Give Fed Chairman Ben Bernanke credit for a creditable defense of the JPMorgan Chase-Bear Stearns transaction, as well as a sobering wake-up call about the multiple frailties of the financial markets, and the economic scene.
In retrospect, we'd would be hard put to argue the bear market is over, the recession will be moderate and short, and the bottom has been seen in financial stocks. I agree with Christopher Wood, chief strategist of the Credit Lyonnais Securities Asia brokerage, that "the Fed's unprecedented action has only delayed market clearing Japanese-style and certainly does not mark a definitive bottom." We also hear of well-known investment professionals who are harboring considerable cash balances. This past weekend legendary investor George Soros called the crisis "a time of the destruction of values." He did not make it sound as it was over by underscoring that the Fed is at "a point of no return. It cannot prevent a recession or the increased unwillingness to hold dollars" around the globe.
Despite the angry outcries of politicians, Bernanke's reasoning for preventing Bear's bankruptcy was powerful. Mull this over at least twice.
"Our financial system is extremely complex and interconnected," Bernanke told Congress last week. "With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counter-parties."
Bernanke continued his warning that such a "chaotic unwinding" — if it could have been accomplished at all — would have triggered disorder across asset values in the rest of the economy as well.
Moreover, Bernanke's sidekick at the New York Fed, Timothy Geithner, added, "Had we not acted, we would in effect have penalized those individuals, companies and financial institutions that had behaved more prudently, but would have suffered significant damage from the effects of default by a major institution."
Obviously it was crucial for the Fed to initiate a radical change in policy to maintain the stability of an institution — Bear Stearns — it doesn’t even regulate or supervise. Radical is also the word for Bernanke’s opening of the discount window to all nonbank broker dealers that are among the primary dealers in Treasury securities on behalf of the Fed. Never before has the Fed lent a $29 billion underpinning to a bank taking over a nonbank either. Had these steps not been taken we will never know the destruction that might have ruined more than defaulting homeowners.
Across Manhattan there are many observers — including Bear Stearns senior officers who are in dire straits from borrowing money on the shares they never sold and face financial ruin.
Their most telling gripe: If the Fed had opened the discount window to the investment banks on Thursday, March 13, instead of Monday, March 17, might Bear have been able to get the transfusion it need to keep its doors open? We'll never know for certain.
Despite all the Fed actions to stabilize the markets, Bernanke laid out all the negatives, one by one. We believe it was as clear an exposition as possible and far more useful than getting the scenario bit by bit, which is hard to digest clearly.
Financial market conditions
- Lenders are reluctant to provide credit, which has forced investors to liquidate holdings and reduce their leverage. Ultimately, reducing leverage, which must be on the minds of the Fed officials supervising major investment banks like Lehman Brothers, Morgan Stanley and Goldman Sachs, makes the financial system safer.
- Credit availability is restricted by limited capacity and the unwillingness of some large institutions to extend new credit. Witness the number of leveraged buyouts that are cratering or being canceled — a virtual plague. Global debt underwriting volumes dropped over $2 trillion since July 2007, which is an enormous loss of liquidity to the financial system, says Meredith Whitney, an Oppenheimer & Co. bank analyst.
- Strains are evident in numerous markets, commercial paper, municipal bonds, student loans and mortgage-backed bonds from government agencies.
The economic ramifications
- The cumulative decline in single-family home-building starts since early 2006 has been more than 60 percent. Just recently, New York real estate brokers have contacted us about the way prices on apartments are softening fast, helped along by the layoffs on Wall Street.
- Unemployment will be moving higher. The 5.1 percent it hit last Friday in the latest figures underscores the recession we are now in. The pullback in hiring will cause a reduction in capital-spending plans.
- Disposable income is rising at a rate of only 1 percent — down from 3 percent — and obviously will cause consumer spending to decelerate. Bernanke believes the tax rebates and fiscal stimulus will reverse this trend in the second half of 2008.
- Inflation meant the price index for personal consumption expenditures rose 3.4 percent over the past 12 months, up from a more manageable 2.3 percent. Bernanke is optimistic inflation will moderate as futures markets are forecasting that oil and other commodities are softening.
We agree with Bernanke's summing up last week before Congress: "In light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high, and the risks remain to the downside."