Turmoil on the Money Front

Financial markets gyrate, as the banking system faces historic change

Confusion, turmoil and a struggle to cope. That was the mood of the nation's topsy-turvy world of money last week, as bankers, brokers and businessmen grappled unsurely with the consequences of Jimmy Carter's latest effort to rally the nation to the inflation fight.

Financial markets were swept by a crazy quilt of slumping and surging prices. Businessmen fretted over whether Carter's "disciplined" new effort to make money and credit scarcer and more costly would pitch the economy into recession for real, or if it would perhaps be swept aside by another onrush of inflation. On Wall Street, the Dow Jones average of 30 leading industrial stocks dropped 23 points on the first day after Carter announced his program. It then bounced back and forth before finally closing out the week down 26.5 points at 785, its lowest level since April 1978.

Meanwhile, gold and the dollar went through equally wild gyrations. Through it all, bankers and moneymen most directly affected by the initiatives found themselves unexpectedly confronting questions of sudden new urgency: Were credit cards a dying business? Was there still a future for the savings and loan industry? Could the Federal Reserve legally regulate Wall Street?

In spite of the President's and Congress's pledges to cut spending and balance next year's budget, the murky world of finance held the spotlight because the most immediate effects of the Carter program would be felt by banks and other savings institutions. The President's decision to use the Federal Reserve to slow the growth of credit would pinch every sector of the economy from department-store dishware to heavy-industry assembly lines. Some bankers even feared that a credit crunch, when almost no loan money would be available, could hit by summer. That would doubtlessly slow the economy, which is still lurching forward unsteadily at a 2% annual rate, and thereby begin to curb the rise in prices.

Businessmen initially voiced strong skepticism about the Administration's latest inflation-fighting strategy. Would the Fed's actions prove to be so heavyhanded as to cause a far steeper slide than anyone expected? If so, many economists were fearful that Washington might react in a panicky rush to begin spending all over again, sending inflation surging to new and even more frightening heights. Observed one Zurich banker last week in a rueful sentiment that was almost universally shared among business leaders and economists everywhere: "I am afraid that at the first sign of a sharp recession, there will be a change in course."

Administration officials added to the uncertainty by issuing what seemed at first glance to be a broadside of conflicting statements over whether or not the President would support a tax cut if the economy went into a freefall. The confusion arose when Carter's anti-inflation adviser, Alfred Kahn, whose outspoken statements in the past have often caused the Administration embarrassment, declared that a steep economic downturn could well force the Government to pump up spending by cutting taxes.

The Administration's actual position was put repeatedly during congressional testimony by Federal Reserve Chairman Paul Volcker, who stressed that it would be inappropriate to consider any sort of tax cut until the budget for fiscal 1981 was balanced. Chief Economic Adviser Charles Schultze echoed the point in his own congressional testimony, saying, "Balancing the budget is our first priority and remains our first priority." Carter simply said, "When I am absolutely certain that the 1981 budget will indeed be balanced, I will then, and only then, consider tax reductions."

Tentative signs of an economic slowdown have been accumulating all winter, and last week brought yet more evidence that the battered economy cannot continue to grow for much longer. After limping along since autumn in the face of steadily soaring mortgage and construction costs, the nation's housing industry, which traditionally leads the economy into and out of recessions, is now slumping sharply. Housing starts for new homes and apartments in February fell 9.2% below the year-earlier level.

Moreover, construction of single-family homes, the mainstay of the industry, plunged 22%, to an annual rate of 774,000 new units. Lamented Merrill Butler, president of the National Association of Home Builders: "It is the most serious situation, in my opinion, that our industry has experienced since the Depression. Nearly 2 million people will be thrown out of work this year, and $32 billion in wages will be lost because of the decline in homebuilding. That is the same as five Chrysler Corporations going broke."

But the new interest rate hikes that hurt housing show few signs of stopping. Last week banks pushed the prune rate they charge their most credit-worthy customers to 19%. Even New York loan sharks have raised their fees from 5% to 6% per week and little money is available.

Just as Carter was making credit control a key focus of his retooled anti-inflation program, a joint congressional conference committee was agreeing, after years of debate, to broad-ranging legislation that would dramatically alter the structure of American banking. This will intensify the survival-of-the-fittest struggle going on among savings institutions, as they labor with soaring interest rates and try to attract new depositors.

The proposed new banking legislation would:

> Phase out, over the next six years, federal ceilings on the interest that banks and savings and loan associations (S and Ls) can pay depositors. Currently, commercial banks can pay only 5.25% and savings institutions 5.5% on their passbook accounts.

> Permit S and Ls and savings banks to expand further into the personal and consumer loan markets, which have been long dominated by commercial banks. Savings banks would also be permitted to make loans to business, an activity from which they have until now effectively been barred. Traditionally, thrift institutions have concentrated their lending in home mortgages.

> Allow both the thrifts and commercial banks to offer so-called NOW accounts, which pay interest on checking deposits.

The upheaval in the savings business has been most dramatically seen in the recent explosive transfer of money from banks and S and Ls into the trendy money market funds. During the month prior to Carter's new measures, $4 billion came out of mattresses, cookie jars and savings accounts and went into money market accounts.

The cause of the shift, which constitutes one of the most dramatic and abrupt movements of investment capital in modern times, was simple: high interest and ease of investment. The funds pay far higher interest, often 13% or more, than most bank savings plans, and initial investments often cost as little as $1,000. The funds also offer day-to-day withdrawal and even check-writing privileges.

As more and more deposits have flowed out of the banking system and into the funds, the banks have been forced to borrow increasingly large amounts by selling certificates of deposit, usually in denominations of more than $100,000, at interest rates high enough to attract buyers. Not surprisingly, some of the biggest customers for the certificates have turned out to be none other than the money market funds. In sum, the more the passbook deposits in the banks have shrunk, the fatter have grown the money market funds, and the higher has climbed the cost to the banks of borrowing the money back again to stay in business.

In an effort to ease the pain, the Federal Reserve in June 1978 allowed banks to begin offering any depositor willing to part with a minimum of $10,000 for six months an opportunity to earn a rate of return more or less equal to the money market funds. The new superrate was keyed to the interest that the U.S. Treasury must pay for its weekly sales of six-month bills to finance federal debt. This has helped slow the outflow of deposits, but in the process has forced up the cost of depositor funds to higher levels than ever.

Hardest hit of all have been the nation's mutual savings banks and S and Ls. Because the thrifts have historically been forced to rely largely on mortgage lending for their business, much of the industry's current income is still coming from home loans written years ago, when rates were no more than half the current national levels of 15 1/2% to 17% for a typical 25-year loan.

Worse still, with housing prices and mortgages now rapidly climbing out of reach for just about everyone, even the income from new mortgages is beginning to dry up. As a result, more and more thrifts are finding it all but impossible to pay the double-digit interest rates needed to attract deposits. Asserts Saul Klaman, president of the National Association of Mutual Savings Banks:' "It's this simple: the money market funds have been a disaster for our industry." Some normally antiregulation financiers are now demanding controls on the money market funds similar to the ones banks face. Adds Klaman: "If you look like a duck and waddle like a duck, you ought to be regulated like a duck."

Largely in response to such protestations, the Federal Reserve announced, as part of the new Carter program, that all money market funds must set aside 15% of any future deposits in non-interest bearing accounts with the Federal Reserve. Since money market funds cannot then invest this cash in bank certificates of deposit or any other high-yielding accounts, the effect for fund shareholders would be a modest reduction in the net interest they could earn.

Almost immediately, however, big Wall Street brokerage firms like Merrill Lynch, which manages the largest money market fund of them all, the Ready Assets Trust ($10.8 billion), began dreaming up new money market funds. These would pay perhaps 2% lower interest than the old accounts. Merrill Lynch insists that the new fund will not be identical to its existing one, nicknamed "the RAT." But Wall Street wags were talking nonetheless last week about a "cloned rat." Meanwhile, the Investment Company Institute, a trade association representing more than 200 money market funds, announced it would petition the Federal Reserve to rescind its order on the ground that the Credit Control Act of 1969 does not authorize such action.

No amount of tightening up on the money market funds is likely to be of much immediate help to the thrift institutions in any case. Wall Street analysts estimate that at least 20% of the nation's S and Ls are already losing money in the current squeeze. Last week Cleveland's Washington Federal Savings and Loan was forced into receivership. The bulk of its assets were acquired by another Ohio thrift institution after Washington Federal was unable to pay for Government securities it had ordered.

Banking experts would not be surprised at all to see at least a few more S and Ls keel over in the coming months. Said Wall Street savings and loan analyst Jonathan Gray: "There is simply no way to describe the situation without sounding inflammatory. If rates stay at their present levels, by the end of the summer about 75% of the nation's S and Ls will be losing money."

In fact, defaults and bankruptcies seem far less likely than does an accelerating wave of mergers and acquisitions, as small and weak thrifts are folded into larger and stronger ones. The new federal legislation for the savings industry will set off intensifying competition between the thrifts and commercial banks across the whole range of banking services. It could in time become as accurate to speak of "brifts" and "thanks" as thrifts and banks. Record high interest rates, a credit squeeze, the mad race for customers and now the new federal banking laws have set off a shakedown of the whole American financial system.

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