How Bad Will It Get on Wall Street?

As the credit crisis grinds on, the prospects for a quick recovery darken

The Street may start to favor private equity and hedge funds Gabe Palacio/Aurora

by David Henry and Matthew Goldstein

It has been a year since the global credit markets first seized up, and four months since the dismantling of Bear Stearns. Yet bad things keep happening, from the failure of IndyMac and the stock routs of Lehman Brothers (LEH) and others to the market's collective yawn at the Treasury Dept.'s plan to bolster mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). Once again, the optimists who thought the crisis was over have been proven wrong. "People underestimated how bad things were last summer," says Frank Partnoy, a former Wall Street derivatives trader turned professor at the University of San Diego Law School.

Did they ever. July's rat-a-tat-tat of dismal news suggests that the scope of the credit crunch is much broader than most people thought. Traders, investors, bankers, and economists are waking up to the possibility that Wall Street's recovery from the worst financial disaster since the Great Depression could grind on for years. And they're realizing that while the debacle was of Wall Street's making, its aftermath will weigh on banks, other companies, and consumers alike.

One thing is for sure: The new normal won't be as fun as the recent past. Banks will be smaller and fewer. Capital will be harder to get for some consumers and companies. And more of that capital will be parceled out by lightly regulated hedge funds and private equity firms, for better or worse, as the balance of power on Wall Street shifts.

Why hasn't the healing begun? The answer lies in the mechanics of leverage, or borrowed money, which banks not only provide to customers but also use themselves. Leverage is a powerful but dangerous tool, intoxicating on the way up and devastating on the way down. Banks live on the stuff: When they post profits, they borrow more money to make more loans and book still more profits. During the boom, bigger mortgage loans pumped up home prices until people couldn't handle the debt and the bubble burst. Then the banks, poorer from the losses, had to cut back their own borrowing, too. Now the damage is spreading. How far? Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending; for investment banks, the figure can be $30.

The extent of the credit contraction to come will depend on the banks' initial losses—an elusive figure, to be sure, and one that keeps growing. The latest loss tally is $400 billion across the credit markets, but the International Monetary Fund says the total could swell to $1 trillion. Slap on a leverage multiplier of 10 or 15, and the math turns grim. "I believe we will live in a deleveraged state until the next generation of management gets in place and doesn't remember what we went through here," says Robert Greifeld, CEO of Nasdaq (NDAQ). "The harder question is about the lack of leverage in the broader economy: How does it ripple through?"

"Fearful of Losses"

It's tempting to view the July swoon as a sign that a bottom is near. Sure, the U.S. stock market seems to be nearing a trough and could rally soon, as it did on July 16. Then again, in protracted downturns the first several waves of bottom-fishers are usually wiped out. Witness the pain suffered by many of the professional investors who have bet on beaten-down financials in the past year.

More important, the stock market and the credit markets are rarely in perfect sync. In the credit market, history shows that "even after things hit bottom, there is a slow, long recovery," says Todd A. Knoop, economics professor at Cornell College and author of a textbook on the impact of financial-system swings on the economy. Earlier in the decade, credit markets remained weak after the stock market began a sharp recovery. Says Richard Sylla, professor of economics and financial history at New York University: "A couple hundred years of financial history show that whenever you have a financial crisis like this, banks don't like to lend."

The next few years promise to be especially rough, judging from the numbers so far. Banks cut back on credit in the three months through mid-June at a 9% annualized rate, the worst contraction in 35 years of data, according to Leigh Skene of Lombard Street Research. Issuance of mortgage-backed securities and corporate junk bonds this year is down 87% and 63%, respectively, according to research firm Dealogic.

A recent study projected that losses resulting just from mortgage-related lending would sap $1 trillion of credit from the U.S. economy. Banks "have to shrink," says the University of Chicago's Anil K. Kashyap, one of the authors.

Even if banks were able to rush back into heavy leverage soon, investors likely wouldn't stand for it. "On the way up, banks get penalized [by stock investors] for not being aggressive enough," says Martin Fridson, CEO of money manager Fridson Investment Advisors. "On the way down, the pressure is on to show how conservative you are. If lenders are fearful of losses, they are going to contract."

The Endangered Banks Lists

Regulators could add fuel to the deleveraging machine with tougher rules. Already, Swiss bank regulators want to tighten standards following big losses at UBS (UBS) . The Federal Reserve, in return for opening its discount window to investment banks, will likely limit the amount of leverage those banks can use. "If new regulation occurs, the next [credit] cycle could be muted," warns David Trone, a senior analyst with Fox-Pitt Kelton Cochran Caronia Waller.