Bottom to crisis nowhere in sight
Answer may lie in fine print of arcane securities
How long can Wall Street's turmoil go on?
No one really knows - and that's the scary part.
The root of the panic on Wall Street is that investors have lost $350 billion from their securities backed by subprime mortgages. Losses - as much as $250 billion more - are now spreading into the prime-loan market as the housing downturn deepens. But on top of that, Wall Street holds tens of trillions in other arcane securities that were based on these mortgages.
The devaluation in these mortgage securities is toppling Wall Street giants who own these investments, from Lehman Brothers Holdings Inc. to American International Group.
These mortgage securities are so complex that it's hard to calculate the value of these investments because owners do not clearly disclose their holdings. As a result, analysts and economists can't grasp how widespread the problem is - and when it will end.
"You turn over every stone and more creepy crawlies come out," said Raghuram Rajan, a professor at the University of Chicago Graduate School of Finance. "You know there are securities linked to the value of mortgages. You don't know how much those securities are worth."
Any attempts to gauge the size of these markets are "an estimated guess," said Byron Douglass, senior research analyst for Credit Derivatives Research, whose firm sells research on the bond markets.
"When you zero in on the number, we don't know what the real risk is in there. It could be small or large. We just don't know," he said. "It's breathtaking."
The market ballooned in recent years after speculators such as hedge funds and traders jumped in to buy and sell the arcane securities, which can be backed by a variety of other debts such as commercial mortgages and corporate bonds, in hopes of earning high returns, said Mark Zandi, chief economist for Moody's Economy.com.
Brian Bethune, chief US economist for Global Insight Inc., a Waltham consulting firm, said it is difficult to know when the financial crisis will end because "it's hard to figure out who owes what to whom, and when that becomes a problem, markets don't function properly."
Bill Gross, chief executive of California money manager Pacific Investment Management Co., in a January newsletter to clients warned that this market was turning the financial system into a modern-day "pyramid scheme."
AIG, Lehman, and Merrill were all active buyers and sellers of mortgage-backed securities. Wall Street firms, including Morgan Stanley and Goldman Sachs Group Inc., also packaged mortgages together in pools, issued securities backed by the pools, and then sold them to investors.
In addition, they created and traded complex securities known as "credit default swaps," which are at the heart of current worries about how bad the crisis may become. These "swaps" are essentially five-year insurance contracts sold by one Wall Street firm to another firm to protect themselves from losses on their pooled mortgage investments.
As long as housing prices were rising and the economy was strong, homeowners made their monthly mortgage payments, and investors didn't have to pay up on their insurance policies.
But now, as more and more Americans fall behind on their payments, Wall Street's players are having to pay money on the insurance contracts they sold to other investors.
Losses for these securities have not reached the level of losses on the underlying mortgages, but AIG was a major player in that market and already posted $18 billion in related losses this year.
Concerns about its exposure are behind federal efforts to prop up the insurer with an $85 billion loan announced last night by the Federal Reserve of New York.
The insurance contracts form an unseen but tangled web of connections linking AIG and Wall Street investment banks to hedge funds and even countries that invested in them. They are also one item in a smorgasbord of similar contracts - many of them based on corporate debt, credit cards, automobile loans, and commercial property loans - that is an unfathomable $63 trillion.
"It may be the next flash point," Zandi of Moody's Economy.com said.
If the US housing market starts to recover, many of the problems on Wall Street may shrink or dissipate. But growing problems are more likely to push US house prices down further - and add to uncertainties about how long it will take for the financial system to recover. The current housing downturn is unprecedented, because it is the first time prices have declined in virtually every region from California to Florida.
If house prices continue to fall, said Wellesley economics professor Karl Case, "It could get worse."
Kimberly Blanton can be reached at blanton@globe.com. 