3. No bull market without the financials: History shows there is no strong market without a strong financial sector, with the financials making up about 25% of the S&P 500. So keep an eye on still ugly numbers at big banks like Citigroup, now scrambling to shore up its capital reserves. The writedowns are likely far from over. John Thain, head of Merrill Lynch, told analysts that subprime securities won’t likely ever recover–meaning they’re dead money. Citigroup faces $37.3 billion in exposures to toxic waste from securitized subprime assets still on its books. A big $14.3 billion of its massive $18.1 billion pre-tax writedown came from this toxic junk (ironic that the name of the now moribund Superfund that the big banks wanted to launch to take care of off-balance sheet subprime waste echoed the name of the EPA’s toxic clean up fund). Citi isn’t alone. UBS, now cheekily called the Union Bank of Singapore thanks to Singapore’s cash infusion, faces a gross exposure of $28.9 billion, and Merrill Lynch, $7.5 billion to subprime loans and securitized mortgages, down from $21.5 billion at the end of the third quarter.

4. The problem is spreading beyond subprime: We already see the weak consumer creating credit card problems at American Express, and credit card and consumer loan problems at Bank of America and Capital One. Just take Citi alone. Meredith Whitney, executive director in equity research at Oppenheimer who was way out in front calling the problems at the financials, finds a “disturbing trend” in the rapid rise in consumer losses at Citi. Consumer credit costs at Citi increased by $4.1 billion, which included a net charge of $3.31 billion to increase consumer loan loss reserves. That $3.31 billion compares to a net reserve release of $127 million a year ago. Yikety yikes. Whitney warns “we believe this is simply not enough against a portfolio that is deteriorating so rapidly.”

5. The operative term is ‘Spread the Pain’: Dilution to existing investors is the order of the day at the financials caught in the housing quicksand, which has investors at places like UBS in an uproar. Citi alone is raising $14.5 billion through convertible preferred securities, with a sweet 7% coupon. Ouch. It also delivered a 41% cut in its quarterly dividend to 32 cents per share from 54 cents per share–raising debate about why it’s raising capital from foreign and domestic investors if the money is just going out the door toward the dividend. Whitney, who advocates deeper cuts to Citi’s dividend, estimates Citi faces close to 20% dilution on forward earnings.

6. Downgrades have picked up: In December alone, Standard & Poor’s, Moody’s and Fitch downgraded $314.9 billion worth of subprime and mortgage related securities, according to Bloomberg. That’s up from $110.8 billion in November and $165.1 billion in October. December was the single highest month for downgrades in the past five years. Also, no corporate defaults yet, though Moody’s expects that to happen this year. Another reason there’s panic in the bond insurance sector at places like MBIA and Ambac.

UP NEXT: Will the political fixes work?