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Financial markets asking: Where’s the bottom?

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Financial market crises often end with a final, cataclysmic event — a rush of panic selling of stocks or a sudden drop in a currency's value. With the stunning collapse of Bear Stearns over the weekend, many investors are asking themselves: Is this the final upheaval in the earthquake that has been building since the capital markets first started shuddering last August?

The answer, and a major reason for the turmoil in the first place, is that no one — not even Fed or Treasury officials — has any idea.

Until Bear Stearns began to unravel Friday, the financial market had been focused on the Fed’s regular interest rate-setting meeting Tuesday. Most expected the central bank to cut the short-term rates again; opinion was divided between a half or three-quarters of a percentage point.

But after Wall Street began shunning Bear Stearns last week — calling in loans and cutting off future credit — the Fed responded by engineering a takeover of the troubled firm, averting the wider damage of widespread defaults.

“What we're in here is the closest thing we've seen to a bank panic since the Depression,” said Senate Banking Committee Chairman Charles Schumer, D-N.Y. “It's with investment banks, it's with larger investors. But it's the exact same thing. Confidence is so important. The quality of the asset matters less than confidence, and hopefully this move will restore confidence when it comes to some of these other firms."

For added measure, the Fed cut one key rate by a quarter-point Sunday and agreed to make loans through its "discount window" to investment banks as well as commercial banks.

Now forecasters have all but thrown up their hands trying to predict what the Fed will do on Tuesday. Given the tumultuous environment, many expect the central bank to slash the benchmark overnight lending rate by a full percentage point, to 2 percent, less than half the 5.25 percent level when the Fed began cutting rates last June. 

Some investors worry that the Fed’s aggressive efforts to pump tens of billions of dollars into the financial system comes with a hefty price — higher inflation and a weaker dollar.

“Our dollar has been killed,” said Brian Wesbury, chief economist at First Trust Advisors. "The price of gold has gone from $700 to $1,000. The price of oil has gone from $70 to $110. This inflationary pressure that the Fed has caused is making mayhem in the financial markets."

To make matters worse, the turmoil shaking the global credit markets is not about the cost of money. Banks have cash, and if they need more they can borrow it cheaply from the Fed. The problem is that, after watching assets backed by mortgages melt away, banks are afraid to lend.

Some observers see the dramatic collapse of Bear Stearns as a sign that the worst may be over.

“Once the fear is alleviated, liquidity will come back into the markets,” said Richard Bove, a banking industry analyst at Punk Ziegel and Co. “I think we'll find this out in the next four or five days. It's not going to last two, three, four, six months.”

But other observers say it could take longer. The reason is that much of the distressed debt at the source of the credit meltdown is held outside of the view of regulators and investors in the global credit market — the banks, investment firms, pension funds, insurance companies and others who swap trillions of dollars worth of debt every day.

What’s got them all spooked is a relatively new form of debt securities based on highly complex transactions used to offset the risk of borrowing. Those pieces of paper turn out to be difficult to price under the best of circumstances.

Though they’ve been battered by losses related to the housing recession and mortgages gone bad, banks are still in relatively good shape — so far. Loan delinquencies are at about half the levels seen at the peak of the last big credit crunch in 1991, according to a recent research report by Morgan Keegan.

But those delinquencies are rising. With home prices falling, and billions of dollars of paper backed by mortgages at risk of default, the biggest unknown is tied to the million of loans scheduled to reset to higher rates that many homeowners will be unable to keep up with. So until the housing market shows some signs of stabilizing, it’s all but impossible to know how much more money will be lost from mortgage defaults.

“We won't even know what happens until they reset, first of all, later this year and in '09 or '10 — or even go to their 30-year length," said Wesbury. "The financial markets are pricing in all of these (defaults) for the next, two, three, five, 20 years right now. So, have we priced it all in or not?”

Fed officials are hoping to overcome the breakdown in confidence by making money cheap —and offering to lend to whoever need its.  In guaranteeing the credit line that JPMorgan used to back Bear Stearns obligations, the Fed crossed a line that has historically walled off the tightly regulated banking industry from the far more risky securities business.

Some Fed watchers say that targeting loans directly to the source of the problem helps get to a solution more quickly.

“If you look back 20 years or so, what the Fed would do is call up the commercial banks and say, ‘Now, be sure to lend money to all the investment banks,’” said former Fed Gov. Robert Heller. “And rather than doing it indirectly through the banks, which creates another problem because they take assets on to their own balance sheets, the Fed is short-circuiting the process and giving liquidity directly where it's needed the most.”

The worry is that the move may encourage investment firms to make riskier bets in the future — knowing that the Fed is ready to back up those bad bets to avoid wider financial calamity. But Heller says the process of rescuing Bear Stearns has already been painful enough to discourage such future bed bets.

“You cannot talk about a bailout of Bear Stearns,” he said.  “If you're a shareholder of Bear Stearns, you would have lost it all. You're walking away with 1 percent of your asset value.”