By the end of last week, any lingering hope that the housing downturn would be contained had vanished. As this week begins, signs of contagion seem to be everywhere.
Unnerved by mounting losses in mortgage- related investments, investors have started to shun tens of billions of dollars in corporate debt offers as well — and seem likely to go on doing so for months to come. That would stanch the flow of easy money that has fueled the leveraged buyout boom, which would, in turn, expose the extent to which stocks have also come to depend on cheap credit. Stocks took a dive last week because debt-driven buyouts had long boosted the share prices of targeted companies. Stocks have also benefited directly from easy money because public companies have borrowed heavily to buy back their own stock, a ploy to drive up earnings per share.
The fallout of housing-related turmoil is also likely to extend beyond financial markets. Among the deals that faltered last week were the $7.4 billion buyout of the Chrysler Group and the $5.6 billion purchase of the Allison Transmission unit of General Motors. Unless investor capital is forthcoming, it could become increasingly difficult for the automakers to avoid bankruptcy. At the same time, the housing slump has also driven down analysts’ monthly forecasts for car and truck sales to levels not seen in nearly a decade.
The double whammy of weakness in housing and in autos has already hit the chemical maker DuPont. Last Tuesday, the company was the Dow’s biggest loser, in part because of lackluster demand for a pigment used in house paint and lower paint sales to automakers.
There is also growing evidence that housing woes are curtailing consumer spending, the mainstay of the economy. As home prices fall, home equity borrowing is drying up as a source of disposable income, while wages and salaries are hardly enough to cover many households’ consumer and mortgage debt, along with the rising costs of food, energy and other essentials. As a result, consumption ebbs.
Officials at the Federal Reserve and the Treasury Department cannot manage these problems on their own. If the Fed wanted to reduce interest rates, for example — which financial markets are expecting in the wake of last week’s plunge — it would need cooperation from other central banks to ensure that lower American rates would not dangerously weaken the dollar, provoking inflation.
Similarly, assurances that the economy will be fine, such as the one delivered on Friday by Treasury Secretary Henry Paulson Jr., ring hollow in the absence of an international reporting framework to monitor the positions taken by globally active hedge funds. Otherwise, there’s little reason to believe that government officials have all of the information they need to assess the risks to the financial system and the economy. To date, however, Treasury officials have played down the need for more monitoring.
Throughout the Bush years, international cooperation has been neglected. Last week’s gyrations are another signal that the need to work with others cannot be safely ignored.