It’s hard to find any expert who doesn’t think the Federal Reserve will raise interest rates slightly when it meets next week. It is harder still to find agreement on why the Fed should make that move. After all, the core inflation rate in December — one-tenth of a percent — was the lowest in a generation. Besides, the nation’s central bankers usually ratchet up the cost of borrowing to control or even to try to head off inflation.
The economy’s problem isn’t inflation in general, but prices could be out
of control in one sector: the stock market. If that’s true, it makes sense for the Fed to try policies that more precisely dampen the “irrational exuberance” of some stock speculators, rather than end the good times just when more people are beginning to feel the benefit. One place to start: Make it harder to borrow money to speculate on stocks by raising what’s called the margin requirement.
Nobody knows the mixture of mania and solid performance that underlies the stock market. But there’s reason to be concerned about whether the boom will continue when people start to borrow heavily to buy shares in the expectation that the market will keep rising indefinitely, then using their stock gains to underwrite more borrowing and buying, which in turn drives up the market. Such borrowing “on margin” helped to fuel the rise and crash of the stock market in the 1920s.
In 1934 the Federal Reserve got the power to adjust margin requirements to regulate “the use of excessive credit to finance transactions in securities.” For many years it raised and lowered margin requirements periodically, much as it changes rates charged on loans among banks. But it hasn’t used the power to adjust margin requirements since 1974. Since then individuals have been able to set up margin accounts with brokers and borrow up to half of the value of stocks they buy.
A chorus of economic experts has been second guessing the Fed’s plan to raise the interest rate. Many of them, including such economic luminaries as famed investor George Soros, leading Wall Street economist Albert Wojnilower and Stanley Fischer (the number two man at the International Monetary Fund), suggest changing the margin requirement, a tactic that would more directly address inflated stock prices and prevent those who have not yet benefited from the stock market boom from paying its price.
There’s good reason to support economic growth by holding interest rates down for most economic activities. Unemployment is low, which is good — contrary to a common view on Wall Street. Thanks to the tight labor market, the lowest-paid workers have finally scored some wage gains. But the gap in family incomes between the top fifth and nearly everyone else has continued to grow in all but a few states over the past two decades, according to a new report from the Economic Policy Institute and the Center on Budget and Policy Priorities. Most Americans haven’t yet shared fairly in the bounty of the nation’s longest boom. There’s also no evidence that whatever gains some workers have made is pushing up inflation.
So why the rush to raise interest rates, a move that ultimately hurts economic growth, jobs and wages?
In a speech to the Economic Club of New York on Jan. 13, Fed Chairman Alan Greenspan argued that the “wealth effect” of the stock market boom — the sense people have that they’re much richer thanks to their stock portfolios — has “tended to foster increases in aggregate demand beyond the increases in supply. It is this imbalance between growth of supply and growth of demand that contains the potential seeds of rising inflationary and financial pressures that could undermine the current expansion.”
In other words, the people who got rich, at least on paper, when their tech stocks shot up by more than 1,000 percent last year are buying bigger mansions, bigger SUVs and more high-tech adult toys — and their voracious demand may begin to drive up prices. Despite the spread in stock ownership, it’s worth remembering that about 85 percent of the stock market gains over the past decade have gone to the richest 10 percent of the population.
Even when these people don’t speculate on margin themselves, they benefit
from the mania of those who do — until the bubble pops.
In recent years, margin debt has been rising three times faster than household debt or overall debt. Margin borrowing from brokers rose 62 percent last year alone. There were big jumps in November and December, according to the Financial Markets Center, a Virginia-based research and advocacy group. Margin debt rose in those months to an estimated 1.4 percent of the value of all stocks. That matches the record year-end high since World War II, which was reached in 1986, the year before a big stock market crash. The accumulated margin debt is now equal to roughly 2 percent of the gross domestic product, higher than at any time in more than 60 years, according to the Financial Markets Center.
Day traders and other speculators who have contributed to the frenzied bidding for the few stocks responsible for most of the equity boom probably account for much of the rise in margin debt. Some brokerage firms have recently raised margin requirements on their own, and in December the New York Stock Exchange and the National Association of Securities Dealers tightened their regulations of margin borrowing for day trading.
There’s been a boomlet of suggestions that the Fed should raise margin requirements. Respected establishment figures have joined the chorus, including Edward Yardeni, chief economist at Deutsche Bank Alex. “If investors are buying stocks because they really believe in a new era of perpetual prosperity,” Yardeni told the Associated Press, “they should be happy to buy stocks with even 100 percent of their own money.”
So far the Fed has refused to consider the option, using academic research that argues adjusting margins has no clear effect on stock market volatility. But Tom Schlesinger, executive director of the Financial Markets Center, says such studies miss the point. Adjusting margin requirements never was intended to reduce day-to-day fluctuations but rather to dampen longer term trends and to minimize the chances of euphorias and panics. Schlesinger argues that raising margin rates at least reduces margin borrowing.
Critics of adjusting rates argue that speculators will simply borrow elsewhere — from mortgage-backed credit lines or even credit cards. That’s partly true. But Schlesinger says borrowing from brokers still accounts for most speculation on margin.
The downside risks of raising margin requirements are virtually nil, and there’s a reasonable chance it might work.
Former House Banking Committee chairman Henry Reuss wrote in the Financial Markets Center newsletter that the Fed should “cool the speculation before there is a crash with a rifle shot at the real culprit, stock market speculation, rather than a blunderbuss volley at growth in general.”
Similarly, James Galbraith, professor at the LBJ School of Public Affairs at the University of Texas, argues, “If your objective is to take air out of the stock bubble, one should not proceed towards that choice by kicking the stuffing out of the economy as a whole. To the extent that the Fed is motivated by worries about stock market issues, let’s have stock market policies.” In addition to margin requirements, Galbraith would argue for a transactions tax aimed at day trading and similar situations where buyers hold a stock for a very short time. But that solution would require congressional action, not just a decision by the Federal Reserve.
Even skeptics like David Hale of Zurich Financial Services or Mortgage Bankers Association consultant Lyle Gramley agree that raising the margin requirement would have some symbolic value. “This would be a way to send a policy signal about the stock market but not in general about the economy,” Hale said.
Despite his skepticism about the power of margin adjustment, Gramley indirectly confirmed the fears of Galbraith and Reuss. “How far the Fed has to go to slow the economy depends critically on whether the stock market reacts negatively,” Gramley said. “If the stock market goes its merry way, the interest rates will have to go up even more.” In other words, in order to curb speculative fever and control the stock-market induced profligate spending of the richest Americans, the Fed will have to throw ordinary workers out of their jobs and depress their long-stagnant wage growth. Why should people who never benefited from the stock market boom pay the price for its having gotten out of hand?
Margin borrowing isn’t the only force driving the stock boom, of course.
But because it feeds the most frenzied cutting edge, tighter margin
controls might change market psychology. But investors can magnify the
speculative potential — and risk — of their money with other financial
instruments, like stock options and stock index figures.
These financial derivatives may partly explain why margin borrowing, despite being at post-war record levels, is still much below the rate in the 1920s, when margin debt reached 18 percent of the value of the stock market. To the extent that derivatives, like options and futures, fuel the euphoria, then there is a case for tighter regulation of those markets as well.
Critics of any Fed move to tighten margin requirements say that it’s inappropriate for the Fed to substitute its judgment for the wisdom of the markets and millions of investors. But even a cursory reading of either history or financial market theory demonstrates how irrational financial markets can be and how dangerous to the real economy those irrational highs and lows often are.
“The inappropriateness argument is based on the thought that ‘Who is the Fed to stick its nose into the marketplace and tell investors they know more than they do about the actual value of companies,’” Schlesinger said. “We just think that’s disingenuous, given the Fed’s lack of compunction about intervening in labor markets and financial crises.”
In the end, all Fed policies involve judgment calls about regulation of the marketplace. If they’re concerned now about a superheated stock market, then the time is ripe to try a policy aimed at the stock market and sharply limit the ability of speculators to drive up share prices with other people’s money.
Is the problem with capitalism that there are too few capitalists? Is the solution to encourage every American to get into the stock market? Before the tech bubble burst at the beginning of this century, I thought this was an interesting notion that deserved careful consideration. Mea culpa. Today, after two disastrous stock market crashes in less than a decade, I think that the idea of “the investor society” or “the ownership society” or “universal capitalism” (defined narrowly as encouraging wider individual ownership of stocks and bonds, as opposed to broadly, to include proposals for sharing profits from public resources or sovereign wealth funds) is a profoundly misguided idea. The proponents of universal shareholding in the 1990s were right that more Americans should share in the gains from economic growth, which have gone disproportionately to the owners of capital and overpaid CEOs. But the method of spreading the gains by encouraging individual working Americans to risk their money in the stock market was ill-conceived.
During periods of rapid asset inflation, whether the assets be stocks and bonds or houses, it is tempting to conclude that the middle class and poor, as well as the rich, should be able to enjoy the benefits of asset appreciation. In such an era, like the 1990s, the warnings of realists are drowned out by the claims of optimists that the rise in stock market or house values is a permanent trend, not an unsustainable bubble. The failure to recognize the stock market bubble for what it was encouraged schemes to increase the ownership of stocks and bonds by America’s high-school educated, working-class majority. The utopian dream was that, in addition to earning income by means of wages, every American could be a capitalist, supplementing wage income with income from capital gains. The fact that, during the bubble, stock market returns outpaced the virtual returns from “investment” in Social Security created converts for the libertarian scheme of partly or wholly replacing Social Security with tax-favored individual retirement accounts invested in the stock market.
That this was madness was argued by a lonely few at the time. By now its lunacy should be apparent to everyone but die-hard libertarians and stock market touts in the financial press. Appealing as it seems, “universal capitalism” — the idea that middle- and low-income Americans can or should rely for a substantial part of their incomes on investments in the stock market — is bad for ordinary Americans and the American and world economies as a whole.
Proponents of universal individual stock ownership often view it as a supplement or replacement for public income maintenance programs, of which the most important are Social Security and unemployment insurance. Likely Republican presidential nominee Mitt Romney recently praised the libertarian idea of private unemployment insurance accounts. Diverting Social Security payroll taxes into the stock market is another right-wing idea which, like Count Dracula, repeatedly rises from the dead.
But public income maintenance programs are far less volatile than stocks and bonds, particularly at the federal level. The federal government has a diverse, continental tax base. And it can borrow more easily than the states to meet its obligations during downturns like the Great Recession. Average Americans can count on Social Security and the federal contribution to unemployment insurance far more than they can expect the stock market to be up at the exact moment when they are fired or have to retire.
This is not liberal propaganda. It is common sense. Any rational person would prefer the security of government-funded retirement and unemployment insurance to the insecurity of private retirement accounts and unemployment accounts. The truth is that Social Security and government unemployment insurance are far better deals than the universal capitalist alternatives.
In addition to being a bad deal for ordinary people, the push to increase stock market participation by the majority of Americans has had bad effects on the economy as a whole. At the root of the volatility of the global economy in the decades leading up to the crash of 2008 was an excess of global savings and too little wage-enabled consumption by ordinary people in developed and developing nations alike. This problem had many causes, including the strategy of Asian mercantilist countries of suppressing the incomes of their workers and the diversion of the gains from economic growth in the U.S. into rewards for shareholders and CEOs rather than higher wages for workers.
One factor in macroeconomic instability was federal tax policies that encouraged employer-based pension funds, in the 1940s and 1950s, and then Roth IRAs and 401K’s, beginning in the 1970s. These tax incentives channeled enormous amounts of money from working Americans into mutual funds. This money—at least what was left, after the brokers had extracted their hidden fees — added to the oceans of money sloshing around in search of unrealistically high returns, producing a pattern of ever more severe booms and busts.
Among other harmful effects, Wall Street management of the retirement money of millions of Americans, whether in the form of employer or union or public pension funds or IRAs and 401K’s, contributed to the culture of short-termism in the American business community. Answerable to flighty investors demanding high short-term returns, CEOs neglected the long-term health of one American company after another, in order to goose quarterly earnings reports by dismantling and offshoring industrial capacity, slashing wages and benefits, or engaging in financial machinations (some of them criminal, as in the case of Enron).
Last but not least, the fantasy of the investor society has had a corrosive effect on the ethics of Americans. The unspoken premise is that it is not enough to work hard in order to get ahead. Average Americans as well as the rich few must gamble in the stock market as well. To their detriment, millions of Americans whose wages failed to keep up with economic growth bought into this Wall Street-peddled fantasy of a nation of day traders and house flippers. They and the rest of us are still paying the price for the corruption of American morals by the get-rich-quick mentality.
It is time to wake up from the daydream of the investor society and face reality. The bubbles were just bubbles. No serious economic expert expects the next few decades to be a golden age of rapid growth capable of enriching janitors with stock market accounts as well as tycoons.
The United States is not a nation of capitalists. It is a nation of wage earners with a minority of capitalists. The only genuine capitalists — individuals who can live entirely from their investments — are a minuscule minority in the U.S. and all other so-called capitalist countries. Having a modest amount of retirement money in a mutual fund does not make anyone a capitalist except in the Wall Street Journal’s Op-Ed pages. For the foreseeable future, few Americans will derive any significant income from capital gains during their working lives, just as few will derive more than a small portion of their retirement income from sources other than Social Security including 401K’s. Right-wing propaganda about an emerging “capitalist majority” to the contrary, America is and will remain a nation of wage earners dependent on pay-checks and public social insurance like Social Security and unemployment insurance.
In the name of dealing with the federal budget, there is a well-funded push in Washington for cutting Social Security and forcing Americans to rely more for retirement on 401K’s and other tax-favored accounts. This conventional wisdom manages to be stupid and crazy at the same time. Given the dangerous volatility of the stock market, the truly prudent course would be to expand risk-free Social Security payments to most Americans, while reducing or phasing out tax breaks for volatile, risky stock market accounts funded by employer pensions or private savings accounts.
Businesslike prudence counsels an effort to shrink the failed, volatile private retirement savings programs and expand the more secure public retirement system. The expansion of the low-risk Social Security program, proposed by Steven Hill among others, can be paid for with higher payroll taxes or a mix of payroll taxes and general revenues, including increases in income tax revenues that follow the capping or eliminating of IRAs, 401K’s and similar poorly performing, tax-favored private retirement programs.
Just as private investments are a poor substitute for Social Security, so the promise of capital gains is a poor substitute for wage increases. Low- and middle-income Americans need higher wages or greater, secure public benefits, or both, not the promise that they can supplement their low wages or inadequate benefits with day trading — a promise that in hindsight looks like a sick joke.
Libertarian ideologues will continue to lobby in favor of replacing public social insurance with private accounts in the stock market; that is what they are paid to do, by the Koch brothers and their other donors. And self-styled “budget hawks” — most of whom are ideological conservatives posing as pragmatic centrists — will continue to claim falsely that the U.S. cannot afford Social Security in its present form, much less in an expanded form that would increase American retirement security while reducing macroeconomic volatility. Finally, fund managers on Wall Street will continue to salivate at the prospect of replacing part or all of Social Security payroll taxes with voluntary or compulsory “individual mandates” pressuring Americans to buy the risky products they peddle and to pay the Wall Street middlemen their fees.
Do not be fooled by this well-funded propaganda. Americans need higher wages and more generous, secure public benefits, not schemes to encourage them to compensate for lousy pay and inadequate benefits by gambling in the risky stock market. Some ideas really do fail the test of history. After two catastrophic stock market crashes in less than 10 years, the once-fashionable idea of the investor society gets a failing grade.
The sense of panic and confusion in Europe seems to grow by the hour. Let’s review the last day or so of events.
- Germany’s economics minister warned that, to save the euro, Greece might have to go through some sort of “insolvency procedure.” Bloomberg News promptly reported that there is now a “98 percent” probability that Greece will default.
- An Italian bond sale went badly, forcing Italy’s borrowing costs sharply higher. Investors were heartened, however, by the news that Italy’s foreign minister was begging China to bail out the country with a significant investment. This was the same foreign minister who had previously warned against China’s “reverse colonialism.”
- The price of insuring against the default of bonds issued by Portugal, Italy and France jumped.
- Bank stocks in France tanked. French banks own about $57 billion in Greek debt — and much, much more in Spanish and Italian debt.
- German Chancellor Angela Merkel smacked down her own economics minister, and declared that she wouldn’t allow Greece to go into “uncontrolled insolvency.”
- “I think we will do Greece the biggest favor by not speculating much, but instead encouraging Greece to implement the commitments it has made,” Ms. Merkel told RBB Inforadio, a public broadcaster in the Berlin region. “What we don’t need is unrest in the financial markets — the uncertainties are already big enough,” she said.
- Merkel’s promise calmed the waters — for the moment. French bank stocks — and the U.S. stock market — suddenly rebounded.
So what does this all mean? First guess: Anyone looking to Congress, the White House or the supercommittee for answers to U.S. economic problems — or for even a hint as to the future direction of the U.S. economy, is almost certainly looking in the wrong place. The biggest downside threat to the U.S. economy, right now, is Europe. Whether or not Merkel can steer a path toward resolution of the Greek crisis will likely exert far more influence on American livelihoods than whether or not the payroll tax cut gets extended, or even whether Republicans succeed in forcing more austerity down U.S. throats.
Just how exposed U.S. banks are to Europe is a hotly debated question — some banking analysts claims direct exposure is relatively minimal, while others note that we just have no idea how much credit default swap insurance U.S. banks have sold to European banks.
Who ends up holding the bag if Europe implodes? Astonishing as this is to contemplate, just three years after credit swaps played a major role in precipitating the financial crisis of 2008, we just don’t know. But even in the midst of our ignorance, formulating a disaster scenario is child’s play.
If Greece slips into default (controlled or uncontrolled) and Italy follows down the insolvency garden path, French banks are certainly in big trouble. If the French banking sector collapses, at the very least, Europe will be headed for recession, and at worst, the interconnectedness of the global banking system will transmit chaos straight across the Atlantic to New York in less time than you can say “systemic event.”
Another recession in Europe would be bad enough — add yet another grim headwind to the troubles limiting U.S. growth. But another global credit crunch? Is it any wonder that every new headline from Europe seems to spark an immediate zig or zag in the U.S. stock market?
Just when Wall Street seemed to have settled down, a barrage of bad economic reports collided with fresh worries about European banks Thursday and triggered a global sell-off in stocks.
The Dow Jones industrial average fell 419 points — a return to the wild swings that gripped the stock market last week.
Stocks were only part of a dramatic day across the financial markets. The price of oil fell $5, gold set another record, the 10-year Treasury hit its lowest yield, and the average mortgage rate fell to its lowest in at least 40 years.
The selling began in Asia, where Japanese exports fell for a fifth straight month, and continued in Europe, where bank stocks were hammered because of worries about debt problems there, which have proved hard to contain.
On Wall Street, the losses wiped out much of the roughly 700 points that the Dow had gained over five days. Some investors who bought in the middle of last week decided to sell after they were confronted with a raft of bad news about the economy:
– More people joined the unemployment line last week than at any time in the past month. The number of people filing claims for unemployment benefits for the first time rose to 408,000, or 9,000 more than the week before.
– Inflation at the consumer level in July was the highest since March. More expensive gas, food, clothes and other necessities are squeezing household budgets at a time when most people aren’t getting raises.
– Sales of previously occupied homes fell in July for the third time in four months — more trouble for a housing market that can’t seem to turn itself around. This year is on pace to be the worst since the late 1990s for home sales.
– Manufacturing has sharply weakened in the mid-Atlantic states, according to a report from the Federal Reserve. Manufacturing had been one of the economy’s strongest industries since the recession ended in 2009, but its growth has slowed this year.
The manufacturing news was especially bleak on an already bad day, said Dan Greenhaus, chief global strategist at brokerage BTIG. He called the Fed report “an atrocious set of numbers.”
“That really set the market on its head,” he said.
Wall Street and other financial markets have wrestled for several weeks with fears that a new recession might be in the offing. Morgan Stanley economists said in a report Thursday that the U.S. and Europe are “dangerously close to recession.”
“It won’t take much in the form of additional shocks to tip the balance,” they wrote.
Worries about European debt also hang over the market. A default by any country would hurt the European banks that hold those European government bonds, plus American banks that have lent to their European counterparts.
Renewing the fears, The Wall Street Journal reported Thursday that U.S. regulators are looking at the U.S. arms of big European banks to make sure they have enough money for day-to-day operations.
“I don’t want to pretend that the market knows what it’s thinking about too much,” said David Kelly, chief market strategist at JPMorgan Funds. “We live in an environment of sell now and ask questions later. The European market was off very heavily this morning before the markets opened. But honestly there wasn’t any news of any substance. We always collect whatever crumbs we can find and point to them.”
Asian markets started Thursday’s drop. Japan’s Nikkei 225 index fell 1.3 percent. The main stock indexes in South Korea and India each dropped a little more, then Europe more than that — 4.5 percent in Britain and 5.8 percent in Germany.
In the United the United States, the Dow fell 419.63 points, or 3.7 percent, to 10,990.58. The Standard & Poor’s 500 index fell 53.24, or 4.5 percent, to 1,140.65. The Nasdaq composite fell 131.05, or 5.2 percent, to 2,380.43.
The Dow is down 13.6 percent since stocks began falling July 21 — four weeks that have rattled Americans watching their retirement savings and other investment accounts shrivel.
Lee Applegate, a retired sales executive from Cincinnati, watched the latest market plunge uneasily but said he was planning to stay the course with his investments. He and his wife have several retirement accounts.
He remembers the mistake he made in pulling his money out of stocks in early 2009, just before the market started its two-year surge. Since March 9 of that year, the S&P 500 is up 68.6 percent.
“I think things are going to get worse before they get better,” Applegate said. “But I’m still going to ride it out.”
Last week was one of the wildest in Wall Street history. The Dow moved more than 400 points on four straight days for the first time. But stocks had been relatively stable this week because investors were calmed by strong earnings reports.
The Dow had fallen 76 points Tuesday and risen four points Wednesday — the first time in nearly three weeks that the average rose or fell by less than 100 points on two straight days.
That ended Thursday. And with stocks down big, money flooded into U.S. Treasurys and gold, both considered safer investments.
The yield on the 10-year Treasury note briefly fell below 2 percent for the first time, hitting 1.98 percent, before rising to 2.07 percent. Low yields show that investors are willing to accept a lower return on their money in exchange for safety.
The price of gold reached yet another high — almost $1,830 per ounce. Gold keeps setting records, with some investors looking for stability and others simply looking to cash in.
The price of oil fell $5.20 to $82.38 per barrel after the economic reports raised concern among traders that demand for gasoline would fall. One survey this week found Americans have already cut back on gas 21 weeks in a row.
And the average rate on a 30-year fixed mortgage fell to its lowest on record. The rate on the 30-year fixed, the most popular mortgage, hit 4.15 percent — the lowest in at least 40 years and barely beating the record from last November. The last time long-term rates were lower was in the 1950s, when 30-year loans weren’t even widely available.
Nicole Sherrod, a managing director at broker T.D. Ameritrade, said the market volatility has led more clients to put automatic protections in place to sell a stock or an investment fund once it falls below a certain value.
“Our clients are saying that this is not a buy and hold market,” she said. “This is a buy and protect market.”
In addition, computer systems that are programmed to analyze charts, capitalize on tiny changes in price and execute trades with no human intervention are making the market rougher.
High-frequency trading programs make up about half of the trading volume in a normal market day but 70 percent or more on a volatile one.
AP Business Writers Dave Carpenter in Chicago and Matthew Craft and David K. Randall in New York contributed to this report.
European bank stocks tanked Thursday as fears over the anemic pace of the global economic recovery and the institutions’ ability to get access to funding intensified.
Most bank stocks across Europe were underperforming in already fragile markets, with British bank Barclays and French bank Societe Generale leading the way down, ending the day with losses of 11.5 and 12 percent, respectively. Germany’s Commerzbank fell 10 percent.
Analysts said the plunge seemed to be, at least in part, a reaction to increasing signs that banks are struggling with liquidity — or access to the cash they need to run their day-to-day operations. Banks typically fund their activities with very short-term loans, and the seizing up of the credit markets where they get those loans was one of the hallmarks of the 2008 crisis. First banks refused to lend to one another, and eventually companies and consumers weren’t able to get loans.
A number of European banks are already dependent on last-resort credit from the European Central Bank because of a reluctance among financial institutions to lend to one another since many are heavily exposed to bad debt like that of Greece, Portugal, Italy and other foundering countries.
The European Central Bank said Thursday that one bank had borrowed $500 million a day earlier for seven days through the bank’s dollar lending program at 1.1 percent. The bank was not identified.
A request for dollars from the ECB suggests that at least one big bank is having trouble obtaining funds. Analysts said fears about one bank’s troubles are enough to spark concerns about the entire industry because traders are already worried about banks’ sovereign debt holdings.
“These are worrying signs,” said Neil MacKinnon, an economist at VTB Capital in London. “You could think of it as a mini-Lehman moment: There is the risk that a major eurozone bank might be a casualty.”
In 2008, the investment bank Lehman Bros. filed for bankruptcy, causing the global credit markets to freeze up almost overnight. Banks refused to lend to each other because they feared more failures and greater losses. Companies and consumers were unable to get loans.
Last week the European Central Bank opened its credit window and let banks borrow as much as they wanted for six months, an unusually long time that gives them more certainty about their funding. The ECB allotted 114 banks euro49.75 billion, more than expected.
In a move that could compound liquidity fears, U.S. regulators said they were stepping up scrutiny of European banks’ U.S.-based subsidiaries, according to two people familiar with the situation. Banks are meeting more frequently than usual with supervisors from the Federal Reserve Bank of New York and the New York State Banking Department, said the people, who spoke on condition of anonymity to discuss confidential matters of bank supervision.
Analysts said that regulators are pressing the foreign-based banks to park more of their dollars in the U.S., in case their European parents falter and start draining them. Federal Reserve data show that foreign-based banks are storing more cash here — $127 billion near the beginning of August, up from $86.1 billion in June.
A similar spike occurred before the 2008 crisis, analysts with Keefe, Bruyette & Woods said in a research note Thursday.
Protecting foreign bank subsidiaries has been a priority for regulators since that crisis. Lehman’s bankruptcy filing fed the global panic in part because the legal and financial status of its European operations were not clear to other banks and investors.
Poor economic news in the U.S. also seemed to be driving the flight from banks, which was also seen on Wall Street. Shares of big U.S. banks plunged faster than the broader market indexes. Bank of America Corp. and Morgan Stanley dropped about 7 percent, while Citigroup Inc. skidded nearly 9 percent. The Dow Jones industrial average was down more than 4 percent.
“People are putting the pieces together,” said Will Hedden, a sales trader with IG Index.
Some of those pieces are an increase in claims for unemployment benefits in the U.S. and Morgan Stanley’s decision to cut its global growth forecasts for 2011 and 2012. Many European banks hold substantial amounts of Greek debt, and have begun to take writedowns on those holdings.
Banks have also been undermined by Tuesday’s revelation from German Chancellor Angela Merkel and French President Nicolas Sarkozy that the two countries’ finance ministers would come up with a proposal to slap a tax on all trading transactions.
A transaction tax — a small percentage taken from foreign exchange and share transactions, for instance — has been proposed as a source of money to pay for bank bailouts but could hurt trading volumes — a key source of revenue for many of Europe’s banks.
If banks and investors had been holding their breath hoping for a panacea from Sarkozy and Merkel, they were disappointed, and Thursday’s dive could reflect the realization that there’s no easy way out of Europe’s problems.
“All we got was more taxes and more bureaucracy and more austerity,” said MacKinnon.
A Finnish deal to get collateral from Greece to secure its rescue loans to the debt-ridden country has also raised renewed concerns over Europe’s handling of its debt crisis.
Many of Europe’s banks, including Societe Generale and Commerzbank, have already taken big writedowns over their holdings of Greek debt and anything that makes Greece’s second financial bailout less likely has been viewed with dismay. Commerzbank, Germany’s largest commercial holder of Greek debt, wrote off euro760 billion ($1.1 billion) in Greek bonds, all but wiping out its second-quarter earnings.
Last month’s decision by eurozone countries to grant Greece a second financial bailout, worth a total of euro109 billion ($157 billion), called for banks, pension funds and other private institutions that hold Greek debt to take their share of the pain.
Daniel Wagner reported from Washington. Pan Pylas in London and David McHugh in Frankfurt contributed to this story.
A trader on the floor of the New York Stock Exchange. (Credit: Reuters/Brendan McDermid) 
Pine and Broadway 
One of the worlds heaviest waves breaks in Tahiti 
A trader strides across the floor of the New York Stock Exchange at the closing bell, Tuesday, Aug. 9, 2011. The Dow Jones industrial average closed up 429.92 points. (AP Photo/Richard Drew)(Credit: AP) 
Specialist Michael O'Mara, center, works with traders at the closing bell, on the floor of the New York Stock Exchange Friday, Aug. 12, 2011. A wild week ended relatively calmly on Wall Street Friday as the Dow today gained 126 points to 11,269 and the S&P was up 6 points, while the Nasdaq composite added 15 points. The key averages were down 1 percent or more for the week. (AP Photo/Richard Drew)(Credit: AP) 
