Financial stocks stuck in Catch-22

Financial stocks are caught in a vicious circle: Falling share prices make it tougher to raise capital, sparking fears that firms won’t be able to fill holes in their books, leading to further share-price falls.

That, in turn, makes downgrades more likely. Ratings agencies surmise that an inability to raise capital puts bondholders at risk. Downgrades can force firms to post more collateral with trading counterparties, putting financial companies in a weaker state, raising the need for more capital and potentially greater share-price falls.

And so the cycle goes, sucking down weakened stocks such as Lehman Brothers Holdings and American International Group.

Unfortunately for investors, there is no clear easy solution save for a distressed sale of a firm, which is what may happen at Lehman. Factors causing the problem are beyond the control of the firms, government and Federal Reserve.

Among them: Real-estate prices continue to fall, dragging down the value of assets held by banks and brokers; global growth is slowing, leading to rising delinquencies on all kinds of borrowing; and financial firms have to reduce their reliance on leverage, or borrowed money, leading to a contraction of credit.

That situation isn’t about to change. Even if home-price delines ease, it will be some time before investors can confidently assess the value of bank and brokerage-firm balance sheets. Without sufficient credit, the global economy will struggle to expand.

But credit expansion can’t occur until de-leveraging has run its course. That could take a year or two. Consider that the leading U.S. investment banks saw combined assets rise to more than $4 trillion in late 2007 from less than $2 trillion in 2003, according to Bank of America, and leverage increased during this period by 50 percent.

Securitization, the creation of synthetic financial instruments, and the proliferation of alternative investment vehicles have all helped to mask the true amount of leverage in the global financial system.

That makes it tough to know how far through the process we are.

Complicating matters is that markets have frozen for many of the assets banks and brokers would like to shed. Or they can only sell them at big discounts — but management teams have balked at that as it would erode capital positions even further.

That inaction has led to bigger losses, sparking a need for even bigger asset sales or capital raises. As this slow process plays out, banks and brokers have to take a defensive crouch.

Eventually, prices will fall so low that buyers re-emerge. That will stabilize markets and in turn financial stocks. But that day is a long way off.