What are the Ramifications of the Fed's Bailout of Bear Stearns?

A week ago, on Sunday March 16, 2008, the structure of American finance shifted. This was lost to public view behind billows of smoke. The acrid smell of burnt out jobs, dreams, pensions and investments wafted down Park Avenue. The financial press reported the dramatic imagery and the fire. Precious few asked what caused the fire and what the destruction left in the way of new realities, lessons and cautions. Let's pretend that substance matters.

It will not be easy and it may not yield comforting well-worn platitudes about "Wall Street Culture" or "bad apples." We need to ask the following questions: What decisions were made? What impacts are these decisions having? What is at stake? How can we do things differently in the future?

The embers still smolder, and visibility remains clouded. We do know that the Federal Reserve, JP Morgan (JPM) take-out of Bear Stearns (BSC) involved sacrificing a smaller, weaker firm and offering enhanced assistance to remaining investment banks. Whenever new rules and new rulers emerge during a crisis, it takes time to assess the full measure of change. The Federal Reserve [FED] has stepped out in front of the Securities and Exchange Commission [SEC], and has acted dramatically and transformationally in the vacuum created by inaction from Congress, the White House and the SEC. The Fed. has led the response to worsening economic and financial conditions.

Waves of massive interest rate cuts have flooded regulated banks, and now investment banks with tens upon tens of billions in cash. The cash infusions have bought time for financial institutions, and now - investment banks. Relief has come as an expanded and extended opportunity to temporarily drop off distressed, unknown value assets at the local Fed bank, and get a known value in exchange. This allows cash to be received in exchange for unsalable and heavily devalued structured financial products.

Parking one's mystery financial meat, comprised of bundled consumer and business loans, delays reckoning and allows banks to continue operating and workout out losses and risks. All the while, dropping interest rates allow financial firms to borrow more cheaply and rebuild balance sheets and capital. Interest rate cuts and loans raise future earnings and reassures investors. Symbolically, the Fed has shown that its stands with dominant financial institutions. We have learned that our leading financial institutions require much help, and that the Fed is struggling to provide that help.

None of this works to fundamentally remove risks and losses. Firms are still losing money, houses are still losing value, late payments and foreclosures continue, and employment is weakening. U.S. and global economic growth forecasts are being lowered. The Fed is simply buying time, working to soothe investor fears and symbolically standing behind the firms its policy largess embraces. Those who are snubbed, who even worse, find themselves fed upon by the remaining firms, public opinion and angry investors. Postponement and public relations responses to crises have given way under the growing weight of fear and loss. Ever greater policy action and market intervention have been, and will continue to be in the offing.

Speculators and owners of structured product have become rate easing and assistance junkies, but greater fixes of Fed liquidity candy are required in order to propel the markets higher. Ultimately, we will likely see a coordinated renegotiation of mortgage principle and or, greater government led bail out and buy-out. We will see pressure on banks to reduce the mortgage debt owed or even greater outright purchase of bundled home mortgages. The problem lies in the size of possible losses and the vital role played by leading U.S. financial institutions. 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.

At the same time, overt interventions create policy based winners and losers. The worst-case scenarios are too much to bear, and the interventions needed are large enough to change the landscape of American and global financial markets. The architecture and performance of global economic growth are uncertain. We are past the point of working to prevent pain. It is now a matter of figuring who to help and how much. The stakes are always high in such debates.

Our financial system and overall economy prospered on massive innovation, leverage and deregulation. All three are either stalled or running in reverse. When everything aligned just right, 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. Cheap credit and debt-fueled consumption pumped wealth into corporate coffers around a globalized world. This allowed economic development and consumption fulfillment, but the costs and benefits of this system were very unevenly distributed. There is every reason to believe the pain will be too.

Our recent boom was produced by cheap leverage, tolerant regulators and faith in markets. Faith is in very low supply, and fear drives violent reallocations and flights to safety. An awareness of risk has violently re-emerged, and innovation has stalled. Our engine of growth and credit allocation has run out of inexpensive and plentiful gas.

The problems are too big to leave alone and too large to fix without careful, concerted, international policy responses. Absent such an approach, massive swings in policy will produce violent swings in global fortunes and angry response. We now face the prospect that waves of losses, lawsuits and public anger will blame innovation and international exchange for downturn. If this occurs, we will actually run innovation and integration in reverse. Financial neo-Luddites will emerge to smash the credit innovation machine in hope of preventing the pain that has already arrived. Debt will be scarce, more expensive and more suspiciously viewed.

If left the way it is, this could cause rapid swings in purchasing power and prices. As basic assets, food prices, energy prices and national currencies swing in price; wealth and power are violently moved out of some hands and into others. Prices, including currency prices, distribute and direct losses, gains and decisions. This is what we are already seeing in housing markets. Easy mortgage access and belief in constantly rising home prices created a boom, and changes in credit access and faith in real estate inflation are now producing the worst housing slump in modern history. This is rapidly slashing the wealth of middle class Americans. House prices, mortgage bonds and Dollars are falling. This creates financial stresses alongside food and energy prices increases. Billions are being redistributed from homeowners, dollar holders, and food and energy importers.

Our economy has lived off debt and speculation, which created positive feedback loops and pumped air into our economy. We evolved to benefit from, and rely upon this as an engine of growth, but now, it is running in reverse. Households and firms are in the early stages of adjustment, and the process is violent and unequal in its impact. Some will get help, while others will be ignored 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. What this means is 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, new shoots will be sent out through the charred crust of the burnt out old house. In short, the financial rules, regulations and conditions at the center of our economy are changing. Sunday March 16, 2008 was a day of rapid, chaotic change.

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 [PDCF] allows investment backs to borrow overnight at 2.5% and against various illiquid (hard to value and sell) securities. As soon as credit became available, primary dealers began to borrow rapidly, or at a rate of $13.4 billion per day. The new cash access system for primary dealers 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. This will quickly translate into economic change at home and abroad. Treasury officials and our President signed off on this 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 was substantively altered in the Bear Stearns, JPMorgan meetings, and there now appears to be new guarantees and restrictions on our leading Investment banks. I do not wish to blame the Fed; it has been charged with an impossible task and is not getting the support and assistance its efforts deserve.

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 actual recession remains to fully arrive. Housing and finance were first into the fray and have fallen furthest and fastest. Financial markets and the dollar are fast on their heels. There is every reason to expect retail, employment and economic growth to follow.

It is still too early to gauge the depth and duration of a downturn that is a moving target. It is time to demand clear and transparent discussion of options and exposition of decision. We will all live with the choices made; we should all be invited to the table and briefed on the options.

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ECONOMIC REPORT
March consumer confidence down, outlook grim

By Ruth Mantell, MarketWatch
Last update: 11:35 a.m. EDT March 25, 2008Print E-mail RSS Disable Live Quotes
WASHINGTON (MarketWatch) -- U.S. consumer confidence fell in March, while expectations hit a 35-year low on pessimistic views of the business climate, job market and personal income, the Conference Board reported Tuesday.
The March consumer confidence index fell to 64.5 from a revised reading of 76.4 in February. Economists surveyed by MarketWatch had expected a March reading of 73.3. Consumer confidence is at its lowest since the Iraq War in 2003.
The Conference Board's expectations index, meanwhile, hit its second-lowest level ever, falling to 47.9 in March from 58.0 in February. In December 1973, expectations were at 45.2.
Those expecting business conditions to worsen over the next six months rose to 25.4% in March from 21.6% in February. Those expecting fewer jobs rose to 29.0% from 28.0%. And those expecting greater incomes fell to 14.9% from 18.0%.
"Looking ahead, consumers' outlook for business conditions, the job market and their income prospects is quite pessimistic and suggests further weakening may be on the horizon," said Lynn Franco, director of consumer research at the private Conference Board.
Expectations for the inflation rate in 12 months rose to 6.1% from 5.4%.
Consumers' views of present-day conditions declined to 89.2 in March from 104.0 in February. Those claiming business conditions are bad rose to 25.4% from 21.3%. Those saying jobs are "hard to get" rose to 25.1% from 23.4%, and those saying jobs are "plentiful" fell to 18.8% from 21.5%.
Elsewhere Tuesday, the Case-Shiller home price index showed U.S. housing prices in 20 major cities declined by a record 2.4% in January, falling for the 18th month in a row and bringing down prices by a record 10.7% over the past year. See full story.
Buying plans impacted
Data show consumers' buying plans have also been impacted, according to the Conference Board.
Consumers with plans to buy an automobile within six months fell to 5.1% in March from 5.4% in February. Those with plans to buy major appliances in coming months fell to 28.2% from 32.1%.
Ian Shepherdson, chief U.S. economist for High Frequency Economics, sees consumer spending dropping to an on-year rate of negative 2% in the near future, if current consumer confidence levels are sustained.
"If spending does weaken to that degree, an outright recession will be unavoidable and a severe recession will be very likely," Shepherdson wrote. "In short, this is one of the most alarming economic reports we have seen in this cycle so far."
Chain-store sales for the week ended March 22 rose 1% from the year-ago period, but were down 0.4% on a week-over-week basis, according to a survey released Tuesday by the International Council of Shopping Centers and UBS Securities. See full story.
The year-over-year result is "disturbingly weak," given that Easter was the earliest in 30 years, according to Ried Thunberg ICAP.
"Perhaps flooding in the Midwest dampened sales in that region of the country, but even so, sales are poor even considering the state of the economy with falling home and stock prices, high energy prices, turmoil in the financial market, low level of confidence, or -- in a word -- that the country is in recession," Thunberg said.
In contrast, those with plans to buy a home within six months gained to 3.3% in March from 2.9% in February. On Monday, the National Association of Realtors reported that the U.S. housing market showed signs of stability in February, as sales of existing homes rose modestly, boosted by a record decline in prices. See full story.
Ruth Mantell is a MarketWatch reporter based in Washington.
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110 Comments (view all)

OH the news is bad so lets focus on rate cuts------

OH my gosh---only 2.25% left------tick, tick, tick, BOOM!!!!!!!!!!!!!!!!

- ken2

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2008 Mar 25 12:18 PM