Tuesday, March 18, 2008

The bailouts have begun

“Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or financial institution.”

That was Ben Bernanke, just 10 months ago, discussing his reluctance to regulate the booming market for arcane credit instruments. Fast forward to March 2008, and the afore-mentioned remark is coming back to haunt the Federal Reserve Governor. The world has changed so much, and so has Ben Bernanke. In the fickle world of global financial markets and its supposed regulators, "moral hazard" is no longer the concern, and bailout time has arrived. Edmund Andrews has this excellent chronology of the whole sub-prime crisis, leading up to the latest big blow - the collapse and bailout of Bear Stearns, the largest prime brokerage house.

The guarantee of a 28-day credit line to Bear Stearns, engineered through JPMorgan Chase by the Federal Reserve Bank of New York last week, is a defining moment in the crisis, with implications that go far beyond the immediate short term. It is the clearest yet indication to Wall Street that no sizeable firm with a book of mortgage securities or loans out to mortgage issuers will be allowed to fail right now. Bear Stearns will not be the first to fall wayside and cry for help, only to be rolled out the bailout carpet! It is only the new LTCM!

The Bear Stearns bailout did not stop with the facilitation process for a private takeover by JP Morgan Chase. The Fed also announced a $30 bn line of credit to JP Morgan Chase to engineer the takeover of Bear Stearns. This was an extraordinary bargain for JPMorgan Chase - buying Bear Stearns at a tiny fraction of its market value just one week ago, and with the Fed shielding it from much of the risk.

This was followed by an unprecedented open-ended lending program for the biggest investment firms on Wall Street and lowering of the rate for borrowing from its so-called discount window by a quarter of a percentage point, to 3.25 percent.The move is aimed at preventing a chain reaction of defaults.

The credit squeeze which started with sub-prime mortgage holders facing difficulty in finding lenders, has spread to cover all short-term commercial debt, known as asset-backed commercial paper - used to finance mortgages, credit card debt, car loans and business loans. As Wall Street Banks strated taking multi-billion dollar write-downs, they have stopped lending and have been asking hedge funds and other borrowers to put up more money on the table to cover their borrowings. These margin calls are forcing sell-offs by hedge funds and other borrowers, making even relatively safe instruments like Municipal Bonds look risky.

The cassandras of doom among the financial analysts and the media covering Wall Street, have been spinning out stories one after the other about the potential losses. Bernanke himself initially estimated the sub-prime losses at just $100bn last July. On March 7, 2008, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn, assuming a peak-to-trough house price fall of 25 per cent. Martin Wolf chipped in with losses amounting to $1,000bn. Prof Nouriel Roubini of New York University’s Stern School of Business broke new ground by prophesying the losses at a massive $3,000bn. The total volume of mortgage backed securities is about $6.1 trillion. The race to the discover the bottom goes on.

Financial media and commentators are calling for Government and Fed intervention, so as to "prevent the crisis spreading to other markets", a by now commonly touted reason for bailouts. That Wall Street and its media are experts at spreading fear is well chronicled - sample this by Ben Stein about Goldman Sachs. This frenzied race to the bottom has generated a fear psychosis that is threatening to sweep away the Bernanke and Co.

With every passing day, and more bad news spilling out, the Fed is forced to lower rates or step in with extraordinary measures like accepting even non-tradeable mortgage backed securities for its Term Auction Facility (TAF) loans. Wall Street expectations are for ever lower interest rates, so much so that the effect of any rate cut this week is likely to be minimal and and very short term. The fear is that the monetary policy is now a virtual fait accompli, dictated by media and Wall Street pressures, than by rational considerations and professional expertise of Bernanke and his colleagues in the Fed.

Update 1
As expected, the Fed caved in and lowered the Federal Funds rate, the short term rates charged on banks for overnight loans, rates by an unprecedented 75 basis points to 2.25%. This is the sixth cut in six months, and it now appears to be only a matter of few months before we reach ground zero, leaving the Fed with little room to even manouevre. Further, as the interest rate buffer gets reduced the inflationary and other recessionary expectations gets accelerated.

Update 2
Paul Krugman in his inimitable style describes the Fed policy as equivalent to putting out fire in a crowded theatre without a fire engine.

He writes, "Bank runs come in two kinds. In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire. In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We’re in the second case. The Fed has spent the last 7 months trying to assure people that there isn’t any fire. But there is. Worse yet, thanks to decades of deregulation, the theater doesn’t have a sprinkler system - and the town the theater is in doesn’t have a fire department. And now we have to put together an emergency response."


Nitin Goyal said...

Amazing to see these events unfold. These days, as one of my Profs used to say, even the Governments are powerless over the forces of International Finance. Central banks, Federal Governments have not much power over the flow of capital and find it virtually impossible to rein in these forces.

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