Countries that had so far escaped the yearlong credit crisis largely unscathed scrambled on Monday to quantify the potential losses after Lehman Brothers Holdings Inc (LEH.N: Quote, Profile, Research, Stock Buzz) filed for bankruptcy.
Banks’ borrowing costs soared because of the uncertainty over how far and wide the Lehman impact might extend. If that translates into a crackdown on lending terms for companies and consumers, the economic fallout will be severe.
U.S. growth prospects already looked gloomy even before this weekend’s drama, which also included Merrill Lynch (MER.N: Quote, Profile, Research, Stock Buzz) agreeing to be bought by Bank of America (BAC.N: Quote, Profile, Research, Stock Buzz) and insurer AIG (AIG.N: Quote, Profile, Research, Stock Buzz) looking for financial help.
"At this point, the U.S. will be lucky to escape with a mild recession," said Ken Rogoff, a Harvard University professor and former International Monetary Fund chief economist.
The pain quickly spread to Asia and Europe.
In Taiwan, which had reported little in the way of losses from the subprime mortgage mess, the top financial regulator said Lehman-related exposure for its companies and retail investors totaled $2.5 billion. Two Japanese banks appeared on the list of major Lehman creditors.
In Europe, Germany’s Finance Minister Peer Steinbrueck said the initial impact on Germany was limited, but Economy Minister Michael Glos said Lehman’s collapse could seriously harm Europe’s biggest economy.
"We hope that we don’t see a crisis which pushes the global economy to the brink of ruin," Glos said.
Across Europe, banks’ funding demands far outstripped the supply offered by central banks, indicating that firms were keeping a tight grip on cash as they assessed the damage.
U.S. interbank interest rates spiked to three times the Federal Reserve’s target of 2 percent, and calls grew for additional interest rate cuts.
"This weekend’s events raise the probability of one or several major central banks cutting interest rates, possibly as early as this week, and perhaps in a concerted action," Morgan Stanley economist Joachim Fels wrote in a note to clients.
The U.S. central bank’s interest rate-setting committee meets on Tuesday, and trading in rate futures markets showed that investors think another reduction is possible then.
Although the financial pain was acute on Monday, Harvard’s Rogoff said the Federal Reserve and Treasury Department were right to deny taxpayer money to salvage Lehman Brothers.
"The government’s actions may lead to a deeper recession but much shorter because they’re letting the private sector work this out," Rogoff said. "It takes a lot of guts a few months before an election to let this happen, but it is absolutely the right thing to do."
The depth of the downturn depends largely on how banks behave in the coming weeks. Douglas Elmendorf, an economist with the Brookings Institution, said it will be several days before markets settle down enough to give a clear signal on the status of lending conditions.
If banks manage to unwind their transactions with Lehman this week, the effect on corporate and consumer lending may be manageable. If they cannot, and losses mount, that will clearly restrict lending and lead to higher borrowing costs.
"If you could stop the world for a week and let everybody figure out exactly what their exposures are and try to find other counterparties, that would help," he said.
Because of that uncertainty, Elmendorf said he expected the Federal Reserve to hold off on lowering interest rates at its Tuesday meeting but make it clear that it stood ready to act swiftly should credit conditions remain tight.
Brian Bethune, chief U.S. financial economist with Global Insight, said the Fed did not have the luxury of waiting to see if credit markets worsen and called for an emergency rate cut now to cope with the fallout.
"We should not delude ourselves into thinking that without a significant move from the Fed there will not be further tightening of credit conditions as a result of the events over the weekend," he said. "That will threaten the economy and the financial system even further."
He pointed out that even before this weekend’s drama, data showed that lending conditions tightened over the summer and the pace of credit growth was at recessionary levels. Consumer spending has already weakened, and unemployment is rising.
"The economy is very weak, the recession wolves are pounding down the door and the financial system faces new deflationary threats from the bankruptcy of Lehman Brothers. This is an emergency situation, and an aggressive response from the Fed is needed," he said. Reuters