Wall Street's meltdown is likely to be a sign of things to come.
The shock waves of what happened on Black Sunday will flow into 2009, writes Kathleen Madigan from Dow Jones.
"US households are already under strain from falling house prices and incomes that haven't kept pace with inflation for several years. More than half of them own stocks, either directly or through mutual funds. Two-thirds of the mutual funds are in tax-deferred accounts, mostly retirement plans. Consumer wallets took a big hit even before Wall Street firms began closing their doors. In the year ended in the first quarter, households lost more than a trillion dollars in equities and mutual funds. But unlike in 2001, when stock portfolios also fell, the current losses aren't being offset by gains in home values. As a result, household net worth has fallen for two quarters in a row, to its lowest since the end of 2006. In response, consumers are cutting back on spending. Retail shopping outside of cars fell in August by more than expected. Some economists now forecast real consumer spending to fall in the fourth quarter – something that didn't happen during the 2001 recession. A pullback by consumers is sure to darken the situation because it will give banks another reason to not lend – and stocks another reason to keep falling."
This is going to take a long long time to unwind. Lehman's collapse is going to affect millions of people, even if it does that indirectly. The reason is simple: most banks and pension funds around have done deals with Lehman, and hedge funds traded with them. Unwinding those deals is going to take months and many banks don't know how much they are exposure they have. So the credit crunch will continue, and that's going to hurt businesses and consumers.
And in the end, you can blame a lot of it on policies that encouraged people to take on so much debt. "There is so much debt-individual, government and corporate debt-it just grew and grew and grew," David Oser, chief economist at ShoreBank told the Chicago Tribune."The best you can hope for is that we're at the bottom to stay for a while."
London-based investment consultancy Independent Strategy warns that it's a sign of what's ahead. In their paper Black Sunday they say the demise of two non-deposit taking financial institutions (NDFIs) gives us a glimpse into where we are heading.
"When bank credit does contract, the impact on the real economy will be more marked than even we have seen so far. The reason is that most bank credit is the sort of money that gets spent in shops and garages or is used by the corporate sector to invest in real assets. NDFI money is used to invest in financial markets, causing security prices to rise and fall. This only indirectly affects the real economy by changing the value of wealth.
"So the next stage of credit contraction will be global recession, and by global I mean just that. Europe, the US and Japan will all experience it. And the idea that, in a globalised financial system and economy, emerging markets like China and India can escape a global recession unscathed is illogical. This process of economic contraction is only starting to be felt. Global recession will mean further losses in the credit system. This time the losses will be smaller as a percentage of higher-quality assets, but will affect much bigger pools of debt (e.g. the prime mortgage market is seven times bigger than sub-prime and other consumer debt is four times as big). This means that, even with lower loss ratios, potential losses could be as big as sub-prime losses and destroy as much bank capital, causing further credit contraction."
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