The Vicious Credit Cycle Goes Round and Round

The financial sector has appeared more stable since the drama in March when the Federal Reserve intervened to stave off the collapse of Bear Stearns, feeding the hope of many observers that the worst effect of the credit crunch may be past. But that hope is dashed in a new report from Bridgewater Associates Inc., a large institutional manager that runs hedge funds and portable alpha programs, among other strategies. Financial institutions remain under threat from a self-feeding spiral of debt contraction that fuels asset liquidation that in turn triggers more debt contraction, according to Bridgewater’s Bob Prince, Bob Elliott, and Jason Rotenberg. They point out that investment banks in particular face liquidity and funding risks because of their dependence on short-dated financing that can quickly be withdrawn at the first sign of stress, unlike the commercial banks that have stickier deposits.

The Federal Reserve’s opening up of its lending facility to investment banks should help alleviate an immediate crisis, but “the core issue remains that these institutions are primarily funded by hot, purchased money,” the Bridgewater analysts argue. “While perceptions collapsed earlier this year and then bounced after the Bear Stearns rescue, actual conditions continue to unfold in one direction, toward deterioration.” Bridgewater warned of danger ahead in 2006, while others were still dancing to the tune of easy money.

More Bad News

The analysis reinforces other recent bad news. In the first week of June, Standard & Poor’s lowered the credit rating or outlook for most major investment banks and warned of further write-downs to come. The ratings do remain investment grade, however. In the same week, the New York Stock Exchange announced that its unprofitable members made an aggregate pre-tax loss of $24 billion in the first quarter, which translates to an after-tax loss of $14.5 billion, compared to $3 billion in after-tax profit in the first quarter of 2007.