The dust remains to settle from the Federal Reserve/JP Morgan (JPM) take-over/take-out of Bear Stearns (BSC). Since the Friday March 14, 2008 meltdown we have seen wild swings. Sentiments, interest rates and market indexes have roller coastered on fear, fall-out and policy response. There is massive window dressing going on.
As the quarter and month end, losses and redemptions threaten. Pressures build and shift to trade off between winners and losers. That is the short term trading oscillation. The longer term issues involve figuring a landscape altered by the undisclosed and essential features of the Fed, bank, US Treasury policy shifts of Sunday March 17, 2008. Much of this story remains to be explained and market reaction is not terribly valuable when markets know little of what was decided. What we do know is that the Federal Reserve and leading market players have taken the next step down a slippery slope.
Ever greater policy action and market intervention have been and will continue to be in the offing. Markets have become rate easing and assistance junkies. Ever greater fixes of Fed liquidity candy are required to get markets high(er). Ultimately, we will see coordinated renegotiation of mortgage principle and or, greater government led bail/out and buy-out. The Fed and the leading market players Fed policy is unquestionably aimed at, are stuck between two competing realities.
Two swords hang over the heads of interventionist policy and deregulated speculative reality. The leading banks are too big to fail and too big to bail. The problems are too big and politically sensitive to leave to market solutions. Overt and massive interventions create many and serious problems.
The first hanging blade is sharpened by ideology and steeled by systemic risk. The second slicing instrument was forged by recent structural reality. The ideological sword involves market faith. The systemic blade has to do with how we organized the great boom (1982-2000, 2003-2007). Our financial system has prospered on massive innovation, leverage and deregulation. All three are either stalled or running in reverse. Faith and feeding frenzy drove interest and profits to new and innovative product areas. This allowed expansion of credit to American consumers and expansion of profit to financial firms. The buying of American and European consumers fueled economic development and rising incomes throughout the world. Endless cheap and easy credit allowed massive positions to be built with limited initial capital.
Leveraged home buyers provided the raw material to innovators and leveraged structured product buyers and traders. Production runs grew, commodity prices were pressured and fortunes made. Long believers could massively bid up their targets with credit and create the momentum many learned to follow. This was true of houses on Main Street, leveraged positions on Wall Street and around the world. All this required cheap leverage, tolerant regulators and faith in markets. Faith is in very low supply. If you doubt that, look at Bear Stearns and Fed actions. As for long-play feeding frenzies, they are few, far between and engineered by increasingly massive government intervention. Upswings are now created by rate cuts, bail-out/buy-out deals and waves of short covering.
Fear drives violent reallocations and flights to safety. Awareness of risk has violently re-emerged and innovation has stalled. We now face the prospect that waves of law suits and public anger will blame the instruments innovation produced for the downturn. If this occurs, we will actually run innovation in reverse. Financial neo-luddites will emerge to smash the credit innovation machine in hopes of preventing the pain that has already arrived. Leverage will be scarce, more expensive and more suspiciously viewed. If unsmoothed, this could cause rapid swings in purchasing power and price. Unwinding carry trades, deleveraging speculative balance sheets, price flip-flops loom as risks to be avoided. Leverage and innovation made new things possible and stretched returns. The deleveraging process can create losses greater than capital- Carlyle, Bear…..
The second sword is involves structural change. Our economy has lived off debt and speculation. They created a positive feedback loops and pumped leverage air into bubble positions. We evolved to benefit from and rely on this as an engine of growth. It is running in reverse now. Households and firms are in the middle stages of deleveraging. Some will get help. Others will be cold shouldered into extremis. Thus, Bear found itself crippled by a Fed cornered by the size of the task before it.
JPMorgan was assisted in helping itself to Bear's still warm remains. The surviving leaders in the investment banking space were told to help themselves to overnight cash at 2.5% interest. Life and death were determined by Fed granted access to the deleveraging medicine, cash. What was decided in those meetings seems like a new financial regulatory regime for leading Wall Street firms. The regulatory structure has been changed. Access to the discount window, greater Federal Reserve oversight, new risk modeling and lower balance sheet leverage must be in the offing for Wall Street titans? This means a different structure of financial operation is taking hold in the heart that pumps credit through the global veins of commerce.
New risks and new opportunities will take shape molded by a changed structure. New shoots will be sent out through the charred crust of the burnt out old house. This may be neither rapid nor, orderly. Thus, the second sword over market agents heads involves factoring and adjusting to a new structural environment.
Stuck between firms too large to let fail and balance sheets too large to bail, the Fed struck a balance. The New Primary Dealer Credit Facility allows investment backs to borrow overnight at 2.5% and against various illiquid securities. It is similar to the formally regulated banks' arrangement at the Discount Window but, is 1/90 the loan duration. This move into new territory suggests the Fed has changed its role in the economy. We can only assume that the present Treasury officials and President signed off on this. This is a big move. Rumors abound that formal legislation to shift capital market supervision toward the Federal Reserve and away from the SEC awaits introduction.
It looks like our financial regulatory system substantively altered in the Bear Stearns, JPMorgan meetings. There seem to be new guarantees and restrictions on our leading Investment banks? Just to help others, Goldman Sachs, Morgan Stanley, Lehman Brothers took some time off from cold calling Bear clients to visit the new candy man. They seem to be moving forward under the new order. I bet the folks at Bear wish the structural changes and new deal were opened to them? Just to test the new system for glitches, of course.
As time passes and new structures take shape, we expect there to be further bouts of rapid price oscillation, readjustment and deleveraging. It would be wise to note, the recession remains to fully arrive. We are still front running the main event and earnings season is right around the corner.
Disclosure: None
