Our Take: Mapping the Downturn

The credit crunch is cutting a wide swath through markets, employment, and broad economic conditions. Is the worst behind us, or yet to come?

In the inaugural installment of this column, published last Nov. 9, we guessed the credit crisis was in "the bottom of the fifth," - i.e., right at the halfway mark.

Our assessment proved way too optimistic. Now, with more and better information available about the extent of damage to the financial system and the real economy as well as the government's policy response, we take up the topic again. When can we expect to see hiring and compensation in the financial sector hit bottom?

U.S. non-farm employment has shrunk for three straight months. Home prices continue to fall. Earnings estimates are dropping. Short-term credit markets remain chaotic despite $400 billion of liquidity injections by the Fed and other central banks.

Precarious markets are taking a visible toll on careers across the industry. They're reflected in diminished deal volume from complex debt securities, equity-linked bonds, and initial public offerings in Shanghai. Worldwide merger and acquisitions business fell 22 percent in the first quarter compared with a year earlier, and whole categories of once-lucrative transactions such as large leveraged buyouts and complex debt securities have all but vanished - erasing many a banker's job along with them.

Banks reportedly have slashed some 34,000 slots. Many more will get the ax, if the pattern seen in past downturns is repeated. Headhunters say that even hedge funds, which continue to add staff, are less willing to dangle compensation guarantees in front of new hires than they were a year ago. Funds are holding the line on compensation for specialties like structured debt, whose sell-side opportunities have dried up.

How Long Have Markets Been Correcting?

When seeking to chart the course of a business cycle, it's useful to look backward as well as forward. Markets are self-correcting by definition: for securities just as for widgets, interaction between supply and demand brings prices to a level where markets "clear" and institutions and individuals are no longer "stuck" with assets they can't sell. This process, instantaneous in a theoretical "perfect" market, takes time to play out in real life. So when looking for a potential end point, it's logical to ask, how long ago did the current correction begin?

The sub-prime market began collapsing late in 2006. Spillover to the broad financial markets first drew wide notice in June of 2007, when two Bear Stearns mortgage hedge funds suddenly went belly up. The overall U.S. economy is thought by some to have slid into recession around the turn of this year. Since December the Federal Reserve and other central banks have adopted a series of escalating steps to inject ever-growing quantities of liquidity into troubled money markets. The markets, therefore, have been adjusting for anywhere from three to 18 months. Comparing this timeline with previous episodes can provide a rough template for estimating how far the process has progressed.

Sellers and Buyers Moving Closer on Prices for Assets

Hopeful, albeit tentative, signs are emerging. Reports that Citigroup is working out a deal to sell $12 billion of loans at a loss to three large private equity funds might be an early step toward restoring an orderly market for some $200 billion of leveraged buyout loans that banks got stuck with when credit markets headed south last year. Mortgage lender Washington Mutual obtaining a $7 billion investment from a group led by private equity firm TPG is another promising development. Unlike the sovereign wealth funds that lined up to buy stakes in U.S. banks around the turn of the year, TPG is more like the sort of "smart-money" investor who steps in when an institution or asset is on the verge of bottoming out.

Both reports raise the prospect that value-oriented investors and owners of illiquid assets might be drawing closer together on how much further those assets must be discounted in order to clear the logjam and re-liquefy balance sheets. As we wrote on Feb. 29, once banks start unloading their underwater loans and securities to arm's length buyers, they'll be on the road to resuming their traditional role as suppliers of credit.

It's still too soon to draw firm conclusions. Fresh information will arrive next week when major institutions including JPMorgan Chase, Merrill Lynch and Citigroup release first-quarter results.