Saturday, March 15, 2008

An Ominous Bear

Until recently, I was confident that our economy would weather the current storm without undue difficulty. With the fall of Bear Stearns, I am far less sanguine. The long-term policy of record low interest rates may have dug us into a hole that proves the worst recession since WWII.


Bear Stearns, one of the big five investment banks, has gone belly up and the federal reserve has stepped in. This from the WSJ:

Yesterday's combined J.P. Morgan-Federal Reserve rescue of Bear Stearns is one of those judgment calls that are easier to second guess than they are to make in the heat of a financial panic. Regulators have to balance the risks to the larger financial system of letting a big investment bank fail against the discipline of seeing bad risk management punished by the marketplace.

These columns prefer the discipline of the market, but then we don't know all of the facts that regulators confronted as they looked at Bear's troubles. Specifically, we don't know if letting Bear collapse might have had a domino effect on others in the debt and derivative markets.

The Fed and J.P. Morgan are acting in concert to give Bear short-term access to the Fed's discount lending window that Bear couldn't access on its own. A big plunger in the debt markets but not a standard commercial bank, Bear's private sources of funds had dried up. The overriding public interest at the current moment is to maintain a functioning financial system, and regulators clearly felt this was at risk from a Bear failure. Just once we'd like to see what would happen if a big bank did fail, but the current general market panic arguably isn't the best time to have that experiment. Presumably Bear will now be shopped to private buyers. . . .

Read the entire article. Dinah Lord, blogger and former trader, reflects on a similar situation she lived through during her days on Wall St., as well as including links discussing the fall of Bear Stearns.

Dale Franks sees the Bear Stearns situation as dire news indeed. He writes in the QandO blog:

The market took a hit today. It was a body blow. And, whether you know it or not—although, if you're reading this, you'll know now—the economy took a body blow, too. The only thing we don't know is how much damage was caused. But there was damage, and it will become apparent before too much longer.

It's all about liquidity, you see. For the last several days, there's been concern about whether Bear Stearns, one of the Big Five investment banks, was going to be able to meet its financial obligations to client and creditors because of it's exposure to bad mortgage loans. Company executives have been saying, "Yes, we will," right up to this morning, when they said, "No, we can't."

Essentially, JPMorgan Chase will step in to provide financing for 28 days, and those loans, while coming from JPMorgan's coffers, will be underwritten by the federal Reserve.

If you're a Bear Stearns stockholder, by the way, you're screwed. What will probably happen is that, to prevent the firm from going under completely, JPMorgan will acquire Bear Stearns for pennies on the dollar. At the least, the chances of Bear Stearns continuing to exist as an independent entity are probably over for good. Bear Stearns' CEO admits as much, saying the firm is seeking a "more permanent solution".

And if Bear Stearns can't make it, you have to wonder what the actual position of Merrill Lynch, which is also exposed to the Carlyle fund problems, or Thornburg Mortgage, which failed to meet some margin calls earlier this week. Countrywide Home Loans is already involved in a bailout from Bank of America, and has had foreclosure rates double.

At the heart of the problem is an ongoing liquidity crunch. As exposure to bad loans causes foreclosures to increase, huge sums of money are just being written off—basically disappearing from the economy.

The primary effects of this disappearance—the failure of the banking institutions, is bad enough.

Beyond those effects, however, there are effects on the economy as a whole, because these large write-offs not only remove money from the economy in terms of the amount of the disappearing loan assets at the institutions themselves, individuals who do business with these institutions lose the ability to borrow money. Their credit lines disappear. the institution's borrowers lose their money as well.

This money supply shrinkage usually causes people to hoard cash, because they worry that they won't have enough cash to meet their future needs. They stop investing, for example, because they lose faith in the institutions. The dearth of available loan money causes people in the building trades to lose jobs, because new housing starts decline, so they have to begin saving up their own cash, and cutting purchases. And the effect ripples outward through the economy.

We generally call this widespread hoarding of cash a "recession".

That's certainly what the National Bureau of Economic Research calls it. Is calling it, in fact. And they say it may be the worst recession since World War II.

The worst recession in my lifetime was the back-to-back recessions in 1982, when unemployment rose to almost 12%. If we're in for a worse ride than that—well, I don't even want to think about that.

But, apparently, we have to. . . .

. . . Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline...

Prime brokers and banks are reining in credit to leveraged investors. This is a direct consequence of the damage done to banks' credit capacity by the writedowns of loans in other areas, such as structured finance and mortgages. This reduces their risk-free capital (value-at-risk ratios have doubled in the last year in the U.S.). In order to maintain adequate reserves as a proportion of risk assets, lending must be cut...

Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.

We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.

Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time.

What has happened is that the liquidity crunch from mortgage credit problems—too many subprime loans, too many second mortgages, plus declines in housing values—have been amplified from bank lending up through securitized debt, then again amplified in the derivatives markets.

This decline in available credit—i.e. money—is not going to be fixed by a 3% drop in short-term interest rates. And it certainly isn't going to be fixed—or even noticeably ameliorated—by a one-time rebate of $600 per taxpayer.

I'm afraid we're in for an awfully bumpy ride. The problem with Bear Stearns today is not the problem. It is the most visible symptom, though, of the real problem with the economy and one that we'll be facing soon.

Read the entire post. Now I am concerned.

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