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The Summer Credit Storm

Prepared by: Lee Hudson Teslik
Updated: August 16, 2007

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After successive dips rattled global stock markets the week of August 13, investors were left shaken and wondering just how economically poisonous U.S. credit concerns would prove to be. The most recent troubles came as problems among U.S. lenders metastasized into European markets, with the French bank BNP Paribas announcing it would suspend (IHT) three of its funds due to credit-market uncertainty. Shares of Deutsche Bank, Societe Generale, and other leading European financial organizations took a hit (Bloomberg) on the news. As spooked traders took cover, punishing markets worldwide (AP), the European Central Bank led a charge to pump money (MarketWatch) into the banking system as a stabilizing measure. These efforts notwithstanding, the short-term outlook remains murky. The typically sober Financial Times reported that with “further credit bombshells likely, there is every possibility that the coming days will see renewed turmoil.”

Why is this happening? The short answer is that a lot of uncertainty lingers about just how much bad debt is out there. CFR.org noted in March that as U.S. subprime lending practices proliferated, investment banks bought up debt from bad loans, chopped it up, and repackaged it for resale to unwitting investors. Now, as borrowers default on the original loans, the hedge funds and institutional investors that bought the repackaged debt are left scrambling as their investments implode. Bear Stearns Copresident Warren Spector emerged as an early casualty after two of the firm’s mortgage-related hedge funds crumbled (Bloomberg). More recently, Goldman Sachs announced it was bailing out (NYT) one of its funds with $3 billion in reserves after the fund lost $1.4 billion, nearly 30 percent of its value, in just over a week.

If other firms’ closets conceal more such skeletons, experts say the impact specifically on debt markets could be severe. But what would a credit crunch mean for the broader economy? Analysts disagree. Richard Beales of the Financial Times proffers a pessimistic take: “The notion that all this is a blip in a bull market is losing its credibility. The lending landscape has changed dramatically. The argument that stocks should go up because they are still decent value sounds increasingly hollow.” But others say the picture is blurrier. CFR’s Sebastian Mallaby writes in the Washington Post that there is both “pain” and “gain” in the subprime meltdown. “When the dust settles,” Mallaby writes, “investors will have learned not to put blind trust in rating agencies, which are paid by bond issuers and so have an incentive to exaggerate how safe bonds are.” The Economist seconds Mallaby, arguing that a return to tighter credit practices may be precisely what the market needs for its long-term health.

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