The Federal Reserve System tried to reshuffle the financial deck late March 16. For the next 24 hours, the global financial markets tried to figure out where the Fed’s action left the system. At the end of the day, they were not happy. But at the same time, they were not suicidal. That represents a victory for the Fed.
It is important to understand what the Fed was trying to achieve. In essence, its goal was not complicated. It was trying to manage the collapse of a financial institution — Bear Stearns — such that it did not default on its clients, individual and institutional. The threat it faced was of bank failures, in which depositors would lose their savings. If Bear Stearns had been unable to carry out financial transactions on Monday morning because of a lack of cash, its clients effectively would have found their assets frozen. And that would have touched off a ripple through the financial system that might have caused a series of uncontrollable failures.
The Fed did two things to prevent this scenario. First, it engineered a buyout of Bear Stearns by JPMorgan Chase at $2 a share. The Fed was not at all interested in protecting investors in Bear Stearns, who were nearly wiped out. Nor were they interested in protecting Bear Stearns employees. The Fed was interested in having JPMorgan Chase — a huge bank with a strong balance sheet — in effect guarantee the liquidity of Bear Stearn’s account-holding clients, thus avoiding the threat of falling dominoes.
The Fed’s second move was to redefine the rules of access to low-cost, short-term financing from the Federal Reserve. Historically, such financing has been confined to banks. It has now been extended to brokerage houses. By doing this, the major brokerage houses can access money from the Fed for 90 days, up from 30. That sets the stage for an orderly consolidation of the system, in which major banks with strong balance sheets use short-term Fed money to acquire weak and failing institutions without having to pull liquidity out of the system by using their own money or trying to borrow money from banks. In effect, the Fed created a situation where other institutions in the same condition as Bear Stearns can be merged into healthier entities without the need for this weekend’s urgent scramble.
JPMorgan Chase got a pretty good deal out of the move. For less than a quarter billion dollars, it acquired the marketing strength and customer base of a major financial institution, something that could well be valued in the tens of billions once things settle down. We are not clear on what Bear Stearns’ debt structure was but its Manhattan building alone is said to be worth three times what Bear Stearns went for. Obviously there are a lot of liabilities traveling with Bear Stearns, but we suspect that given Fed financing, JPMorgan Chase was not engaging in charitable activity. Indeed, there already are rumors that Bear Stearns’ shareholders might resist the takeover. But by the time that happens, if it even does, the deal will be well down the road. In the meantime, its clients were served Monday morning.
The Fed is working to create a system for dealing with weak institutions that neither allows defaults to clients nor sucks liquidity out of the system as acquiring institutions raise money to make acquisitions. Just as the Fed effectively brokered this acquisition, we expect it to be brokering other ones in the coming days and weeks using its new tools. Alternatively, now that it is known that the Fed will protect clients as it would protect bank depositors, there will be fewer failures than otherwise. This is because the kind of pressure that built up on Bear Stearns last week may not happen again.
Those old enough to remember companies like Bache remember similar actions before. What the Fed has done is in fact not unprecedented. What is new is that it now regards brokerage houses and equity markets as being on par with banks and money markets. That is important, but not earthshaking.
The S&P 500 has shed about 20 percent of its value since October 2007. In 2000-2001, the S&P fell about 40 percent before beginning to recover — and the 2001 recession was not a transformative event. It was just another recession and a mild one at that. Obviously, the markets may continue to fall. But we are still struck by how well they are holding up in the face of remarkably negative sentiment and a sense of intense crisis.
We do not predict the market, but we do regard the equity markets as a guide to future behavior of the economy. Given negative sentiment and the failure to fall more than it has, it seems to us that the markets are saying that the liquidity crisis is being managed. For all the apparent gloom, the markets are doing surprisingly well. Between this liquidity crisis, soaring oil prices and the falling dollar, the equity markets are in fact remarkably calm. But that is a leading indicator and it might change on a dime.
We continue to believe that petrodollars and Chinese dollars are stabilizing the American system. And the Fed now has reduced the threat of structural failure of financial institutions. As we have said, a recession is to be expected after six years of expansion. But the latest actions by the Fed strike us as evidence that while a recession may be likely, it won’t be catastrophic.