As loans dry up, so will economy

These instruments opened up a vast new market for individuals with low credit scores, and their high but risky yields led to the creation of a derivatives market aimed at transforming them into highly rated securities that could then be sliced up and sold to unsuspecting buyers overseas. In turn, proprietary trading desks were expanded to trade these instruments back and forth.

All of these efforts to create what a Harvard endowment executive termed the "global liquidity factory" generated ungodly fees and were predicated -- as I have written earlier -- on the notion that the real assets underlying the loans and derivatives, U.S. real estate, would keep rising.

Now, of course, we know that as soon as home prices began to peak in 2006 and mortgage loans began to collapse, the bond values began to collapse, and the gig was up. Yet the banks had massive, expensive corporate machinery and personnel in place whose very existence depended on healthy securitization and derivatives markets, not to mention gullible customers.

Greedy little pigs

So the industry now has to deal with the fact that it has burned an entire generation of overseas clients who are faced with massive write-downs of the values of bonds they've bought over the past seven years. Those portfolio managers are still so angry at Wall Street banks that they don't want to hear about any new securitized debts, leveraged loans or derivatives of any kind, no matter how healthy and ordinary they may look. They have slammed the door.

It's this shutdown of the securitization market that is showing up now on banks' balance sheets as a big smokin' hole. Despite many bank executives' wishful comments to the media over the past few weeks that "the worst is behind" them, the business that supported million-dollar salaries to 25-year-old bankers fresh out of graduate school is dead.

As you can imagine, loss is painful, and, as in any other part of our lives, it's easier to just shut it out than deal with it. This has meant that banks are not yet cutting back their expenses and infrastructure to the extent necessary to allow them to get back into the business of borrowing money from depositors and lending it out to worthy companies like Western Recreational Vehicles.

The bottom line, Maryland economist Morici says, is that bankers grew to have such an "overenthusiastic opinion" of their self-worth that the idea of making loans that can't be securitized at high fees is unpalatable.

"There's a greedy little pig that has to be paid," he said. "They seem to think that they have alternatives so they don't need to resurrect their former business plans, but they're wrong. It will take a while, but they will learn they need to become plain old banks again."

Wien likewise concludes that banks need to face a "reduced level of profitability . . . going forward" until some new source of extreme profit growth emerges.

Until they do, I'm afraid that bank shares will stagnate within a few bucks of current levels. In banks' weakened state, credit growth will also likely flat-line, reducing the entire economy's ability to expand. In this new Age of De-leveraging, perhaps we'll sense a turnaround is near only when a top MBA school announces that mining and agribusiness have replaced investment banking as the No. 1 choice of careers for new grads.

Fine print

To learn about the Robert H. Smith School of Business at the University of Maryland, where Morici is a professor, click here. To read a recent op-ed article by Morici, click here. . . .

To learn more about Wien and see his 10 predictions for 2008, click here or download this file (.pdf).

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At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.

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