Wednesday, March 19, 2008

The Fed Did What???

This will be a long post. In an unprecedented move over the weekend, the Fed bailed out the 5th largest investment bank, Bear Stearns, by providing backing for its sale to JPMorgan Chase. This action is particularly unusual given that a single firm is the target of this bailout strategy, something that hasn't happened since the Great Depression.

There are only two times that I can recall in recent history that the Fed has intervened in a psuedo-similar fashion and in neither case was a single entity involved. Interestingly, while most economists and politicians loathe public bailouts, in both cases the federal government ulitimately made money on them.

The first was during the 1995 peso crisis, when the Clinton administration offered Mexico $20 billion in loans, with the country's oil revenues as security. The International Monetary Fund offered another $18 billion. Critics condemned the loans as a bailout. However, in the end, Mexico did not require the entire amount, the country's finances recovered, and the U.S. ended up making a profit on the interest payments.

The other situation of similar intervention came when the government turned a profit from the Air Transportation Stabilization Board, an entity set up after the 9/11 attacks to support the airline industry. The board utlimately provided a total of $1.56 billion in loan guarantees to six carriers. The government earned just under $350 million from fees and stock sales, according to the Treasury Department.

So what was special about this situation? How did the situation get this bad? John Waggoner and David Lynch offer this succinct explanation:

Bear Stearns failed because its investors no longer believed it could repay its loans — even its short-term, overnight loans. Even worse, investors concluded the bank no longer could stand behind the complex agreements it had with other financial institutions. And Bear Stearns had a web of intertwined agreements with other banks, investment houses and corporations.

So while its demise could send ripples through the economy, its significance helped lead the Federal Reserve to support JPMorgan Chase's offer for Bear Stearns. As part of the deal, the Fed agreed to fund $30 billion of Bear Stearns assets that would be difficult to sell quickly, raising the possibility that taxpayers could be on the hook for part of the bailout.

The road to Bear Stearns' collapse — and the Federal Reserve's response to it — began with the housing bubble. As home prices soared to economically unsustainable levels, fewer people could afford to buy. In response, banks and other lenders created new types of mortgages, which made loans affordable to people who normally wouldn't qualify for a conventional 30-year mortgage.

The beauty of these subprime mortgages, at least from a mortgage broker's point of view, was this: Banks and brokers collected fees for closing the deals but faced no risk once they sold the loans to Wall Street.

Wall Street was eager to buy subprime loans, mix them with other types of debt, package them into complex securities and sell them to other investors. As long as housing prices continued to soar, everything seemed fine. Borrowers in shaky loans could refinance their loans or sell their homes for big gains. Investors in the new securities that Wall Street created could enjoy rich interest payments.

Once the housing market started to fall, though, borrowers started to default on mortgages. As defaults piled up, the complex securities Wall Street had created from those mortgages began to crumble. More and more lenders grew wary of making loans, especially if the collateral was mortgage-backed securities.

Bear Stearns was one of the biggest underwriters of complex investments linked to mortgages. Two of its hedge funds, heavily invested in subprime mortgages, folded in July. Bear's investors became increasingly reluctant to do business with the company. Despite the company's assurances that it had plenty of cash on hand to continue operations, it collapsed Friday.

The story of Bear Stearns isn't just a saga of a spectacular Wall Street failure. The company's failure signals far deeper problems with the nation's economy and raises questions about the consequences of Bear Stearns' problems for ordinary Americans.

So how will all of this affect you???

The yields on money market mutual funds and bank deposits will fall, as the Fed continues to cut interest rates. Stock prices will continue to be extremely volatile. The good news is that financial markets have not collapsed. The stock market bounced back on Tuesday, with the benchmark S&P 500 experiencing its best day since October 2002.

The value of the U.S. dollar will continue to sag, thanks to lower interest rates. As interest rates here fall, global investors sell their dollar holdings to find investments with higher returns. That pushes the dollar's value lower — meaning Americans face higher prices.

Notable quotes that I think reflect the underlying current of these recent events:

"Recessions are almost always crisis of confidence, and that's what we're having right now" -- David Wyss, chief economist at Standard & Poor's.

"The market was being run by mathematicians that didn’t know financial markets. And you keep hearing... 'that event should only happen once every hundred years, according to my model'. But those every hundred years events are coming along every two or three years, which should raise some questions." -- Former Federal Reserve Chairman Paul Volcker.

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