A year into credit crunch, more pain expected

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By Alistair Barr, MarketWatch

Last update: 7:37 p.m. EDT Aug. 1, 2008SAN FRANCISCO (MarketWatch) -- "Troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system," -- Federal Reserve Chairman Ben Bernanke, June 5, 2007, during a speech from Cape Town, South Africa.

Just two months later, last August, those words seemed a distant memory. The financial system was in disarray, forcing the Fed and the European Central Bank to pump more than $250 billion into short-term funding markets to keep them working properly. The subprime mortgage crisis had gone global and the credit crunch had begun.

As the first anniversary of the crisis arrives this coming week, the Dow Jones Industrial Average is down 14%, U.S. economic growth has more than halved, financial institutions have suffered $350 billion in write-downs and fired chief executives and thousands of workers, while house prices have slumped as much as 40% in some areas. Bear Stearns, the nation's fifth-largest investment bank, had to be bailed out by the Fed and J.P. Morgan Chase (JPMJPMorgan Chase & Co News, chart, profile, more FNM) and Freddie Mac (FREFreddie Mac FRE) , the bedrock of the U.S. mortgage market, may be next.

Eight U.S. banks have failed since the beginning of the year, including First Priority Bank of Bradenton, Fla. late Friday. See full story.

"I doubt we're even a third of the way through it," said Michael Burry, head of Scion Capital, LLC, an $800 million hedge fund firm, which made huge returns betting against riskier parts of subprime mortgage-backed securities. See related story. "A real recovery won't happen until late 2010 or early 2011. A lot of the bills from the credit bubble haven't come due yet."

Burry expects inflation to increase and the U.S. dollar to decline further as the government creates more dollars to try to ease the pain of the credit crunch. To prepare, he's invested in commodities, foreign currencies and overseas stocks, with a focus on Asia.

Nowhere near bottom

To be sure, Burry has profited from negative bets against the housing and mortgage markets and may be more bearish than others because of that. However, he isn't alone in his views.
"We probably have at least another year to two years to go in this process," said Eric Hovde, chief executive and portfolio manager at Hovde Capital, which manages a series of hedge funds focused on financial services.

House prices have taken another sharp leg down recently and that won't show up on the balance sheets of banks and other financial institutions for three to six months, he noted.

"Housing alone will keep credit destruction and depletion of capital in the financial sector at a rapid clip for another year," Hovde said.

Greg Case, chief executive of Aon Corp. (AOCAon Corporation News, chart, profile, more AOC) , the world's largest insurance broker, is perturbed by the beginning of what may be a slowdown in Europe.

"We're a very global firm operating in 120 countries. Our concern is that we're beginning to see some of the same characteristics in Europe as we've seen in the U.S.," Case said. "Overall economic pressure is increasing. That leads to tightness in credit and pressure on financial institutions. We see it everyday with our clients."

Max Bublitz, chief strategist at $5.8 billion investment firm SCM Advisors LLC, reckons the credit crunch is in its fourth or fifth inning. House price deflation is probably in the sixth or seventh inning.

However, a pullback by consumers, the engine of the U.S. economy, is still in the early stages, he warned.

"The consumer is dealing with their homes going down in value and their stock portfolios falling -- they're being hit on the asset side of their balance sheet," he said. "They're also suffering on the income side too, with wages stagnating and food and energy prices climbing."

Government intervention means there probably won't be a devastating decline in the U.S. economy, but Bublitz expects economic headwinds well into 2009. Growth in gross domestic product, adjusted for inflation, may not return until 2010, he added.

House prices

House prices have to stop falling before the credit crunch can begin to ease, Bublitz and Hovde said.

But how?

The residential real estate boom was partly fueled by new types of mortgages that helped many people buy homes that were previously too expensive. These loans were extended on the assumption that house prices would rise indefinitely.

Now that's turned out to be wrong, these mortgages have disappeared and won't come back for years, Scion's Burry said. Without such financing, buyers may struggle to pay up and home prices may languish, he explained.

Bank lending

The supply of loans for home purchases can begin to increase again when banks and other financial institutions resolve the bad debts that are weighing down their balance sheets, Burry and others said. That process will take time.

In the second quarter of 2007, just before the credit crisis hit, U.S. banks had set aside reserves representing just 1.23% of their total loans, according to data from RiskMetrics Group (RMGriskmetrics group inc com)

That was one of the lowest levels of reserves ever in the U.S. banking system and made banks look better capitalized than they actually were, Zach Gast, a financial sector analyst at RiskMetrics, said.

By the end of March, banks had increased reserves to 1.71% of total loans. But that didn't keep up with the speed at which their assets deteriorated during the first quarter, he noted.

RiskMetrics hasn't finished compiling data from the second quarter, but Gast reckons banks have increased reserves a lot more and have probably kept pace with rising bad loans.

The problem is, as reserves increase, that eats into banks' capital, which makes them less willing to lend, Gast explained.

"If banks don't have enough capital, they may not be able to grow assets by lending more," the analyst said. "People have to get comfortable that an increase in reserves isn't going to detract from the capital adequacy of banks. I don't know when we get there."

To get a sense of how long this may take, Gast looked back at previous downturns in the credit cycle and focused on how banks dealt with souring commercial and industrial loans, which are usually among the most volatile.

"Typically it takes three to five years to work through the system," Gast concluded.

In the current credit crunch, loan delinquencies began climbing just two quarters ago, he added, while noting that some types of bad loans, such as credit card debt, work their way through the banking system more quickly than commercial and industrial loans.

Purging process

The situation is clearer with securities that are collateralized by loans, such as mortgage-backed securities. Financial institutions have had to report the fair value of these assets based on market prices or computer models, Gast explained.

Recent write-downs and sales of these types of securities by Merrill Lynch (MERMerrill Lynch & Co., Inc MER) bolstered confidence because they suggest that some large financial firms may be finally dealing with problem assets. See full story.

However, efforts by the U.S. government to cushion the impact of the credit crunch has slowed this purging process, Burry said.

After Bear Stearns almost collapsed, the Fed began lending directly to brokerage firms for the first time since the Great Depression. That prevented more force selling by allowing some firms to continue financing large exposures to mortgage-related securities. But it also means such assets remain on the balance sheets of several financial institutions.

"The government should not be involved in bailing out financial companies that have taken risks incompatible with their survival," Burry said.

"This might all go very quickly if the government asks society to take responsibility for the troubles it brought upon itself," he added. "But instead, the government is creating dollars left and right to manipulate the economy into a better showing in the short term."

Such action will create longer-term problems, such as further drop in the U.S. dollar and rampant inflation, Burry said.

But policymakers probably had no choice. Without the bailout of Bear Stearns and plans to support Fannie and Freddie, there may have been a catastrophic economic slump, SCM's Bublitz argues.

"Hands-off government sounds great in theory, but who knows what it would be like without such support?" he said. "Bailouts, while repugnant to some, just had to happen because the alternatives were too dire."

Bublitz expects a less intense but longer credit crunch. But unlike Burry, he expects a sluggish economy to restrain overall inflation.

Step up and leverage up

The credit crunch could be eased sooner if a major investor steps up by borrowing more money and using that to buy trouble assets from financial institutions, Paul McCulley, managing director of fixed-income giant Pimco, wrote in a July note to investors.

That entity should be the U.S. government, he said.

Otherwise, financial institutions will continue to cut leverage and sell assets into a market of few buyers. This in turn will drive prices lower again, pressuring firms into more de-leveraging and more asset sales, McCulley explained.

"The federal government ... needs to lever up its balance sheet to absorb assets being shed through private sector de-levering, so as to avoid pernicious asset deflation," he wrote. "It really is as simple as that."

A structure similar to the Resolution Trust Corporation, or RTC, has been suggested by some economists, Bublitz noted.

RTC was a government-owned investment fund that bought bad loans after the savings and loan crisis at the end of the 1980's. The fund helped get financial institutions lending again by relieving them of soured debt.

"I do see some type of government entity," Hovde said.

But RTC was a conduit that eventually sold on bad loans to other investors. If a similar structure is used to relieve the current credit crisis, there will still need to be investors willing to buy after bad debts are resolved, he noted.

"Unfortunately a solution like this will cost taxpayers a ton of money," Hovde said.