It’s hard to imagine the total meltdown of the country’s No. 5 broker, the likely loss of 7,000 jobs and the fact that $18 billion in market capitalization went POOF! was the good news story of the week.
But if Fed Chairman Ben Bernanke hadn’t stepped in to rescue Bear Stearns from certain bankruptcy and insisted a deal be in place before markets opened in Asia for the new trading week, the country’s entire financial system could have collapsed.
A Bear bankruptcy could have forced the Dow Jones industrial average into a 1,200-point dive in the first hour, and hedge funds that trade through Bear would have been frozen.
Investors, hearing of the collapse of Bear, would very likely create a run on their investment banks and panic would have spread throughout the land – the way blackouts leap from one community to the next along the grid.
So Bernanke’s arm-twisting of Bear executives to accept the $2 a share late-night deal and his decision to change 50 years of Federal Reserve policy and allow brokerages to borrow directly from the Fed – even though it will likely result in massive layoffs and fiscal pain for all of Bear’s 14,000 employees – was indeed good news.
IT was no surprise that Ber nanke went all-in. An expert on Fed policy during the Great Depression who was called upon to consult with Japan’s Central Bank some years ago during that country’s long economic downturn, Bernanke is a staunch proponent of an aggressive Federal Reserve.
Bernanke once said, “To understand the Great Depression is the holy grail of macro-economics. . .” He is hoping to prevent a 1930’s style crisis complete with a run on the banks and credit erosion, which, in turn, will bring banking activity to a screaming halt.
“The experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns,” he said in May 2004, when he was a Fed governor.
A year earlier, Bernanke told the Japan Society of Monetary Economics that the public expects the leaders of the central bank to take more aggressive actions the further they are from their announced objective.
The $30 billion backstop the Fed gave JPMorgan in their takeover of Bear was certainly what was required to get the deal done. Jamie Dimon needed the Fed assurances to confidently go in and stand behind Bear’s troubled balance sheet.
This gamble does not come without risk.
Some say that if a good piece of the housing market doesn’t come back, then the Fed’s gamble to accept mortgage debt as collateral for loans will cost the taxpayers plenty. But so far, Bernanke’s moves seem to be working.
In the first week that the Fed allowed brokers to borrow directly, $28.8 billion was loaned out. As a result, the balance sheets of investment banks are looking stronger and investors, who had run away from financial sector stocks toward commodities for several months, are now diverting cash back into the Merrills, Lehmans and Morgan Stanleys of the world.
Indeed, the S&P 500 Index posted its first weekly gain in a month following the Fed’s move.
Bernanke’s moves have also cut the gap between Treasuries and corporate bonds – thus finally bringing down mortgage rates.
THAT doesn’t mean the markets have hit a bottom or that the credit crunch is over.
Wall Street, after all, has been selling the risky subprime-wrapped CMOs for a long time.
Wall Street also likes to find a profit center and exploit it until every last drop has been squeezed out of it. The Street found a way to package all grades of mortgages and slice and dice them into complex securities obscuring the risk.
With the collapse of the mortgage bond business, thousands of brokerage employees will find themselves out of work.
Economists, journalists and investors will second-guess his actions but I applaud his sense of urgency and willingness to fight for a solution rather than take a passive stance and do nothing.
Leverage has been around since the beginning of time. It is very common for funds to use 4-to-1 and even 5-to-1 leverage.
Unfortunately, the numbers being thrown around by private equity, hedge funds and investment banks are gargantuan. Models built on 40, 50 and even 70-to-1 leverage can cause systemic damage beyond our worst fears.
Tom Hallen, of ION Partners, in Santa Monica, Calif., has done some excellent analyst work on this. Tom pointed out that leverage of this magnitude might take years to unwind and it is very clear that the big unwind has begun.
As free marketers we have been proponents of deregulation and government keeping a hands-off policy.
Many times I have spoken out against excessive government interference, as I have always believed that free markets function best when left alone.
Unfortunately, as an industry, we failed to police ourselves and now face the consequences.
Obviously, the Fed and regulators were asleep at the wheel. While the crisis peaked on Ben’s watch, former Fed chief Alan Greenspan kept rates dangerously low for too long.
The price for our failures is that the pendulum is going to swing all the way to the left as bill after bill comes out of congress looking to regulate every aspect of the financial markets.
On Thursday, Rep. Barney Frank (D-Mass.), who chairs the house financial services committee said the Federal Reserve should broaden its powers and act as “financial services risk regulator.”
Surely, others will follow. The danger to the system is that well-meaning lawmakers will each try to impose their remedy and together the package of cures could be more toxic than Wall Street’s greed.
David Nelson is the CEO of DC Nelson Asset Management.