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Balance Sheet Time Bombs

In Subprime Crisis, the Worst Is Yet to Come

By Beat Balzli and Frank Hornig

The consequences of the US real estate crisis are far greater than previously suspected. Wall Street could face losses of over $200 billion, and German banks are unlikely to escape unscathed. The full extent of the disaster will not be known for months.

Only a few weeks ago, in October, the world still seemed a fairly orderly place to Charles Prince, the chairman and CEO of Citigroup. Although the bank's earnings were already heading south as a result of the subprime crisis, Citigroup's largest individual shareholder, Saudi Arabian Prince Alwaleed bin Talal, wasn't losing his cool. What was happening on the financial markets was a "mere hiccup," the Arab multibillionaire explained.

A short time later, at the beginning of last week, it was time for another Citigroup executive to take the company jet to the Saudi Arabian capital Riyadh for some urgently needed damage control. Until 2003, Sandy Weill was chairman of Citigroup, the world's biggest bank at the time. Weill, who is now 74, is credited with having expanded the company in the 1990s into the broadly diversified financial services conglomerate it is today. Now his life's work was in jeopardy.

Weill knew that the "hiccup" had quickly turned into a serious threat. "We discussed the situation, what was wrong and why things are happening like that," Prince Alwaleed told the magazine Fortune, describing his crisis meeting with Weill.

News of the meeting in Saudi Arabia sent faraway Wall Street into turmoil. Only a few days after Merrill Lynch CEO Stan O'Neal was let go, Citigroup chief executive Prince was also asked to clear his desk.

Both executives were guilty of a fundamental miscalculation. As a result, the two companies will each be forced to write off between $8 billion and $11 billion in bad debt. But, as dramatic as the events at Merrill Lynch and Citigroup were, they do not mark the end of the banking nightmare that began in mid-summer.

That was when the first financial institutions and hedge funds began issuing warnings that the US real estate bubble was on the verge of bursting. Many homeowners who had borrowed heavily against the equity in their homes, confident that real estate prices would continue to rise, were suddenly faced with the realization that they could no longer afford to keep up their mortgage payments.

The repercussions of the crisis have mushroomed since then, with billions at stake now instead of millions. And despite ongoing efforts by politicians and central banks to bring calm to the market, a crisis that began among smaller banks has since spread to the industry's giants.

The effects of the disaster on almost every major Wall Street institution and many European banks have been far more severe than previously supposed. The 10 biggest losers have already reported losses of more than $40 billion, and even this is only the beginning.

"I believe that we are still not aware of all the risks," said Alexander Dibelius, the head of investment bank Goldman Sachs's German office, only two weeks ago -- shortly before the CEOs at Citigroup and Merrill were let go.

Economists and central bankers are already predicting total losses in excess of $200 billion. "The bloodbath in credit and financial markets will continue and sharply worsen," Nouriel Roubini, a highly regarded American economist, recently wrote on his blog.

His fears stem from the fact that so far banks have only published their results for the third quarter of 2007, which, for most institutions, ended in August or September. The real estate crisis has worsened since then, with even greater losses expected for the fourth quarter.

The true scope of the debacle will likely become apparent only after annual financial statements are published next spring. Quarterly statements are an imperfect indicator, because they enable banks to defer their losses relatively unnoticed.

One of the results of the dismal news is that, after weeks of rising prices, the US's leading stock market index, the Dow Jones, took a sharp downward turn in recent days. The central banks' efforts to improve the situation by increasing liquidity and lowering interest rates have evaporated like drops of water on a hot stone. Fear and suspicion are the prevailing sentiments on the world's stock markets. A banker in Frankfurt predicts: "We are just at the beginning of the second tsunami wave."

Its effects will likely extend beyond the banking sector. AIG, America's largest insurance group, is already reporting a 27-percent loss for the third quarter. In addition to the now notorious high-risk subprime mortgages, financial worries in the United States are now also being stoked by concern over subprime credit cards and subprime auto loans. For consumers unable to pay their mortgages, the monthly credit card bill or the car loan are also likely to present a problem.

With the price of oil close to the $100 mark and the dollar in a nosedive, the outlook for the US economy -- and the world economy -- is becoming increasingly bleak.

In a hearing before the US Congress last Thursday, Federal Reserve Chairman Ben Bernanke warned lawmakers of the consequences of the crisis: higher inflation, declining consumer spending and lower growth rates. On the same day, Bernanke's counterpart in the European Union, European Central Bank President Jean-Claude Trichet, expressed concern over what he called the "brutal moves" in the euro-dollar exchange rate.

To make matters worse, the banks' mortgage problem is developing into a crisis of confidence reminiscent of the collapse of the scandal-plagued US corporations Enron and WorldCom. The first investor lawsuit has already been filed, and the US market watchdog, the Securities and Exchange Commission (SEC), is taking a closer look at questionable accounting practices. New York Attorney General Andrew Cuomo has also launched his own investigations.