Economy, banking locked in vicious cycle: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Should we be more worried about the new crisis coming to a head in the financial system or that the United States is self-evidently in recession? Sadly, we don't have to choose.

Banks, starved of capital, are calling in their debts, turning clients, notably hedge funds, into forced sellers, as large swathes of the financial markets are caught in a vicious cycle of margin calls, fire sales and further price falls.

The Federal Reserve has tried to break the cycle, again, by offering another $200 billion to banks, on easier terms and for longer, but confidence in their ability to succeed has fallen.

Meanwhile, back in the real world, consumers and company managers have gotten the message and are firing each other as, respectively, providers of goods and services and wage earning employees.

Last week's U.S. payrolls data was grim indeed and the retail and consumption figures are little more encouraging. "The Fed's efforts to isolate the effects of the financial crunch from the real economy have clearly failed," said Lena Komileva, economist at brokerage Tullett Prebon in London.

"We are now seeing the materialization of this new relationship between the financial and real economy where both are now in crisis."

In essence, the negative feedback loop the Federal Reserve fears, with banking and the economy pushing one another downhill, is taking hold.

Payrolls in February fell by 63,000, falling for the second straight month and by the most in nearly five years.

At the same time, banks have become even more unwilling to take risks with their capital. They are asking borrowers to post more collateral against loans, even when those loans are being used to finance investment in supposedly safe instruments like U.S. Treasuries or mortgage bonds backed by Fannie Mae (FNM.N) or Freddie Mac (FRE.N).

This is forcing some to sell, driving down prices further, a process that risks blowups of leveraged borrowers. It will also certainly mean higher borrowing rates for already shell-shocked homeowners.

While it is impossible to know how deep the recession will be, it is reasonable to expect that investors, having seen the strength of the downward momentum, will try to front run it, betting on further erosion in house values, in mortgage and credit card debt and in the value of the banks themselves.

This is a very difficult set of circumstances for the central banks to fight, and indeed there is reason to believe that their actions are having less impact as the crisis grinds on. A note from Goldman Sachs on Monday saying that they thought it possible that the Fed would do an emergency inter-meeting cut supported asset markets, but not nearly as much as such a suggestion would have only weeks ago.

1929 AND ALL THAT

And while arguably some prices for corporate debt and mortgages are now at levels that imply a depression, much less a recession, there is no good reason to expect those prices to improve in the near term, even if you believe that 1929 is not at hand.

Jan Loeys, head of global market strategy at JP Morgan Chase in London, argues that prices now being paid for a range of assets are more a reflection of the liquidity crisis among banks than of the fundamental prospects for the economy.

"The recession needs to be more like a depression in order to justify current prices," he said.

But while cash deposit rates in the UK and Europe are still high, and while investors still don't know where the financial market bodies are buried or what the shape of the recession will be, a recovery is unlikely.

"You have fundamental uncertainty, as a result no one is willing to put any money down until they can gauge the contours of this contraction," Loeys said.

It may be going too far to argue that we are facing a recession that will be worse for asset prices than every other one in living memory bar the depression.

But some of the challenges facing markets and the economy as a result of the great debt unwinding are sobering. Friedman, Billings, Ramsey estimates that the current $11 trillion in U.S. mortgage debt is backed by $590 billion in capital, or about 19 parts debt to one part equity. They believe that is unsustainable and the ratio will end up around 6:1, as either banks attract about another $1 trillion of permanent capital or housing assets fall correspondingly.

The banks will get some of the $1 trillion, but not most, meaning that mortgage debt and housing has a lot further to fall. The impact of that on the economy, and the impact of the economic downturn that will result on the banks is, in a word, scary.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)