A credit crater too big to fill?

By Jon Markman

Despite a weeklong surge in stocks, it's becoming increasingly clear that credit has suffered a catastrophic setback.

It's as if a set of asteroids hit Manhattan, London and Tokyo, carving a massive hole in the architecture of finance. The initial buildings in the impact crater, Lehman Bros. (LEHMQ, news, msgs), Bear Stearns and Northern Rock, were quickly incinerated. But now the toxic rain and tsunamis that were kicked up are rolling onto the survivors in waves and cutting off their air supply.

New data from world money centers suggest the movement of money around the globe has simply ground to a halt, as institutions in the United States, Europe and Asia that are receiving taxpayer dollars from governments are socking it away to shore up their balance sheets, reserve against liabilities expected in the near future and sustain their unprofitable operations.

"Governments are not really trying to save the system anymore," said Satyajit Das, a banking expert in Sydney, Australia. "They now realize that's impossible. They are just trying to manage the decline."

How low will it go?

As a result, once the current rally interlude is over, it's not hard to see the Dow Jones Industrial Average ($INDU) sinking to around 4,000 -- a level it last hit in 1995, before debt started to play such a large role in corporate and personal finance.

That would entail a decline of 70% from its 2007 peak, or about the same amount the Japanese stock market has fallen since 1990 in the wake of its own debt unwinding. Or the amount the Nasdaq Composite Index ($COMPX) dropped from 2000 to 2002. Or the amount the Russian market has plunged since June.

If that seems too harsh, well, the math is pretty easy to explain. Figure you have a well-regarded multinational company that earns $10 a share and sports a price-earnings multiple of 25 when the U.S. economy is rolling along at its long-term trend rate of 4%, or about twice its normal growth rate.

• MSN Money columnists ahead of the curve

Multiply 25 times 10 and the stock is worth $250. But now take away half the financing of customers, the stock buybacks done with borrowed money, the high-yield cash-management systems of the corporate treasury, the leveraging that allows raw materials to be bought with borrowed money and the leveraging that allows its customers to buy with credit cards and layaway plans.

Then ratchet back U.S. economic growth to 0%, which is about the best forecast now for 2009. Figure the company now earns 25% less than at peak (an optimistic estimate), or around $7.50 per share. Because of the slowing growth environment, the market is likely to take the price-earnings multiple down to around 10, which is still more than twice the company's forecast growth rate. Now multiply $7.50 by 10, and the stock is projected to trade at $75, or around 70% lower than the peak.

The problem is that this scenario might be too sunny. The economy is losing around 200,000 jobs a month. Just last week Yahoo (YHOO, news, msgs), Merck (MRK, news, msgs), Chrysler, Xerox (XRX, news, msgs), Goldman Sachs Group (GS, news, msgs) and National City (NCC, news, msgs) announced layoffs.

Unemployment, now skimming along at a relatively tame 6.5%, is expected to mushroom at least to 8.5% if not 9% or higher by the end of next year. With stock and home prices in a tailspin, consumer net worth is already on track to decline 14.7% year over year this quarter, a record plunge.

Credit card revenues have sunk to their lowest level in five years, and a JPMorgan Chase (JPM, news, msgs) official was quoted this week as stating that "loan volume will keep going down as we continue to tighten credit."

Holiday sales are expected to be weak, with same-store sales in November and December projected to sink 2.2% from last year. The lone good news: A decline in the price of gasoline of nearly 50% since June, to around $2.15 per gallon nationwide, will roughly equal a $210 billion tax cut.

ISI Group analysts said that when these factors are totaled and sifted, corporate profits are on track to decline 10% in 2008, and that if U.S. gross domestic product stays flat next year, corporate profits are likely to fall 13% more in 2009. That would be the first back-to-back decline in profits in the post-World War II period.

Meanwhile, Europe, which is responsible for a third of world GDP, is in no better shape, with manufacturing falling off a cliff. Volvo (VOLVY, news, msgs) reported last week that truck orders are off 55%. Greece is staggering as rental rates for its key shipping industry are down 90% since June. Emerging East European countries such as Ukraine and Serbia are seeing their currencies blow up along with their economies. Ditto India, Argentina, Brazil and even China, where growth is slowing from the low double digits to around 7%.

Trying to fill an expanding hole

To counter all these effects of credit extinction, the United States, Japan and the European Central Bank are cutting short-term interest rates, injecting taxpayer money directly into the capital structure of banks, providing hundreds of billions in low-interest loans, guaranteeing deposits and more, on an unprecedented scale.

So why isn't it working? A couple of reasons. First, early in this debacle, the Federal Reserve and Treasury Department apparently decided that they would declare war on the so-called shadow banking system. These were the hedge funds, structured investment vehicles (SIVs) and other nonbank entities that had grown up since around 1995 to create, leverage, re-leverage and distribute roughly $10 trillion in debt.

Continued: The 'global liquidity factory'

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