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Generational Dynamics Web Log for 15-Mar-08
A historic day in Ben Bernanke's Great Historic Experiment

Web Log - March, 2008

A historic day in Ben Bernanke's Great Historic Experiment

In its biggest move yet, the Fed bails out a collapsing Bear Stearns.

What's most important about Friday's events is investors' reactions to it. But first, let's start with a few details.


Intraday Dow Industrials chart and final results for Friday, March 14, 2008
Intraday Dow Industrials chart and final results for Friday, March 14, 2008

After a 9:15 am vote by the Fed Board of Governors on Friday, the Fed invoked a Great Depression law that permits the Fed to loan money to a non-bank in return for sufficient collateral, and last used only in the 1960s. By 9:35 am, the Fed had announced that it was loaning an unspecified amount to Bear Stearns, but since Bear isn't a bank, JP Morgan Chase would be used as a conduit.

(Bear Stearns is an "investment bank," not a "bank." Ironically, Bear would be qualified to borrow directly from the Fed under the new program announced on Tuesday, but that doesn't take effect until March 27. Because this situation was considered an emergency, an arrangement was made to perform the loan through JP Morgan.)

Bank bailouts are becoming increasingly necessary. Britain has had to nationalized the Northern Rock bank to keep it from failing, and many of Germany's public banks are near collapse, and are begin bailed out.

As I've described in "Ben Bernanke's Great Historic Experiment" and "Bernanke's historic experiment takes center stage," Bernanke believes that the 1930s Great Depression could have been avoided if the Fed had simply injected more liquidity into the financial system. Actually, I can't be sure that's what he believes any more, but he certainly USED to believe that.

Unfortunately, there's no way to reflate the huge, leaking credit and housing bubbles, no matter what the Fed does, as regular readers of this web site already know.

The Bear Stearns announcement sent shock waves through the investor community. The markets had moved up at the 9:30 am open, but quickly tumbled after the announcement.

Let's start taking a look at investor reaction, as reported on CNBC.


Alan Schwartz, Bear Stearns CEO, on Wednesday, saying that Bear Stearns was fine. <font face=Arial size=-2>(Source: BBC)</font>
Alan Schwartz, Bear Stearns CEO, on Wednesday, saying that Bear Stearns was fine. (Source: BBC)

The context was that Bear Stearns' CEO, Alan Schwartz, had appeared on CNBC two days earlier, responding to rumors that Bear was having a liquidity crisis. At that time, he said:

"We finished the year, and we reported that we had $17 billion of cash sitting at the parent company as a liquidity cushion. As the year has gone on, since year end, that liquidity cushion has been virtually unchanged, ... The markets have certainly gotten worse, but our liquidity position has not changed at all, our balance sheet has not weakened at all,"

Investors were in a good mood on Friday morning. A day earlier, Standard & Poors had issued a statement expressing the opinion that the writedown of CDOs by financial institutions was half over, meaning that there was light at the end of the tunnel. And early Friday morning, there had been a favorable inflation report.

After the breaking news about Bear, these two favorable events were wiped out of investors' minds.

In particular, the statement by the Bear CEO once again made it clear that Wall Street executives could not be trusted -- saying one thing on Wednesday, and turning out to be dead wrong on Friday.

The CNBC anchors were very discouraged, because they had been hoping for an "up" day on the markets. Here's what Mark Haynes said:

"One thing that really strikes me is the similarity between a whole bunch of markets here. People never dreamed that the decline in the dollar would go on as long as it has. They never dreamed that the decline in real estate would go on as long as it has. They never dreamed that the decline in financials would go on as long as it has. That's also contributing to the crisis atmosphere. ... Another thing, people never imagined that oil would continued to climb for as long as it has."

This is what has been frustrating investors. The expectation is enormous that the credit crunch will be over in a year, and that the market will "find a bottom" almost any day now. So whenever there's any good news, investors think, "Aha! This is it! I'd better buy now, to make some money on the way up."

But that never lasts more than a day or so, because something goes wrong, and as Haynes was saying, it's always something different each time.

A few minutes later, the CNBC pundit Ron Insana came on and said the following:

"I find this interesting. You were saying that nobody dreamed that we would be in this position over a period of time. I think some people as early as last June had nightmares about this scenario. They may not have had dreams about it, but if you go back as far as last February, when we had these first hint of troubles in subprime, then by June it became fairly apparent that what we thought was just a passing phase in the credit markets was something more permanent, something more ominous.

We had the subprime problem, we went immediately into a real estate recession, CDOs, SIVs, Muni bonds, credit default swaps, the dollar, financial firms, the big runup in commodities -- all was emblematic of systemic risk in the United States. And people would not acknowledge that. They gave a variety of different reasons for all this stuff happening, but when you have the amount of leverage, the amount of credit, the number of derivatives in exotic financials, that have been created in the last five years, that are imploding in value now, that still remain something bigger than most people know, and usually, as several people have said, result in trouble in one or more financial institutions."

This is a very interesting list, because Insana was basically showing Haynes just how oblivious he and other investors were. That's what this whole web site is all about -- the things I write about on this web site are perfectly obvious, but nobody wants to believe them, so they believe their fantasies, and are shocked when their fantasies don't come true.

I'd go farther back than Insana, though. It's been perfectly obvious since 2002 that we were headed for a major stock market panic and crash, for the reasons given in "How to compute the 'real value' of the stock market."

Ron Insana is much better than most of the pundits. On a scale of one to ten, most of the pundits are a 1, but Insana is at least a 5. He doesn't get a 10, however, because he didn't realize the danger years earlier, and also because of what he said next, when Haynes asked him, "What's the total - I mean, I've seen REALLY scary numbers thrown around about how much unregulated, questionably rated debt, in the TRILLIONS." (This is funny. Haynes has absolutely no idea what's going on at all.)

Insana responded with "scary" numbers that I've referred to on this web site several times:

"Let me put it in the aggregate globally. There's about 500 to 750 trillion dollars of credit derivatives -- this is the notional value, the face value [Mark Haynes saying "Oh, my God" in the background] -- of credit derivatives worldwide.

That compares to $50 trillion in global GDP. Now, people who defend derivative structures as not being as risky, because that notional value doesn't represent the value at risk -- pick whatever percentage you want of that $750 trillion, let's say it's of 1% that could go bad. It's still $3 trillion, and that's on the low side, against $50 trillion in GDP. You're talking about 8% of global GDP in terms of a debt structure that could go bad. That would have serious implications - it already has -- for the global economy. This is playing itself out - people are describing this as a "whack-a-mole" environment - as soon as you get past one problem -- it's Carlyle the other day - now you've got Bear Stearns - and you've got counterparty risk - you've got all these other considerations...."

This phrase, "whack-a-mole" environment is a good one. It captures the concept of one problem after another that Haynes was referring to earlier.

(Incidentally, I just saw Gillian Tett of the Financial Times talking on the BBC. I've quoted her stuff quite often. She really knows what's going on, and isn't afraid to say it. On a scale of 1 to 10, she may be close to a 10. Contrast her with Grep Ip of the Wall Street Journal, and you really have a really smart woman and a really dumb man.)

What all of this does is relate to the analogy I've been using of the world financial system being a huge, bloated mansion, parts of which keep falling off into the ravine. Soon, the entire mansion will collapse and crash into the ravine. There's no way to stop this.

That's why it's so disappointing to hear what Insana said next:

"The Fed, eventually, having already done some dramatic things, I think, is going to have to be the buyer of last resort, and provide a permanent solution to this liquidity problem by buying bad debts from primary lenders and banks, and monetize this debt in such a way that the credit markets start functioning again. It's an extreme view, but if you know Ben Bernanke's thinking on this, and even Alan Greenspan's for that matter, the Fed's job, at the end of the day, is to prevent a catastrophe, and I think at this juncture, that's the only way they can do it."

If the Fed tries this, they may be able to keep the mansion together for a few more days or weeks, but it will only make things worse when the final crash comes. It's discouraging that Insana doesn't understand that.

But this shows how poor the level of understanding is among experts who are supposed to know what's going on.

Let's have one more quote from CNBC on Friday, to show further the attitudes of investors. It's a conversation between reporters David Faber and Bob Pisani. The subject of the conversation was: How could Bear Stearns say on Wednesday that everything was OK, and then be near-collapse on Friday morning?

"Faber: On Wednesday afternoon, they started to get a sense [of what was happening], but it was Thursday afternoon, after speaking with people who knew exactly what went on, that they really realized they had a problem. It happens that quickly. We've talked about that. It's a typical run on the bank, where people say, "We're done." And whether it was rooted in truth or not, it doesn't matter, it becomes a self-fulfilling prophecy.

Pisani: The worry down here [in the NY Stock Exchange] is -- what's going to prevent this from spreading to somebody else -- let's name another broker down there, name another bank, that this could potentially spread to, and you can see the whole .... The question is, when the rumor becomes reality, where do you stop it? At what point can you come out and sufficiently calm people's nerves?"

This is exactly the point. This new Bear Stearns debacle is, once again, reinforcing the idea that everyone on Wall Street is a liar.

And even if Bear's CEO Alan Schwartz WASN'T lying on Wednesday, and it just "happened" -- which would indicate a fairly severe panic among Bear's creditors -- then it's just as bad, because statements by Wall Street execs can't be trusted anyway. So, either way, anything can happen at any time, and no one can feel confident about anything.

Last Friday, when I quoted an analyst as saying that the bond market had become "utterly unhinged," I described the Fed's new program of liquidity injections as "desperation."

Since last Friday, the hedge fund firm Carlyle Capital Corp. has completely collapsed, and now Bear Stearns is close to collapse. This is a manifestation of the "utterly unhinged" bond market, and it shows that the Fed's policies are doing nothing at all.

In fact, things are clearly much worse today than they were a week ago. The Carlyle collapse came in slow motion. We said that by the "cockroach theory" -- there's never just one cockroach -- there would be other hedge fund collapses, and the Bear Stearns collapse occurred within a 24 hour period, amid signs of panic.

From the point of view of Generational Dynamics, it's very interesting to understand how investors' attitudes are evolving. There's no longer any "bad news is good news" hopefulness. There's a dread, an anxiety, because nothing is going right. A lot of ordinary investors have been the farm on stocks continuing to go up, and they're getting very panicky as stocks keep falling.

There are certain more hedge fund collapse to come. The UK investment banks may be even more vulnerable than American banks, according to a Telegraph article:

"Bear Stearns crisis could hit UK banks

Funding costs for British banks are expected to soar in the wake of Bear Stearns' near-collapse, worsening the credit crunch and potentially pushing up the cost of lending.

Credit spreads for UK banks widened yesterday, providing clear evidence that they are now judged to be higher risk.

Fears are also growing that some banks may have large exposures to Bear Stearns that could prove very costly.

There are further concerns that, as Bear is forced to unwind its positions, banks will have to revalue their assets - leading to more write-downs.

British lenders such as Alliance & Leicester and Bradford & Bingley are already struggling with high funding costs and the knock-on effect from Bear could lead to further liquidity problems, analysts said. A&L has already put the cost of the credit crunch on its funding at 150m."

And so, the coming stock market panic and crash might well be triggered from Europe, rather than America.

From the point of view of Generational Dynamics, the last generational panic and crash occurred in 1929, and we're now overdue for the next one. It might occur tomorrow, next week, next month, or next year.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (15-Mar-08) Permanent Link
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