Can It Get Any Worse?

On Tuesday the Federal Reservecut short-term interest rates another three-quarters of a point to 2.25 percent, the lowest level since the end of 2004. That's just days after its unprecedented decision last weekend to provide $30 billion in financing to JPMorgan Chase in its bid to acquire the beleaguered Wall Street firm Bear Stearns. The central bank's recent moves have been dramatic, but will they improve the economy—or, at least, head off further crises? NEWSWEEK's Jennifer Barrett asked Charles R. Morris, a former banker at what is now JPMorgan Chase and author of the newly released "The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash" (PublicAffairs; $22.95). Excerpts:

NEWSWEEK: The Federal Reserve has now lowered the short-term interest rate two percentage points since December. Is this a smart move ?
Charles R. Morris: The Fed's emphasis seems all directed to keeping consumers spending and borrowing, and to keep asset prices high. That is just more of the "hair of the dog," or exactly the opposite of what we need. It will also feed into the collapse of the dollar, which has been a big cause of the recent uptick in inflation, especially in energy. The Fed can't stop a recession; it's already underway. We have to switch gears from a low-saving, high-spending country to nearly the opposite. It's impossible to make that switch without going through a recession. The current strategy will just drag out the process.

So you're saying, Why make it cheaper for consumers and banks to borrow now?
I can't imagine why they want to encourage more borrowing. I think it's because when you have a hammer everything looks a like a nail … But what we need to do is to cut consumer spending. You have consumers stretched, really overleveraged. Then we need to mediate an orderly reduction of asset prices—an honest deleveraging. I'm talking about prices of homes, bonds. And it's better to do that sooner than later … We also have to help low-income people who could be badly hurt, but we're not helping them by propping up investment banks.

How much could home prices fall?
Home prices will probably fall another 15 to 20 percent, if you look at differences between rental and mortgages. [Average monthly rents in many areas are now about 15 to 20 percent lower than average monthly mortgage payments for a comparably sized home.]

You estimate that once the dust settles, investors will have lost about $1 trillion in defaults and write-downs from mortgages and other loans. How did you come up with that estimate?
That encompasses residential mortgages, corporate debt, commercial mortgages, credit cards and several others. About half of it will be on the books of banks. It's actually a very conservative estimate, based on the losses and write-downs that have already taken place. It also takes full account of likely recoveries, from defaulted mortgages and loans. But the trillion-dollar estimate assumes that the de-leveraging goes smoothly—as if we could have a big meeting and agree on reasonable numbers. If we continue this crazy crash-a-month cycle, we're more likely to overshoot by two to three times.

So you're probably not a big supporter of the Federal Reserve's decision this weekend to begin providing loans to investment banks, starting with $30 billion in financing for JPMorgan Chase's purchase of Bear Stearns.
It's a window, and a shocking one, into how bad some of these assets are. Reports from the weekend deal are that JPMorgan came in on Saturday expecting to do a deal for about $10 to $12 a share. Then they went through the books and said no way. Bear Stearns has $138 billion of bonds and equities on the asset side—most of them normal stuff. But about $46 billion are in dicey mortgage-backed instruments, so that's where the problems must be. And even with the Fed putting up $30 billion, JPMorgan Chase was still wary—it paid $2 a share. It looks like that $46 billion in mortgages isn't worth much, maybe 20 cents on the dollar … I'd like to see the Federal Reserve take the lead in enforcing honest accounting.

Would it have been better to let Bear Stearns slide into Chapter 11?
I think so, yes, because it starts some truth-telling. You can't just keep papering it over. Clearly Bear Stearns wasn't worth much if the Fed had to put up $30 billion.

What about credit-card debt? Are you concerned about defaults?
It's not as bad. The credit card companies have been dealing with low-quality borrowers for a very long time, and they are completely vicious. If you miss a payment they can cut you off immediately and start charging you 40 percent interest on the balance. There's no 90-day warning period. The consumer-debt bubble got so high because consumers could take so much out of their homes. Households have even begun selling off stocks they owned—maybe cashing in their 401(k)s—to cover mortgage payments or expenses. We've seen a large net equity sale among households that's tied to the drying up of the mortgage market.