Month: March 2008

Did the Fed Bag the Bear?

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Is this the week that the Fed destroyed the bear stearns village in order to savbe it  — or vice versa? 

On Tuesday, the Federal Reserve announced a new, unprecedented arrangement to provide credit in the form of Treasury securities against discounted mortgage-backed collateral  of up to $200 billion that would be available to broker-dealers,  as distinct from lending to banks through the Reserve Bank’s “discount window” and previously announced and executed special auctions also limited to commercial bank participants.

In retrospect after Friday’s emergency action to provide a loan of undisclosed size to Bear Stearns to keep the firm temporarily afloat through the intermediary of J P Morgan,  it seems apparent that the Tuesday plan was designed to help one particular broker-dealer — namely Bear Stearns —  to deal with the seriously adverse balance sheet consequences of hedge-fund positioning gone awry in terms of the rapidly-widening spreads between Treasury securities and mortgage-backed issues: ie, it seems that it was the Bear that was holding the bag! 

But what if some discerning market participants didn’t really need to wait until Friday to figure that out? And what if these participants, understanding that the first availability of the credit facility announced by the Fed on Tuesday was not to come until the end of this month, smelled enough Bear Stearns blood in the water — as a result of the Fed’s own announcement — to call in their credit lines to that firm in such a fashion that Thursday night’s funding crisis for Bear was the result?

If that is the case, then the Fed woke up Friday to an emergency that it had perhaps itself unwittingly abetted with an all too obviously telegraphed pass that sent a message to Bears’ creditors to “get out while the getting’s good”?

As for Bear Stearns, it now looks like putting a couple billion of the firm’s albeit modest capital into their hedge funds caught in the subprime squeeze last July might have been a cheap price to pay to live to trade another day.

Should Ben the Barber Follow the Haircut with a Rate Cut?

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The Chairman of the Federal Reserve spoke truth to Paulson this week. Acknowledging the depth of the housing finance crisis (and, like his predecessor, acknowledging the limitations of Fed rate cuts in terms of solving the problem),  he directly countradicted Bush Administration policy and urged bankers to accept the reality that they are better off haircutting the principal of underwater mortgages than triggering foreclosures of those mortgages.

The banks would thus not be forced into steep write-offs immediately but only the more minor haircuts involving the excess of mortgage amount over current house price value, and could also move to secure a first-in-line claim on any subsequent price appreciation to claw back the haircuts at a time of later sale

Bernanke was in effect saying that the moral hazard involved in bailing-out the balance sheets of both improvident mortgagors and mortgagees in this manner is less damaging to the economy as a whole than a period of steeper write-downs in the banking industry, a collapse of mortgage credit altogether, and a resultant severe economic contraction that even lower Fed funds rates will be too late to stop. His is neither a Japanese solution to a real estate meltdown (leave the sorry loans on the books too long) or the doctored accounting solution that propped-up the S&L industry in the US in the 80’s well-past its “use-by”‘ dates. His suggestion involves real pain, but more controlled pain — tiring to the body perhaps like targeted radiation, but not sickening altogether like the chemotherapy of excessive rate cuts that also debase the currency and trigger further commodity inflation  (at least until that boom is busted by the realities of recession).

Yes, he is making a policy suggestion that to some degree would takes pressure off the Fed  –not to mention the declining US dollar, which could firm if the Government acted to facilitate Bernanke’s barber-shop move. But the Government shows no sign of doing so — especially by authorizing more Federal agency  mortgage purchases and guarantees.

It is therefore quite possible that the inter-meeting rate cut device employed in January to stave off a capital markets rout will be back on the table — maybe as early as this Friday or Monday morning. There is just too much panic in the US capital markets since Bernanke called the question on the underwater mortgage mess, further illustrated by this week’s figures on increased foreclosures and home equity value deterioration. One thing the economy cannot stand is a stock market crash on top of a credit crunch.