Signs Are Pointing South on Wall St.

Neil Irwin
Washington Post
November 27, 2007

Credit Woes Foster Bets on Bad Times

Wall Street is betting on a recession.

Investors in stocks and bonds are paying prices that indicate they believe a snowballing housing crisis and worsening credit crunch will soon tip the U.S. economy into a recession, analysts said. Many economists, including leaders of the Federal Reserve, don’t think things will get that bad, but some say the risk of a serious downturn has risen in recent weeks.

Investors were so eager to buy ultra-safe government bonds yesterday that they were willing to accept sharply lower interest rates. The rate on the 10-year Treasury bond fell to 3.84 percent from 4 percent Friday. The low rates indicate investors expect the Federal Reserve to cut interest rates aggressively in the coming year to ease the pain of recession.

Stocks are now down more than 10 percent from their peak in October. The Standard & Poor’s 500-stock index fell 2.3 percent yesterday, dropping the market to a level that Wall Street analysts say reflects an expectation that corporate profits will fall.

Taken together, those and other data indicate that financial markets have a decidedly negative prognosis for the economy. “They’re saying the odds of a recession are pretty damn high,” said Diane Swonk, chief economist at Mesirow Financial.

There are reasons to think things will not get that bad, however. Holiday sales started Friday with a strong 8.3 percent gain over last year, and U.S. consumers have proven resilient in past periods of financial distress. With the dollar weakening, U.S. exporters will be at an advantage; joblessness remains near historic lows, at 4.7 percent; and the stock market, an old joke goes, has predicted nine of the past five recessions.

Moreover, economic growth could slow sharply through the first half of next year, as the Federal Reserve and myriad private firms predict, without technically falling into recession territory. A recession is defined as a significant decline in economic activity, as measured by a variety of indicators, that lasts more than a few months. The nonprofit Conference Board said yesterday that its index of leading economic indicators fell in October, but not by so much as to suggest a recession is about to begin.

Other events yesterday showed how widely worry has spread.

The Federal Reserve Bank of New York said it would make at least $8 billion available so banks do not find themselves short of cash through early January. Former Treasury secretary Lawrence Summers said in a column in yesterday’s Financial Times that he now believes the odds favor a recession, a view he did not hold a few weeks ago.

Housing prices are falling sharply in many of the nation’s biggest cities, and millions of foreclosures are forecast for the next two years. Oil prices are near $100 per barrel, which could thin out consumers’ pocketbooks if the winter is especially cold. And as the value of the dollar drops, imports as varied as French wine and Japanese electronics could become more expensive.

In a view increasingly typical among Wall Street economists, analysts at Merrill Lynch published a research note yesterday with the headline: “We believe we are going to see a recession in ‘08.”

Widespread expectations of a recession could be self-fulfilling because of how financial markets and mainstream America are interconnected. If investors are sufficiently convinced a recession is ahead, they would be reluctant to lend money to businesses that want to expand, making it so.

Just a month ago, financial markets seemed to be healing from the tumult of the summer, when fear of losses in the mortgage sector caused many markets to effectively shut down. But throughout November, the very institutions that were expected to ease the blow to the economy have shown more evidence of trouble.

Investors are worried that major banks are suffering such severe losses from mortgage and other risky securities that they will not be able to lend as much money to consumers and businesses in the months ahead. The same fears apply to Fannie Mae and Freddie Mac, the government-sponsored housing finance companies.

“It looked like the problems in the credit markets were going away or at least calming down a few weeks ago,” said David A. Wyss, chief economist of Standard & Poor’s. “Now the signs are that they’re not.”

The credit problems are no abstraction. They make it more expensive for individuals to obtain mortgages and for businesses to expand.

Higher interest rates for risky mortgages, for example, could make it difficult for would-be buyers to afford a home, which could cause prices to drop further. That, in turn, could spur more foreclosures, which could lead financial institutions to further increase rates they charge on mortgages.

“These things feed off of each other,” Wyss said.

The same is true for businesses. Continuing expansion of the commercial real estate sector, for example, including office buildings and shopping centers, has been a major cushion from the housing downturn in recent months and has kept construction workers employed.

In February, owners could borrow against such properties at interest rates about one percentage point above the rate for Treasury bonds, based on a Morgan Stanley index for moderately risky commercial mortgage-backed securities. At the end of September, commercial property owners had to pay an additional four percentage points. By yesterday, the premium was seven percentage points.

Higher borrowing costs could make commercial builders less likely to move forward with new construction, analysts said, eliminating a crucial source of growth in jobs and in the gross domestic product.

The potential freeze in bank lending could mirror the savings and loan crisis of the early 1990s, a major cause of the 1990-91 recession.

“In any recession, you get to a tipping point where sentiment unravels and feeds on itself. Psychology takes over,” said Mark Zandi, chief economist of Moody’s Economy.com.