In the list of problems central bankers worry about, the very worst is a systemic crisis. Systemic risk occurs when the failure of one financial institution brings about the failure of another, and it arises from the complex network of bank-to-bank trades that exist in a variety of products. Most central bankers go through their careers without even witnessing a systemic crisis; Ben Bernanke has just started his career right in the middle of one.
Make no mistake: this Bear Stearns failure is the very definition of a systemic crisis. Bear Stearns is a major financier for hedge funds; it runs one of Wall Street’s largest back offices for processing trades; it has transactions on its books with everybody big in the derivatives business. If Bear Stearns collapses, there isn’t a bank in the world that won’t be counting their losses.
In normal circumstances a bank failure would result in everyone else going back into the market and replacing the trades from the failing bank. The replacement trades would be at new prices, so a lot of banks would have losses, but these would be manageable. Today so many markets are dysfunctional or non-functional that replacement trades aren’t even available. A Bear Stearns collapse creates a hole in a bank’s portfolio that can’t be filled. The loss has to be guessed at, but worse still, the market seizes up even more, so that less credit is available.
It’s getting hard to count all the markets that are in cardiac arrest: residential mortgage backed securities, collateralized debt obligations, variable rate auction securities, asset backed commercial paper, structured debt, high yield debt, commercial mortgage backed securities, structured investment vehicles, and recently Aaa rated agency securities (Fannie Mae and Freddie Mac bonds). People and businesses are finding it harder and harder to obtain finance. Despite all the hundreds of billions of dollars of ”œliquidity” the central banks have thrown into the system, banks are not lending. Despite the dramatic decrease in short term interest rates engineered by the Fed, long term rates have gone higher and have shut off credit for millions.
This is exactly what happened in the Depression. Banks went belly-up and credit was no longer available. As one bank failed, customers would line up at their own bank demanding their money back, and because it could not be made available, that bank failed too. A daisy-chain of bank failures took place that starved the economy for credit and caused a massive economic collapse.
Economists from Milton Friedman to Ben Bernanke have studied the Depression and concluded that the Federal Reserve was a contributing factor because it tightened money by raising interest rates when it should have been flooding money into the system (dropping it from helicopters, to use Bernanke’s metaphor). Ben Bernanke is as primed as anyone could be to fight the next Depression, but he is failing just the same. A run on the banks is occurring anyway, it just happens to be in a parallel credit creation world that he doesn’t control.
Bear Stearns is at the center of the Wall Street credit creation machine, which is the part of the modern financial world which is now imploding. This parallel universe of banking used the securitization process to create credit, selling loans packaged into bonds and other securities to millions of investors around the world. No central bank stands behind this process, though central bankers like Alan Greenspan cheered it on because it took pressure off commercial banks to make loans that would stress their balance sheets and their capital position.
That stress is happening anyway, because as this parallel credit creation mechanism collapses, commercial banks that are in the Fed system are being forced to take on the loans that used to be held by Wall Street firms or by investors. The appetite for this is very limited and has already been reached. JP Morgan Chase, which is big into Wall Street finance but also is a member of the Federal Reserve, was asked this week to lend money to Bear Stearns to keep it afloat, but would not do so unless the Fed indemnified it for any losses from a Bear Stearns bankruptcy.
Just as in the Depression, credit is drying up throughout the United States economy. The very best efforts of the Fed, the Treasury, and Congress aren’t even slowing down this collapse of credit. Just the other day the government allowed Fannie Mae to increase the dollar size of jumbo mortgages it would accept, but because investors are hesitant to buy any securities issued by Fannie Mae, banks are still not booking jumbo mortgages.
As credit dries up, those individuals and businesses highly dependent on debt for their survival are going to fail. It has already begun in the hedge fund business, starting with those funds which are most highly leveraged. Even a blue-chip fund like Carlyle Capital, which held nothing but Aaa rated agency securities, collapsed because the banks holding these securities as collateral sold them to protect themselves from losses. As such sales accelerate, more and more hedge funds will go to the wall.
Bear Stearns collapsed because it was as highly leveraged as any hedge fund ”“ roughly $30 in assets for every $1 of capital. It only takes a 5% loss on the assets to wipe out all of the capital of the firm. Bear Stearns succumbed because its assets were especially prone to losses since they consisted of mortgage related securities. But losses are now occurring on much safer assets, and since all Wall Street firms have leverage to the degree Bear Stearns did, all of them are exposed to failure.
There are hundreds of companies in the same position. In the past 15 years the credit worthiness of corporate America has deteriorated to the point that 70% of all corporate bonds are now junk debt, meaning these companies have excessive amounts of debt. Less than 10 companies in the U.S. carry a Aaa rating. As those companies with excessive debt are unable to roll over or replace their debt, and as the economy slows, they are going to have a hard time surviving.
This problem is already going global, hitting the U.K., Australia, and other countries that experienced housing booms. Ultimately the credit implosion will fell China and India, two countries that have built their economic engines on highly shaky debt pyramids. Already the stock market in China has begun a collapse that looks remarkably similar to the fall of the NASDAQ in 2000.
Deleveraging is a term economists are using for this process of shedding assets to avoid more serious market losses eroding one’s capital. As hedge funds, banks, corporations, and individuals increasingly rush to deleverage, the losses are exacerbated, and many just won’t make it. This is how systemic risk is bred and how it destroys credit creation. Without credit, a modern economy starves.
Ben Bernanke certainly knows this and has put Bear Stearns on life support in order to stop the contagion from spreading. Bear Stearns ”“ which isn’t even a commercial bank and is not under the Fed’s jurisdiction ”“ is too big to fail in the view of the Fed. It has too many relationships with all the rest of the market to be allowed to go into receivership.
But is this a losing battle? History certainly suggests that systemic crises have a way of rumbling on until all the excess debt is wrung from the system, resulting in enormous economic pain. One of the characteristics of a systemic crisis is the loss of confidence in the financial system, and we saw this on display in the Bear Stearns collapse. Early in the week executives at the bank were saying their liquidity situation was sound despite all the market rumors. Suddenly on Friday it was announced by these same executives that their liquidity situation had deteriorated markedly ”œwithin the past 24 hours.”
Perhaps this is true ”“ executives face severe personal penalties for lying publicly about their company’s situation. But the market was understandably skeptical, which means that the next bank which says publicly it is highly liquid will have to overcome widespread suspicion and doubt. Already rumors are cropping up about other Wall Street firms and large global commercial banks. This is the real battle Bernanke is facing ”“ the confidence battle. All banks exist only to the extent the public is confident the banks can meet their obligations ”“ this is the Achilles heel of leverage. Once confidence is lost, many banks can fail not because their balance sheets are riddled with bad loans, but because of a bank run.
Bear Stearns failed because it hadn’t the resources to survive a bank run. The odds are reasonably high that it will be joined by other Wall Street banks, whatever Ben Bernanke does. He can keep these firms on life support to protect the market, but in doing so he is transferring the risk and the losses to the federal government, thereby nationalizing these banks. It is not difficult to imagine that when all the excess leverage and all the bad debts are eliminated from the system, the federal government will own most of the Wall Street banks, many large commercial banks, and also Fannie Mae and Freddie Mac. As this becomes evident to the markets, the dollar will not survive on the international exchanges, and U.S. Treasury rates for long term debt such as bonds will rise sharply. The U.S. will almost certainly lose its Aaa rating for its debt.
Which brings us back to the question of a Depression. As the banking system is nationalized, and credit dries up, growth in the economy will cease. Already the U.S. is in a recession, but the decline in GDP is about to accelerate significantly to Depression levels of 10% or higher. Unemployment will soar. The true unemployment rate in the economy, counting all the workers who want jobs but are currently being left out of the statistics because they haven’t sought work for awhile, is probably around 8% to 9%. This rate will easily double. The asset deflation that is now ravaging home values will spread not only to other physical assets, but to services and commodities. Nothing will be safe from the pressure to reduce prices and costs. As this process unfolds, the stock market will finally come to terms with the economic reality, and a stock market crash will ensue. This Depression could last somewhat over a year, or be much more prolonged if the Fed keeps too many firms on life support. The Japanese did that in the 1990s during their bout with deflation, and it took at least ten years before the economy started to grow again.
Sadly, the only debate left for the United States, and the global economy for that matter, is how long and how deep this Depression will be.
may be that the Fed will own a priceless(ironically) banking franchise here that will be priceable later. It may be able to recoup many times its investment if it can pull the banks out of jeopardy.
Ben Bernanke, the Ph.D, may be about to learn a profound lesson in stallion trading.
http://mauberly.blogspot.com/
From the London Times:
Talk about burying the lede.
The Great Helmsman will be meeting with the
Plunge Protection TeamPresident’s Working Group on Financial Markets on Monday.Three or four years ago Wall Street brokers had a choice: make adequate returns on their traditional balance sheets, or make hedge fund returns on a much more leveraged balance sheet. Greed won out, and now they are all in the same boat. It doesn’t matter what they own, the value of everything short of Treasuries is going down as people sell all assets to generate liquidity. Because every one of these firms is now really a hedge fund, they will share the fate of the hedge funds.
The Fed can sell the carcasses to the Chinese when the bottom is reached. They have trillions just sitting there in their SWF and would probably like to dominate the world’s financial system on the upswing. Then we can all welcome our new masters with tea and fortune cookies.
By JEANNINE AVERSA
Associated Press
Mar 16th, 2008 | WASHINGTON — Treasury Secretary Henry Paulson on Sunday defended the Federal Reserve’s decision to help rescue Bear Stearns Cos., the teetering Wall Street investment bank. He sidestepped questions about whether other firms are on shaky ground and the possibility of additional interventions of this kind.
At the same time, Paulson sought to send a calming message that the Bush administration is on top of the turbulent situation. “The government is prepared to do what it takes” to ease turmoil in the financial system and minimize any damage to the national economy, Paulson said during a series of broadcast interviews. The Fed’s intervention “was not a difficult decision. It was the right decision.”
The Fed, using a Depression-era procedure, raced to Bear Stearns’ aid Friday along with JPMorgan Chase & Co. Bear Stearns had made a fortune in mortgage-backed securities but faced a possible collapse after those investments soured. Wall Street nose-dived as fears spread about whether other big firms were in jeopardy.
“When you go through a period like this,” Paulson said, “policymakers need to balance various consequences.”
Some critics contend that the Fed’s move was akin to a government bailout — something the Bush administration has repeatedly said it is against.
“Well, every situation is different. We have to respond to the circumstances we’re facing today,” Paulson said. “And my concern is to minimize the impact on the broader economy as we work our way through this situation, and again, the stability of our financial situation.”
Asked whether other financial companies may be in a situation similar to Bear Stearns’, Paulson did not directly answer. He did seek to strike a confident tone.
“Well, our financial institutions, our banks and investments banks are very strong,” he said. “And I’m convinced that they’re going to come out of this situation very strong.”
Paulson would not discuss what would have happened if the government didn’t extend a financial lifeline to Bear Stearns. “I’m not going to speculate about what ifs,” he said.
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Well it must be bad if the administration has no “what ifs” left!
They’ll be avoiding the D word, I expect. We are going to be hearing a lot about our
Chinese reserves are deteriorating day by day. They own over $100 billion in agency securities that nobody wants to buy. Their Treasury holdings are so large that they can only dribble out a bit at a time without disrupting the market and destroying value in their own portfolio.
What they can do is trade in these depreciating assets into ownership positions in U.S. companies, but they would need the Treasury to arrange it to avoid disruptions on the open market. Even then, depending on what they buy, Congress may not like it.
Finally, the Chinese themselves are growing skeptical of investing in the U.S. We saw yesterday that CITIC appears to be reneging on fulfilling their commitment to invest in Bear Stearns. Who can blame them; there has certainly been a material adverse change. After this experience I should think the Chinese will not be so willing to just fork over billions of dollars into U.S. companies, at least not financial companies.
I wonder how it will go over with the general public….
“I lost my job and all my money in the disintermediation.”
By Margareta Pagano, Business Editor
Sunday, 16 March 2008
The Independent
Wall Street is bracing itself for another week of roller-coaster trading after more than $300bn (£150bn) was wiped off the US equity markets on Friday following the emergency funding package put together by the Federal Reserve and JPMorgan Chase to rescue Bear Stearns.
One UK economist warned that the world is now close to a 1930s-like Great Depression, while New York traders said they had never experienced such fear. The Fed’s emergency funding procedure was first used in the Depression and has rarely been used since.
A Goldman Sachs trader in New York said: “Everyone is in a total state of shock, aghast at what is happening. No one wants to talk, let alone deal; we’re just standing by waiting. Everyone is nervous about what is going to emerge when trading starts tomorrow.”
In the UK, Michael Taylor, a senior market strategist at Lombard, the economics consultancy, said on Friday night: “We have all been talking about a 1970s-style crisis but as each day goes by this looks more like the 1930s. No one has any clue as to where this is going to end; it’s a self-feeding disaster.” Mr Taylor, who had been relatively optimistic, has turned bearish: “It really does look as though the UK is now heading for a recession. The credit-crunch means that even if the Bank of England cuts rates again, the banks are in such a bad way they are unlikely to pass cuts on.”
Mr Taylor added that he expects a sharp downturn in the real UK economy as the public and companies stop borrowing. “We have never seen anything like this before. This is new territory for us. Liquidity is being pumped into the system but the banks are not taking any notice. This is all about confidence. The more the central banks do, the more the banks seem to ignore what’s going on.”
Mr Taylor added that the problems unravelling at Bear Stearns are just the beginning: “There will be more banks and hedge funds heading for collapse.”
One of the problems facing the markets is that, despite the Fed’s move last week to feed them another $200bn, the banks are still not lending to each other.
“This crisis is one of faith. We are going to see even more problems in the hedge funds as they face margin calls,” said Mark O’Sullivan, director of dealing at Currencies Direct in London. “What we are waiting for now is for the Fed to cut interest rates again this week. But that’s already been discounted by the market and is unlikely to help restore confidence.”
Mr O’Sullivan added that the dollar’s free-fall is set to continue and may need cuts in European interest rates to trim the euro’s recent strength against the dollar. “But the ECB doesn’t like cutting rates,” he said.
On Europe, Mr Taylor said that while the German economy remains strong, others such as Italy’s and Spain’s are weakening. “You could see a scenario where the eurozone breaks up if economies continue to be so worried about inflation.”
European financial markets were relatively unscathed by Wall Street’s crisis but traders expect there to be a backlash when stock markets open tomorrow.
…
Since most money market funds hold a majority of their assets in corporate paper, it seems that this will be a source of major disappearance of capital. The government will be called on to make good on a lot of this as well. Agree?
It’s one thing for the Fed to support Bear Stearns, at the center of the financial crisis, but there is a much bigger leap for the Fed to do that for an industrial or service company. Perhaps the only type of firm that would be eligible would be GMAC or similar financial operations. But if it were General Motors, that would be up to Congress.
We saw Congress intervene in support of Chrysler, which at the time was a major component of the economy. But I think the first claim on the attention of Congress will not be an industrial company, but Fannie Mae and Freddie Mac. And we are talking about hundreds of billions of dollars to provide a safety net for these two firms. Once that is done, there will be serious questions as to whether Congress can raise any more debt for such bailouts.
I suspect the corporate bond collapse will come towards the end of this crisis – maybe starting later this year and building up into next year. The only other element of the government that will be significantly involved is the Pension Benefit Guaranty Corp., but their resources are limited and they will quickly be swamped in this crisis.
Dr. Peter Venkman: This city is headed for a disaster of biblical proportions.
Mayor: What do you mean, “biblical”?
Dr Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath of God type stuff.
Dr. Peter Venkman: Exactly.
Dr Ray Stantz: Fire and brimstone coming down from the skies! Rivers and seas boiling!
Dr. Egon Spengler: Forty years of darkness! Earthquakes, volcanoes…
Winston Zeddemore: The dead rising from the grave!
Dr. Peter Venkman: Human sacrifice, dogs and cats living together… mass hysteria!
I can hear President Bush now (with Secretary Paulson and Chairman Bernanke standing beside him):
Pitchfork salesmen. Expand into guillotines later.
U.S. papers aren’t yet uttering the D word. When the Wall Street Journal prints that word, we’ll know the Depression will be well and truly upon us.
Numerian,
My view is that Congress should just start loaning direct to home buyers. Some standard rates and deals, something like after WWII.
If mortgage backed securities was the creation of an alternative money supply, then it needs to be regulated. I get that. (Vaguely)
But I think that earlier attack on the financial trouble is better than later, and that Congress needs to do something dramatic to step in and restore order in mortgate industry. Much more dramatic than so far.
If housing prices spriral down, down, down, then consumer spending will be crippled for a generation.
This sprial stuff tends to overshoot.
To hell with fairness and bailing out the unworthy. This is about saving ourselves.
Get the hell out of Iraq, and spend the money on Green infrastructure to prime the pump and to establish a more sustainable pattern of economic activity.
Disintermediation
Fannie Mae and Freddie Mac are mandated by Congress to support the housing industry by buying mortgages and guaranteeing those they do not buy. Originally their mandates were intended to support lower income consumers interested in buying a home, but by the 1990s these GSEs were supporting much larger mortgages. We’ve just seen their cap raised to over $700,000 for mortgages in markets like California.
I should add that the Home Loan Banks are now also stepping up their mortgage purchases, supplementing what the GSEs are doing.
Here’s the problem. The GSEs always had standards for the types of mortgages they would buy. These were called conforming mortgages and did not include the loopy no-income, no down payment stuff of this decade. But the GSEs also had big problems managing the complex prepayment risks in their portfolios (consumers paying their mortgage off early or buying another home – the same thing). This hedging problem got so bad that the federal regulators for the GSEs essentially shut them down in 2004. No audited financial statements were even published for them until this year.
When the shut down occurred, Wall Street cranked up its securitization machine and credit standards fell completely to pieces. Wall Street didn’t care because the mortgages were sold ultimately to “investors”, and because the ratings agencies were giving all these complex securities Aaa ratings. This is the situation that created the current problem.
Until all these bad debts are purged from the system, including related excesses in credit cards, auto loans, high yield securities, structured finance, etc., there is going to be no benefit to Congress taking over the mortgage business through its surrogates the GSEs.
One other reason why this won’t happen, besides no one wanting to go back to the terrible credit standards of 2004-2007, is that Fannie and Freddie are leveraged as badly as the Wall Street firms and hedge funds, about 30:1. They don’t have enough capital to support the losses on their existing portfolios as mortgage problems seep into the prime, highly quality conforming loans they tend to buy and guaranty.
What will really be happening is a bailout of these two companies by Congress to deal with their existing portfolio. There seems to be very little chance that these companies will be growing their portfolio in the next 3 – 5 years. This is why the system is collapsing in on itself.
but we need to think outside the box
some dramatic set of actions that will breed confidence that, even though things will be bad, that a program is being put in place to put a floor beneath which things will not fall
I am vaguely aware of Fannie Mae and Freddie Mac; I do not think that those bureaucracies can be nimble to any new mission. I do not think we should plan around them.
Maybe a new national bank that would buy distressed institutions with conditions that strip away much of the lucre from the financial elite as a condition of preventing a total wipeout. This national bank would also have to start lending.
The whole gambit would test the creditworthiness of the US, but the Arabs and Chinese are already in for a dime, and would probably stay in for a dollar.
Politically, “fixing” the old system (and bailing out the marauders) is a weak case, in my view.
We need something new, bold and practical.
The practical part will be the toughest.
We’ve just seen their cap raised to over $700,000 for mortgages in markets like California.
These limits will do nothing. One needs a $160,000/year income to support a $650,000k mortgage. These incomes are in short supply.
The US need to renage (refuse to honour) its debt.
This will happen after the pitchfork and noose salesmen have made their fortunes.
All banks will be members of the Federal Reserve System. There will be no more investment banks; they will be merged into the banking system.
The Comptroller’s regulatory function will be merged into the Fed, possibly also the FDIC.
The Fed will have a new policy that goes back to targeting growth in the money supply and monitoring and controlling asset bubbles.
The ratings agencies will be put under the supervision of a federal board such as the FASB, which now sets accounting rules.
All mortgage brokers and appraisers will be required to take tests and be federally regulated. Real estate agents and lawyers will face more stringent state exams.
The financial industry will be required to build a clearing house for all over-the-counter derivatives, to provide price transparency and secure clearance.
Much I don’t understand about this stuff, but here’s just a question to maybe help me learn…
Why is the idea of a bank holiday related to Bear Sternes bailout Friday, because it might be necessary to bail out another firm Monday? But wasn’t Friday’s bailout successful? Looks ok to me (not in industry though).
And anyway, this is not a matter of people lining up to withdraw funds. Even if all those with trading assets at company xxx decide to transfer their assets, those transfers would simply take place over the next few days settlement periods, right? Plenty of time to plan a bailout, if necessary, as same assets will exist at receiving firms, who will thereby acquire more capital to work with.
What am I not seeing? Is it all just a confidence game, cooling off?
Bank holiday in US would not work anyway for international transfers and the USD and USD assets are traded worldwide these days. It would just mean that asset prices, exchange rates etc would be set in other marketplaces. Or so it seems.
Clarification appreciated,
That other little gem: “risk re-pricing.” J6P hears that and he say “Oh, yeah, now I get it. Risk re-repricing. Wha????????”
Not like the classic run on a bank where depositors line up for their money back, though we did see that briefly last year in California with Countrywide and in the UK with Northern Rock.
We may still get to the point where the public does get panicky about their deposits, but right now the type of bank run we are seeing is electronic. Customers of Bear Stearns phone up demanding that their account be transferred immediately to some other bank. Some of these customers may be wealthy individuals, but most are huge hedge funds or corporations wanting to move tens of millions of dollars. If you get enough of those calls in a single morning, you discover you don’t have enough cash by the afternoon to satisfy everybody. That’s what Bear Stearns seems to have experienced.
so.
Numerian is probably right. While the Chinese pulled the same trick with their state-owned banks in order to get Western capital, there will likely not be the capital for ours if we have a serious global recession.
In the event there is the capital, you follow the Chinese model, and make people overpay for minority interests.
The Citic deal was to buy a piece of Bear Stearns that valued it around sixteen billion. On Friday it closed at roughly 1/4 of that. So it is no surprise that that particular the deal is off.
http://mauberly.blogspot.com/
There goes the rest of us
There’s something truly scary about the current financial crisis and the potential risks to the global economy when the International Monetary Fund warns that governments need to “think the unthinkable.”
This is a sign that we are in uncharted waters and even the top experts don’t know what will happen next. The IMF is saying that despite recent massive interventions in financial markets by the U.S. Federal Reserve, the Bank of Canada and the Bank of England, things could get much worse.
Indeed, we could be headed for the worst financial crisis since the 1929 stock market crash and the Great Depression of the 1930s.
More
Love they neighbor – you may be living with them.
would you implement a bank holiday to deal with this international situation?
Right now we would have to think about the equivalent for the financial markets. In a way a bank holiday is already happening. Banks are refusing to lend to each other because they don’t know the credit risk in the transaction. The capital markets are shutting down one by one.
I suppose the central banks could declare a cooling off period where no interbank transactions are done, but this is impractical given that you would have to go country to country for legal approval. It seems better to let the market work through its uncertainties itself, though as the Bear Stearns deal proves, the central banks could stand behind the weakest link the market chain and prop up their deals until things sort out.
If in any particular country consumers start panicking and withdrawing deposits from banks, then a traditional bank holiday could be imposed in that country. I would expect to see this in some place like China rather than in the U.S. with its deposit insurance.
You forgot to continue with the rest of the scene, wherein the Mayor asks who is the nutjob (Venkman) and the EPA bureaucrat interjects himself. Venkman gets off one of the best lines in the movie when he responds to Hizzoner on hiring the Ghostbusters:
[Persuading the mayor to let them stop a supernatural upheaval]
Dr. Peter Venkman: If I’m wrong, nothing happens! We go to jail – peacefully, quietly. We’ll enjoy it! But if I’m *right*, and we *can* stop this thing… Lenny, you will have saved the lives of millions of registered voters.
Don’t forget Hizzoner looking over Venkman’s shoulder at the Cardinal who give’s Hizzoner the high sign to go along with Venkman.
Our problem in the current situation is that no one is bothering about the interests of those millions of registered voters.
By LIZ RAPPAPORT and JUSTIN LAHART
March 15, 2008; Page A1
The Wall Street Journal
The U.S. is at the receiving end of a massive margin call: Across the economy, wary lenders are demanding that borrowers put up more collateral or sell assets to reduce debts.
The unfolding financial crisis — one that began with bad bets on securities backed by subprime mortgages, then sparked a tightening of credit between big banks — appears to be broadening further. For years, the U.S. economy has been borrowing from cash-rich lenders from Asia to the Middle East. American firms and households have enjoyed readily available credit at easy terms, even for risky bets. No longer.
Recent days’ cascade of bad news, culminating in yesterday’s bailout of Bear Stearns Cos., is accelerating the erosion of trust in the longevity of some brand-name U.S. financial institutions. The growing crisis of confidence now extends to the credit-worthiness of borrowers across the spectrum — touching American homeowners, who are seeing the value of their bedrock asset decline, and raising questions about the capacity of the Federal Reserve and U.S. government to rapidly repair the problems.
Global investors are pulling money from the U.S., steepening the decline of the U.S. dollar and sending it below 100 yen for the first time in a dozen years. Against a trade-weighted basket of major currencies, the dollar has fallen 14.3% over the past year, according to the Federal Reserve. Yesterday it hit another record low against the euro, falling 2.1% this week to close at 1.567 dollars per euro.
Lenders and investors are pushing up the interest rates they demand from financial institutions seen as solid just a few months ago, or demanding that they sell assets and come up with cash. Banks and Wall Street firms are so wary about each other that they’re pulling back. Financial markets, anticipating that the Fed will cut rates sharply on Tuesday to try to limit the depth of a possible recession, are questioning the central bank’s commitment or ability to keep inflation from accelerating.
There are other symptoms of declining confidence. Gold, the ultimate inflation hedge, is flirting with $1,000 an ounce. Standard & Poor’s Ratings Services, a unit of McGraw-Hill Cos., predicted Thursday that large financial institutions still need to write down $135 billion in subprime-related securities, on top of $150 billion in previous write-downs. Ordinary Americans are worried: Only 20% think the country is generally headed in the right direction, nearly as low as at any time in the Bush presidency, according to the latest Wall Street Journal/NBC News poll.
“Clearly, the whole world is focused on the financial crisis and the U.S. is really the epicenter of the tension,” says Carlos Asilis, chief investment officer at Glovista Investments, an advisory firm based in New Jersey. “As a result, we’re seeing capital flow out of the U.S.”
That is a troubling prospect for a savings-short, debt-heavy economy that relies on $2 billion a day from abroad to finance investment. It is raising the specter of the long-feared crash in the dollar that could further rattle financial markets and boost U.S. interest rates. …
when we’re moving from recession to depression language in the space of roughly two months, following the stock market drop in January. Though, really, this may be a lot more practical and pragmatic than some of us hoped. From wikipedia, a former Fed chairman detailed the causes of the Great Depression. I felt like I was reading a current economic forecast at points.
from: http://en.wikipedia.org/wiki/Great_Depression
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth — not of existing wealth, but of wealth as it is currently produced — to provide men with buying power equal to the amount of goods and services offered by the nation s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers’ loans, and foreign debt. The stimulation to spending by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product — in other words, had there been less savings by business and the higher-income groups and more income in the lower groups — we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.
The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.
Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.
This then, was my reading of what brought on the depression.
I’ll start a soup kitchen
…all we’d need on top of this would be a massive agricultural failure.
… and be house poor.
is that I’m happy to have a well paying job, inflation adjusted, and not tied to the economy at large. If economic upset of this magnitude is going to happen at some point, I’m just as happy for it to happen while I’m 26, just gaining traction income wise, with few assets to lose and plenty of time to acquire more as things right themselves over time.
I should be fine.
It sounds good.
“Why, when I was young during the Bush Depression, …”.
In fact, I officially nominate that as the name for the next Depression. We had the Great War and then WWII, but it seems unfair to have the Great Depression and Depression II. We need something really descriptive, and what could be more appropriate than The Bush Depression.
It does honor to a family that gave us the worst president ever.
I like it “Bush Depression”, may I add the McCain exacerbation? and “Bare Sterns” to describe wall street?
I also suspect two other things:
1. Bush knows it as do his henchmen, so they are pumping liquidity into the system in an atempt to stave off “the great fall” this year, and blame it on their succssors.
2. Admiral Fallon knows Iraq is screwed, and an Iran war a must to deflect our attention from the coming depression, and wanted no part of it. His “indescretion” was deliberate, he’s too experienced to behave like this accidentally.
1. BushCo figured they could put off the reckoning until IBBYBG, but fate didn’t see it that way. Now it’s pull out the stops to CYA.
2. As you say, Adm. Fallon is too savvy to make a mistake like that. He’s sending a message to the country while also removing himself from the scene before th debacle.
Very good series of youtube videos: The Crash of 2008.
but with a twist
the average joe in the 20s losing spending power was a family farmer. the market forces pushing farmers off the land have to be added to the story
also, there was an international element to the banking practices. Huge recycling of German reparations from United States to Germany, and bizantine efforts to maintain the gold standard
Anyway, one thing I take away from my vaguely perceived history lesson is the need to take extraordinary efforts to save the spending of average folks, and for millions, that means housing prices. Wiping out paper profits is fine, even wiping out equity, but there has to be a floor, and people have to have confidence in it
banks won’t lend, for the reasons Numerian says
We need direct lending by the US. Just a hunch. Bit I see no other way
Last week, I inquired of the old Reagan Conservative, Paul Craig Roberts, as to what he would do regarding the precarious American fianacial situation, if he were the Number One at an Asian Rim Central Bank. His answer: ” I would flush ‘The World’s Only Superpower’ down the toilet”! While his response has a certain visceral appeal, I’m keenly interested in YOUR take on this very question! Thanks! JB ASPEN
China and Japan have much at stake in keeping the U.S. importing their products. Everyone recognizes that at some point the situation will have to be addressed because the trade and current account deficits are too enormous. But China and Japan want someone else to take the pain, and so far that has been Europe with the soaring euro. Unfortunately that game ended about six months ago. The yen is now joining the euro in the stratosphere, and China has been forced to push up the renmimbi to do something about domestic inflation. St
Still, there is every reason to think that the Asian powers will want a slow-moving adjustment, not something drastic that would occur if they just pushed out all their Treasuries on to the market. China in particular cannot afford the social unrest caused by a recession; witness the problems underway now in Tibet.
I can sympathize with P.C. Roberts frustration, however. For one, he has been on the receiving end of horrific abuse from his former Republican colleagues, even though he has been right about these problems for years when no one was listening.
Second, there is still no evidence at all that the United States is paying any real penalty for its deficit spending and profligacy. The housing collapse is a home-grown situation and cannot be blamed on the international markets. The dollar decline has been orderly and has not forced the Fed or White House to do anything reasonable to defend it (other than “strong dollar” comments that no one believes). The bond market has been chasing after Treasuries for a year now without the slightest hint that there is any underlying credit risk with the U.S. government. And that is the real problem that I suspect Roberts is referring to. There appears to have been a free lunch for the U.S. all throughout the Bush terms, and the usual discipline of the bond market has disappeared. Had it been there, the U.S. housing bubble might never have occurred.
This is really why I disagree with his suggestion. The U.S. deficits exist because China and Japan, and now the Gulf States and Saudi Arabia, enabled them by buying up all these Treasuries. It is very symbiotic and not too different from the systemic risk in the credit markets; it’s just a governmental version of the same thing. If the U.S. goes down the toilet, China and Japan at the very least will be following in the next flush.
The deflation of the depression did have the silver lining of creating a very strong currency and this provided Roosevelt with a very powerful tool in terms of respect and influence of the government. This was a major factor in the depression, WWII and really provided the foundation for the economy of the ’50’s and early ’60’s. This time, the value of the currency is being thrown on the fire as well. Combined with the extent to which respect for government has been debased, the next president isn’t going to have as strong a set of tools to work with, as Roosevelt had.
I also think Government debt was more responsible for bringing inflation under control in the ’80’s than anyone seems to consider, so the depths of this bubble go back to the late ’60’s.
The silver lining this time around is that we will have a very clean slate to rebuild the economy, since so very much of it is going to crumble. Our grandkids will thank us.
There will be many opportunities for character building. Of course, what doesn’t make us stronger, kills.
The Bush Depression is supported by BushBucks. BushBucks – like the president, nearly worthless.
“Frankly, we’ve lost a lot in recent years.” – General Colin Powell
it the Death Bet — the US knows that if anyone pulls the trigger, they shoot themselves too. The problem is, at some point, the costs of propping up the US may be more than the benefits, or it may be clear the US is going down anyway. China’s inflation issues are massively exacerbated by printing Yuan to buy US dollars.
… what can Joe citizen do?
I’ve been reading all this stuff for a couple of years now – from your site among others. Stuff like this led me to ensure we didn’t do a home equity/2nd mortgage, that we’ve shedded debt and we’ve tried to live within our means.
I’m not a financial/economic guru, but I can follow a lot of this –
and what I read here seems apocalyptic.
So what can we do? Aside from the facetious comments, I’ve not seen any real advice for someone with mortgage, kids, two jobs… and I have to admit, I’m losing sleep worrying about the things to come. I like to be prepared, or as best prepared as I can be… so what can Joe ordinary citizen do?
as Bloomberg Asia reporting right now that JP Morgan/Bear nearing agreement on sale. One can almost argue the case that the vultures waited for Bear to go to the wall, then suddenly – as its market value plummeted – several international financial institutions, including China’s CITIC, are showing keen interest in buyout. “Financial panic” indeed!
“les Etats-unis, c’est le seul pays à être passé de la préhistoire à la décadence sans jamais connaitre la civilisation… Georges Clemenceau
Soch a deal!!!!!!!!!!!!!!
“les Etats-unis, c’est le seul pays à être passé de la préhistoire à la décadence sans jamais connaitre la civilisation… Georges Clemenceau
Since I don’t know your personal situation.
People close to retirement may want to think about getting out of the stock market, and putting their 401k holdings in U.S. government bonds. Buying municipal or corporate bonds in a mutual fund doesn’t ensure that you are free of credit risk.
People who are much younger may want to hold on to equities if you are comfortable the companies are going to be around over the next 5 years or so, and you don’t need the money in that period of time, and you can sit out pretty dramatic paper losses.
Cash in a bank insured by the FDIC is safe up to $100,000 per individual, but make sure it is a bank covered by the FDIC. Brokerage firms or brokerage subsidiaries of banks (like Salomon Smith Barney of Citibank) do not carry such insurance and are not guaranteed by their bank nor does the Fed back them up (though Bear Stearns may change that assumption). Credit unions don’t carry FDIC insurance either. These firms do have some third party insurance, but it is untested in a severe market downturn.
Everyone should have a cash flow plan for the next five years. Is there enough cash on hand to meet all your pressing needs, plus emergencies or other requirements like loss of job, medical insurance, college costs. If you don’t have a cash kitty, how are you going to build it up. It is possible for most people, and I suspect in the next year you will be reading about families doubling up in housing to share costs or other such drastic measures.
This is overall advice for tough times. Again, don’t just go by me. Find someone you can trust who can go over your finances in detail.
Sean-Paul has just posted the news. That is actually not a good figure for the market despite the fact that Bear Stearns will not go into bankruptcy. It means it effectively is bankrupt and JP Morgan Chase has just bought the corpse.
Doesn’t JP Morgan have any cash to at least make the deal look like it has some value? I wonder what the Bear Stearns shareholders are going to do when they get delivery of their new JPM shares? After what they’ve just experienced, I suspect they’ll dump those shares as fast as possible.
On the other hand – this deal has just wiped out millions of dollars of wealth that the Bear Stearns management, employees, and retirees thought they owned. In fact, this is probably the worst sort of thing to befall Wall Street bankers, since increasingly their munificent bonuses have been paid in company stock. There are a lot fewer millionaires on Wall Street tonight, and every investment banker working at Merrill, Lehman, Goldman, and Morgan Stanley has to be quaking in their boots because the same thing can happen to them.
Interesting times.
about greed backfiring back on the greedy people.
The sad part is that the average person has to pay the toll.
I don’t think you can blame it on union workers. But you can blame it on the greedy unions who have become the same as what they were fighting for. Big Business.
repressive governments mix administrative clumsiness & inefficiency with authoritarian tendencies.
This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.
—T.S. Eliot, “The Hollow Men”
Turn back to the Constitution – and READ it.
the same time, Paulson sought to send a calming message that the Bush administration is on top of the turbulent situation.”
Then everything should be just hunky-dory. I mean, why wouldn’t those words inspire confidence?
I figure that’s what the modern-day Hoovervilles will be called. Or maybe Bushvilles, or if the worst fall is held off until after the election, McCainvilles or McCaintowns. Something like that.
Oh, and the proper term for this depression will be the Greater Depression. It will last longer and deeper than the other big one. Of course, that predicated on the fact that there will be anyone left civilized enough to worry about writing about it.
Y’all oughta be watching Mad Max, Road Warrior, and Beyond Thunderdome in the next couple weeks, catch up on your future… The Oil Wars ain’t even begun yet, and then the bombs start falling…
Apocalypse Khan
the big rescue may be just the beginning:
of putting stainless-clad appliances and Sub-zero fridges and granite countertops with controlled lighting in kitchens that no one ever cooks in (honest–I have friends that do little more than make coffee and use the microwave in their white-elephant kitchens), I wonder if I should start a diary thread of cheap, simple-to-make recipes. (I’ve got a million of ‘em).
I think we’re going to need it.
be cool.
The Week That Shook Wall Street: Inside the Demise of Bear Stearns
Wall Street Journal, By Robin Sidel, Greg Ip, Michael M. Phillips * Kate Kelly, March 18
The past six days have shaken American capitalism.
Between Tuesday, when financial markets began turning against Bear Stearns Cos., and Sunday night, when the bank disappeared into the arms of J.P. Morgan Chase & Co., Washington policy makers, federal regulators and Wall Street bankers struggled to keep the trouble from tanking financial markets and exacerbating the country’s deep economic uncertainty.
The mood changed daily, as did the apparent scope of the problem. On Friday, Treasury Secretary Henry Paulson thought markets would be calmed by the announcement that the Federal Reserve had agreed to help bail out Bear Stearns. President Bush gave a reassuring speech that day about the fundamental soundness of the U.S. economy. By Saturday, however, Mr. Paulson had become convinced that a definitive agreement to sell Bear Stearns had to be inked before markets opened yesterday.
Bear Stearns’s board of directors was whipsawed by the rapidly unfolding events, in particular by the pressure from Washington to clinch a deal, says one person familiar with their deliberations.
“We thought they gave us 28 days,” this person says, in reference to the terms of the Fed’s bailout financing. “Then they gave us 24 hours.”
“Frankly, we’ve lost a lot in recent years.” – General Colin Powell
March 18, 2008; Page A22
The best thing about Sunday night’s Federal Reserve-inspired sale of Bear Stearns to J.P. Morgan Chase is the price. At $2 a share for a total of $236 million, this was less a “bailout” than a Fed-mediated liquidation sale. Bear wasn’t too big to fail after all, though there’s still the issue of the Fed expanding its own moral and financial hazard in the form of $30 billion in guarantees on Bear Stearns securities.
Bear shareholders will essentially be wiped out in this close-out sale, with British billionaire Joseph Lewis alone reportedly enduring paper losses of $800 million on his 9.6% stake. Even on Wall Street, that’s real money. Jimmy Cayne, the Bear Chairman and former CEO who supervised this disaster, will lose a bundle on his nearly 5% holding. This makes the Bear sale different from the Fed-managed Long-Term Capital Management rescue of a decade ago, when investors were left substantially intact. We doubt many bankers will look at Bear’s fate and claim there’s no punishment for financial error.
Bear employees, who hold about one third of its shares, are angry and grousing that they could get more cents on the equity dollar in Chapter 11. Some may even be inclined to vote against the sale, but then they’d have to find a market for that $30 billion in mortgage securities that no one wants to finance.
The hard capitalist truth is that Bear’s most senior managers have mainly themselves to blame. They bought their second or third homes with fabulous bonuses during the good times, and they must now endure the losses from Bear’s errant investment bets. Bear took particular pride in its risk management, but it let its standards slide in the hunt for higher returns during the mortgage mania earlier this decade. There’s no joy in seeing a venerable firm expire, but it has to happen if financial markets are going to have any discipline going forward.
As for J.P. Morgan and CEO Jamie Dimon, remind us to have him negotiate our next contract. He gets Bear’s best assets, including a Manhattan building said to be worth $1.4 billion by itself. Meantime, he gets the Fed to backstop Bear’s riskiest paper. We don’t know the quality of that paper — and we hope the Fed has done its due diligence — but taxpayers are now on the hook for future losses. Some previous Fed officials might have told Mr. Dimon to take all of Bear or nothing at that $2 liquidation price, but Ben Bernanke and Tim Geithner of the New York Fed seem to have been desperate to get a sale announced before markets opened on Monday. Mr. Dimon took them to school.
more
It’s time to stop pretending. Deflation is here and it is now. Anyone who sees stagflation or inflation out of what’s happening now missing the boat. Let’s consider the evidence.
“Frankly, we’ve lost a lot in recent years.” – General Colin Powell