Bailout Failure Throws Banks Into Disarray

The failure of a massive $700 billion bailout financial plan Monday removes a critical firewall intended to keep the credit market collapse from spilling over into the global economy.

But even if the plan is somehow revived, cracks are beginning to widen in the foundations of the global banking system.

Aftershocks from the ongoing credit crisis struck again Monday, with the forced marriage of Wachovia and Citigroup and the nationalization of several European banks.

The latest reverberations come just days after regulators seized the assets of Washington Mutual, which was losing ground to mounting writedowns on mortgage-related investments, and found a buyer in JPMorgan Chase. It was the largest bank failure in U.S. history.

To try to calm the waters Monday, central banks around the world said they were offering up billions of dollars in fresh capital to help banks here and abroad as they struggle to stay afloat in the worsening credit crisis. The Federal Reserve said it will make a total of $620 billion available to other central banks, swapping dollars for foreign currencies. That’s more than double the cash pile already provided by the Fed.

The global effort, involving central banks around the world, is yet another indication that the credit crisis that began in the U.S. mortgage market has tainted the river of capital that flows through the global economy. Until recently, the problem had been limited to a handful of British banks.

“We've seen a sharp increase in funding costs over the past two, three weeks overseas ,” said Alex Patelis, head of international economics with Merrill Lynch. “That's bringing the weaker players in the banking sector down. We've seen a number of issues with banks down throughout Europe today.”

As the banking crisis threatens to spill over, the worry is that bankers have been underestimating the potential impact on their holdings from ongoing losses related to mortgage defaults and foreclosures.

The problem bankers and the financial markets face are fairly straightforward. As the multitrillion-dollar mortgage lending spree now unwinds, there’s no way to know how many more potential shocks are out there. It all depends on how much longer house prices keep falling.

Since no one knows the answer, banks have to guess when to mark down the value of all those mortgage-related investments. The further house prices fall, the more they have to mark them down.

Meredith Whitney, head of stock research at Oppenheimer, figures that from the peak of the housing bubble to the trough when prices finally recover, home prices will have fallen by some 40 percent. She thinks banks have been slow to book those losses — which means bigger markdowns lay ahead.

“Wachovia, which had 60 percent of its portfolio in Florida and California, only assumed 21 percent peak-to-trough declines,” she said. “So there are going to be real (markdowns) that Citibank is going to have to take. They are both going to have to take markdowns, and they have to raise capital to these (markdowns.)”