The Echoes Of Crisis

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.