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Confidence in US resilience is fading

At the beginning of 2007, only the most imaginative pessimist could have predicted that a small corner of the US mortgage market would cause global financial turbulence.

But that is precisely what came to pass, and it is not over.

Not since overheating Asian economies triggered an extended bout of turmoil in 1997 has the mood among financial policy makers been so defensive. As in that earlier crisis, the current atmosphere marks a stunning reversal of what immediately preceded it.

The first half of this decade will be remembered as a time of the best economic growth since the early 1970s as Asian economies rocketed forward and the United States and Europe managed to grow as well. The second half of 2007 and the beginning of 2008 - maybe all of it - are looking like a time of broad retrenchment and gloom.

‘The fear factor is large - large and rising - compared to anything that anyone has experienced since the late 1990s,’ said Jim O’Neill, chief economist at Goldman Sachs in London.

What has become known as the subprime crisis because of its trigger - defaults on mortgage loans to high-risk borrowers in the United States - mixes two potent elements: banking industry turmoil and a sharp slowdown in the world’s largest economy. Worries about losses linked to US mortgages dominated the first six months of the crisis, but by December worries about an outright recession in the United States predominated, and early 2008 might be the time when Asia and Europe starts to share the pain.

In that respect, the current chaos differs greatly from the Asia crisis, a jarring period of defaults, bankruptcies and unemployment. Banks and even midsize countries like Thailand - whose decision in July 1997 to float its currency set off the Asian turmoil - can be recapitalized. But there is no magic formula for restarting the stalled US business cycle.

The latest crisis ‘has been a slower-moving train wreck, but no less intense than what we went through in the late 1990s,’ said Peter Hooper, chief US economist at Deutsche Bank Securities in New York who was at the US Federal Reserve during the Asian turmoil. ‘We were able to make it through the Asia crisis without a major downturn in the US economy.’

The Fed cut interest rates Wednesday as part of an effort to bring about a soft landing, but Hooper noted that easier money generally takes up to 18 months to have an effect. Meanwhile, the administration of President George W. Bush and the US Congress are jousting over a stimulus package for the economy, something notoriously hard to design and execute, Hooper added.

Perhaps moves like these will lift the gloomy mood quickly. But perhaps not. Klaus-Peter Müller, the head of Commerzbank, recalled spending a jet-lagged night watching advertising for easy loans - the source of the entire problem - on American television during meetings in Washington in October. It was one of his first inklings that the normally resilient US economy was in for a rough ride. ‘I came back close to depression,’ Müller recalled.

The reality of US economic weakness has helped make the feebleness of the dollar - which has seen the euro near $1.50 - a signature feature of this crisis. To much of the globe, the subprime problem has exposed the US economy as an overleveraged enterprise, based on free-spending consumers and government, whose stock needs to fall.

‘It is just not possible for the United States to go into debt to the rest of the world to the tune of $2 million a minute,’ said Richard Duncan, a managing director at Blackhorse Asset Management in Singapore. ‘Somebody has to service that debt, and right now the United States does not look very able to do that.’

Viewed through this prism, the banks are the easy part. The Organization for Economic Cooperation and Development has estimated that global losses linked to investments in mortgage-backed securities will be $200 billion and $300 billion, much of that carried on the books of banks, asset managers and hedge funds.

About $100 billion has already been accounted for and largely dealt with. Either the write-offs were small enough to absorb, large enough to prompt a sale of the bank, or compensated for by outside investors.

Sovereign wealth funds, the vast pools of state-controlled cash from the Middle East and Asia that are thought to hold as much as $3 trillion, have already injected billions into major banks, including Citigroup, UBS, Morgan Stanley and Merrill Lynch.

More news of this sort appears likely for 2008. Mortgage resets in the United States - the point at which a homeowner transitions from a low introductory interest rate to a market-based one - will peak in September 2008, according to Credit Suisse. That will set the stage for more defaults and losses.

Can the rest of the world escape this pain? This year, in contrast to last, the doubters seem to have the upper hand. ‘Decoupling,’ the theory positing the ability of Europe and Asia to grow even if the United States stumbles, has slid into disrepute over the past year.

With the United States creating fewer jobs, and consumers no longer able borrow against their homes, the engine of world growth is stalling with, economists say, no credible replacement. --New York Times