Living in a World with Less Credit

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Wall Street's Newfound Virtue
In February 2000, one of the street's most powerful executives petitioned the Securities and Exchange Commission (SEC) to allow his firm and other investment banks to raise their levels of leverage. He wanted the commission to alter something called the net-capital rule, which he said was "the single most important factor in driving significant parts of our business offshore."

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That exec was Henry Paulson, then the CEO of Goldman Sachs, now U.S. Treasury Secretary. Four years later, the SEC complied, amending the rule; the effect was to allow Wall Street to borrow even more money to finance its businesses. At the most aggressive investment banks, leverage ratios reached 30 to 1. That is, for every dollar in equity capital the firm had, it borrowed $30.

Now those ratios are being unwound with a vengeance. In interviews, Wall Street executives, like John Mack, CEO of Morgan Stanley, talk of reducing their leverage to a ratio of 12 to 1 — a regulatory requirement, now that both Morgan and Goldman have turned themselves into commercial rather than investment banks — as if there were some button they could push to make it happen. But the truth is that for U.S. banks, reducing their use of debt and rebuilding their devastated balance sheets is a long and painful process. Deleveraging is part of what creates a credit crunch: institutions that have been hammered by the decline in real estate prices will be making fewer loans available to businesses and consumers alike.

We've seen this movie before, and it's not a happy one. Japan's financial sector imploded in the 1990s as bubbles in real estate and stock prices (sound familiar?) burst. Eventually, Japan's central bank drove interest rates to near zero to stimulate the economy. But it was, as the economists say, "pushing on a string." Banks were reluctant to lend because they needed to hoard capital to repair their balance sheets — just as they need to do now in the U.S. Economic growth slowed, and demand for the credit that was available diminished. The result was Japan's infamous Lost Decade: 10 years of low or no growth.

Is that what the U.S. is in for? Not necessarily. One crucial difference is that the Federal Reserve under Ben Bernanke, a scholar of the Great Depression, has reacted to this crisis much more swiftly than his Japanese counterparts did in the 1990s. His nickname is "Helicopter Ben," because he believes it's the government's job to litter the landscape with money, if necessary, to prevent economic collapse. No surprise, then, that he endorsed the Treasury's plan to inject capital directly into the banks and this week backed yet another stimulus package for the economy.

Main Street's Pullback
For millions of Americans, the prospect of living within their means is a meaner one by the day. And it has consequences that are already showing in the bankruptcies of retailers such as Linens 'n Things, Mervyns, Steve & Barry's, Shoe Pavilion, Goody's and Sharper Image and in the possibility of poor holiday sales. The overleveraged consumer is the biggest economic problem the country faces, because debt has been the rocket fuel that has propelled growth for most of the past decade. Two-thirds of the $14 trillion U.S. economy is driven by consumer spending, and the relentless shopper has also been critical to the growth in once booming exports led by economies like China's.

American consumers had become more addicted to debt than Wall Street was. Total household debt at the end of last year was $13.8 trillion, up 20% since 2005. At the same time, the household savings rate ticked down close to zero; the rocket's engine was running on empty.