The venerable bank’s possible collapse is a very important but complicated Wall Street story that needs lots of explanation. Several weekend pieces provide good primers on what's going on and why. A good place to start is Tom Petruno's LAT column. Petruno suggests that unlike the one-shot bailout of investment fund Long-Term Capital Management in 1998, the capital infusion of Bear Stearns could be just the start of Wall Street banks needing government help. In the end, it could be too late. Economist Allen Sinai says, "we will lose, in some form, several major financial institutions before this is over."
The heart of the problem is that the nation is living through an unwinding of a 25-year-long, consumer-led borrowing binge. Bear Stearns was a key player in financing that binge, most notably in high-risk mortgages. Wall Street in recent years designed ever more creative ways to transform loans into bonds and sell them to investors who were hungry for interest income. That alchemy reached its zenith with sub-prime mortgages -- loans to people with dubious credit. Even as investors poured hundreds of billions of dollars into sub-prime-mortgage bonds from 2003 to 2006, there were ample warnings that many borrowers were vastly overstretched. But it wasn't until housing prices began to implode last year, and mortgage defaults rocketed, that banks, brokerages and investors came to realize they had gone too far. Now, with the U.S. financial system already overburdened with debt, many investors simply don't want to take a chance on owning more of it -- unless it's the direct obligation of the U.S. Treasury.
A NYT news analysis by Jenny Anderson and Vikas Bajaj points out that Bear Stearns facilitates the borrowing and lending of financial paper for individuals, corporations, financial companies, pension funds and hedge funds. It’s usually not very glamorous, but it’s what makes capitalism work.
The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual. Hedge funds that rely on Bear to finance their trading and hold their securities would be stranded; investors who wrote financial contracts with Bear would be at risk; markets that depended on Bear to buy and sell securities would screech to a halt, if they were not already halted. “In a trading firm, trust is everything,” said Richard Sylla, a financial historian at New York University. “The person at the other end of the phone or the trading screen has to believe that you will make good on any deal that you make.”
NYT columnist Floyd Norris says the current financial system has largely marginalized traditional banking and lets lenders evade much of the regulatory framework that goes back to FDR's days.
The new system enabled loans to be made by almost any financial institution with the money coming from the sale of increasingly complicated securities backed by the loans. Regulators believed that the new system spread out the risk. Alan Greenspan, a former chairman of the Federal Reserve, said the system had transferred risk from banks — which he called “highly leveraged institutions” — to “stable American and international institutions.” It turned out he was wrong. Much of the risk had remained with commercial banks, but packaged in such a way that they were required to put aside fewer reserves to protect against losses. Much of the rest of the risk ended up with financial institutions that relied on their ability to borrow at low rates whenever they needed it.
The WSJ's Liz Rappaport and Justin Lahart report that global investors are pulling money from the U.S., which steepens the decline of the U.S. dollar. Despite the Federal Reserve's efforts to cut interest rates, lenders are pushing up rates or demanding that borrowers sell assets and come up with cash.
Hopes are fading fast that the U.S. economy was suffering from a thirst for liquidity that standard Fed remedies could quench. Former Treasury Secretary Lawrence Summers, speaking in Washington yesterday, said he sees "an increasing risk that the principal policy tool on which we have relied -- the Federal Reserve lending to banks in one form or another" -- is like "fighting a virus with antibiotics." Bob Eisenbeis, a former executive vice president of the Federal Reserve Bank of Atlanta, says the problem is more than an inability to find ready buyers for assets. "It is time to step back and recognize that the current situation isn't a liquidity issue and hasn't been for some time now," said Mr. Eisenbeis, the chief monetary economist for Cumberland Advisers. "Rather, there is uncertainty about the underlying quality of assets -- which is a solvency issue, driven by a breakdown in highly leveraged positions."