The Magazine

The Credit Crisis of 2008

As was the case a century ago, it's good to have a J.P. Morgan when you need one.

Mar 31, 2008, Vol. 13, No. 28 • By IRWIN M. STELZER
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All of this is being played out against a background of longer-term problems in the banking system. As more and more loans are being written off, the asset sides of banks' balance sheets are dropping. That reduces the banks' ability to take on liabilities, i.e., to make loans. And by a large multiple since banks typically lend many multiples of their assets, and for long periods. That's why runs on a bank can happen: If depositors or institutions that have lent the banks money on the basis of being able to get it back on demand decide en masse to show up at the teller's window with withdrawal slips in hand (it's done rather differently now, but many readers might find this description more comprehensible), there isn't enough cash on hand to satisfy the demand for it. Which is what happened in 1907, and why J.P. Morgan was forced to round up a group of men willing to put up their own money to prevent a run--some contributing "under penalty .??.??. of lacking assistance when the pinch should come home to them," as Carl Hovey put it in his 1911 biography of Morgan. I mention this only because when Long Term Capital Management went under in 1998, and Alan Greenspan organized a rescue effort by major banks in order to ease strains on the financial system, only Bear Stearns refused to help. Which might explain why the firm, famous for its macho, cigar-chomping, go-it-alone style found itself friendless just when it needed more than a few friends.

Two things have to happen before we put paid to the current problems. First, house prices have to bottom out. So long as they keep falling, which almost all experts expect them to do, the value of the mortgages held by the banks will fall. In the case of defaults, the banks are lucky to get half of the face value of the mortgage. And when a house is worth less than the mortgage, the circumstance in which an estimated 8 million homeowners now find themselves, and 14 million soon might, we get the phenomenon known as "jingle mail." That's the term used to describe the sound when the owners walk away from their house and mail the keys to whoever is responsible for collecting their monthly payments of interest and principal.

Second, banks will have to raise more capital. Paulson wants them to stop paying dividends and retain those funds as new capital. This, the boards of most banks do not want to do, lest shareholders, many now holding onto their shares because dividends seem so generous, rise up in indignation. (Citigroup, which 10 years ago fired Dimon, has to maintain a dividend yield of over 6 percent to get anyone to hold its shares.) Bank presidents are making pilgrimages to the Middle East to meet with managers of sovereign wealth funds, which are attractive sources of capital from the point of view of bank executives for two reasons. These funds--the surplus revenues of oil-rich governments--are in for the long haul, and they are passive investors rather than the sort who complain when bank executives mess up.

But once burned, twice shy. Sovereign wealth funds have watched the value of their investments in American banks wither under the dual blows of falling share prices and a declining dollar. At one time these foreigners were seen as a source of "dumb money," which they earned merely by watching oil flow from the ground. No longer: They have taken on professional managers, and are also reserving a bit more of their wealth for internal development, as a glance at the skylines of many Middle Eastern cities makes abundantly clear.

How the banks will solve their need for capital no one can predict. My own guess is that we will see a combination of dividend cuts, the emergence of "bottom fishers" (investors who at some point decide bank shares are under-valued), and a call on taxpayers to swallow hard and ante up to rescue the banking system, even if that means also coming to the aid of bleating bankers. You know, the guys who were so generous to you when you came around for help without so much collateral that you didn't really need any help at all.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).