Bear Stearns: politicians bail out

The US Federal Reserve’s dramatic move to rescue the struggling investment bank Bear Stearns last week may be the event that well and truly stamps the developing financial crisis on to the American public’s consciousness. The unwinding of subprime mortgage loans has been an ongoing concern since last summer, but so far many of those not directly affected have tended to treat it like unpleasant background noise.

The Fed’s emergency salvage of Bear Stearns seems to have changed all that. Many sensed that the American central bank’s intervention had a strong whiff of panic about the fragility of the whole financial system. Worries about the credit crisis went up a big notch. Combined with news during the week of higher oil prices, a further decline in the dollar and more evidence that the US is in recession, the Bear Stearns situation made many stop and think that the country is perhaps in the midst of a far worse economic predicament than previously thought.

Since the 1930s, government interventions to prop up banks have been rare. The Fed could have done nothing and simply waited to see if Bear Stearns went bankrupt. In fact, some critics of its intervention argued it should have done just that, saying that its move only creates a ‘moral hazard’. That is, it encourages other banks to take on risky, bad debts knowing they will be bailed out if all else fails. But, in the context of a nervous market, the Fed feared the run on Bear Stearns, the fifth largest investment bank in the US and a key intermediary in many basic transactions, would have a domino effect that could lead to interruptions in dealings and wider instability on Wall Street.

In the event, Bear Stearns’ share price plummeted on Friday, and stocks generally were down but did not crash. On Sunday evening, JP Morgan Chase, the global financial services firm, agreed to buy Bear Stearns for a mere $236million, far below the $3.5billion it was worth on Friday evening. The Fed certainly hoped its move had contained the volatility. However, when the market opened on Monday there were still worries that Bear Stearns might even collapse entirely before the deal is completed, and that the insecurity might spread to other banks and firms.

The Bear Stearns episode has its roots in the subprime mortgage crisis that emerged in August 2007. Relaxed credit conditions led to housing loans being extended to those who really were not credit-worthy, which in turn underpinned a house price bubble. But when credit is overextended there is eventually a day of reckoning, which in this case arrived last summer, when house prices fell and default levels rose. Many blamed negligent lenders or foolish borrowers, but the underlying issue – easy money – was, as has been explained on spiked before, the result of a sluggish American economy and an influx of funds from Asia (1).

Subprime loans might have been an isolated problem, if it were not for the fact they were ‘securitised’ – that is, packaged into financial instruments and sold on to other institutions. This spread the risk among various organisations, but also generalised the problem across the system. When it became clear that these bad mortgage debts needed to be written off, it was not clear who held this debt, and thus all became suspect or ‘contaminated’. Uncertainty led to a freezing of the money markets generally: banks held back funds to boost their balance sheets in case of possible devaluations, and potential lenders forestalled loans, as they feared borrowing institutions might not be able to repay them.

In this credit-squeezing environment, Bear Stearns was certainly very exposed. It is highly leveraged – its balance sheet of $395billion is built on only $11.8billion of capital from shareholders. To finance this balance sheet, Bear Stearns has relied on short-term loans secured against its portfolio of bonds, including mortgage bonds. As these bonds fell in value, the loans were less forthcoming.

Moreover, the collapse of Bear Stearns shows that the credit crunch is unfolding and spreading even more widely – moving from ‘contamination’ to ‘contagion’. What began as a problem with subprime mortgages has metastasised to mortgages in general and to other forms of debt, such as hedge fund borrowings and corporate, municipal and personal debt. As James Grant wrote in the Washington Post, it now appears that carefree lending, rather than being limited to subprime mortgages, ‘turns out to have been a kind of universal American business model’ (2). Today’s ‘contagion’ actually reveals that the subprime crisis was just the initial expression of a broader underlying problem of surplus capital going into credit reserves rather than new productive investment.

The process of unwinding bad debt can take on a dynamic of its own, and might potentially get out of control. The question stalking Wall Street now is, who’s next? Other investment banks, while perhaps on a more sound footing than Bear Stearns, are also dependent on the confidence of their trading partners. A hedge fund managed by private equity firm the Carlyle Group collapsed last week, and more may follow.

In response, the Federal Reserve seems to be throwing everything it can think of at the credit crisis. Earlier last week, before the Bear Stearns’ bailout, the Federal Reserve announced a $200billion lending programme for investment banks, agreeing to accept the risky mortgage-backed securities as collateral. On Sunday evening, the Fed introduced a broad expansion of its lending, allowing securities dealers to borrow from it on similar terms as banks. It has also cut interest rates five times since September, and is expected to do so again on Tuesday.

As the New York Times noted, the chairman of the Federal Reserve, Ben Bernanke, ‘has long argued that a central bank should base its policies as much as possible on consistent principles rather than seat-of-the-pants judgement’, but now he ‘is inventing policy on the fly’ (3). It is reminiscent, as another commentator put it, of Hillary Clinton’s strategy of throwing the ‘kitchen sink’ at Barack Obama (4). And as with Clinton’s approach, there is clearly a sense of desperation in the Fed’s moves. In recent years the authorities have appeared to handle coolly the challenges that have emerged; for example, the 1998 failure of Long Term Capital Management was contained without the government having to inject funds (instead, it encouraged investment banks to pony up). But, as the steps taken following Bear Stearns’ collapse show, we have now entered uncharted territory and the authorities seem much less sure-footed.

Beyond the Fed’s monetary measures, many have also called for tougher regulation from Washington. But both the Fed’s actions and other regulatory moves are unlikely to address the full extent of the underlying crisis. Furthermore, the call for new, tougher regulation ignores the fact that increased regulation has arguably made today’s credit crunch worse. For example, in the name of introducing greater transparency, the accounting authorities have introduced ‘fair value’ or ‘mark-to-market’ accounting, which is meant to price assets according to the value they can obtain on the market.

But, as critics note, the problem is that there often is not a market for these assets, and the values become just guesses (5). This new accounting approach has forced banks to write down assets they would not have had to write down in the past. In turn, banks have restricted their lending, forcing more asset sales by hedge funds, which leads to even lower prices, more write-downs and a downward, self-reinforcing spiral. Financial crises tend to have such self-reinforcing dynamics, but this time the regulatory requirements have exacerbated the problem.

While the financial crisis expands, many have wondered, where are the elected politicians? Why have they been so quiet? President George W Bush seems to enjoy being considered a lame duck, finding it a relief from having to deal with anything. Clinton and Obama are apparently too busy fighting off guilt-by-association with the identity wars blasts from the likes of Geraldine Ferraro and Reverend Jeremiah Wright, and calling for each other’s aides to be fired, to notice. And Senator John McCain probably doesn’t have anything to say until the Democrats are finished picking their candidate.

The financial crisis should not be mistaken for an economic crisis affecting production. Just because the credit crunch is occurring at the same time as a recession doesn’t mean we’re on the verge of re-running the Great Depression. But it’s still remarkable that the political class acts like these problems are occurring in a parallel universe. Maybe Bear Stearns and its aftermath will shake them from their slumber, but their initial listless response suggests we should not have high expectations.

Sean Collins is a writer based in New York.

(1) See The truth about the ‘credit crunch’, by Phil Mullan, 7 January 2008, and How Asia bails out America, by Daniel Ben-Ami, 24 January 2008

(2) A Bear Stearns market, Washington Post, 16 March 2008

(3) Fed chief shifts path, inventing policy in crisis, New York Times, 16 March 2008

(4) Ben Bernanke in dilemma over bank bail-out, The Sunday Times (London), 16 March 2008

(5) ‘Is fair value accounting really fair?’ by Emily Chasan, reuters.com, 26 February 2008