The collapse and fire sale of Bear Stearns, the fifth-largest United States investment bank, might seem bad news, but it is actually good.
The excesses of Wall Street firms in recent years were so egregious that a shake-out simply had to happen. Since the credit crunch became manifest last August, we have in effect been waiting to see some blood spattering on to those broad investment-banking braces. It would have been a travesty — and rather surreal — if we had had to wait much longer.
Whenever financial crises have occurred — such as in Britain in the early 1970s, the United States in the late 1980s or Japan in the early 1990s — the vital moment has been the one when reality strikes home. All the talk last August and early this year of merely mild global economic slowdowns, of modest adjustments in business practices by the banks was a sign on both sides of the Atlantic that the moment still lay ahead. The fall of Bear Stearns suggests it is now here.
And what a fall. For a powerful investment bank to be worth just $2 a share in the hands of its purchaser, JPMorgan Chase, when it had supposedly been worth $36 only last Friday and as much as $158 last April, shows the true nature of risk in buying equities. This was the biggest Wall Street collapse since Michael Milken’s Drexel Burnham Lambert took its junk-bond tumble in 1990.
JPMorgan, a venerable US name but in recent years one of the less reckless, has got a bargain because the Federal Reserve, the US’s central bank, is lending it enough money to cover Bear’s most troubling liabilities. But the Bear Stearns shareholders have been more or less wiped out, which is what should have happened last September in Britain when Northern Rock ran into trouble.
The demise of Bear Stearns had similar roots to that of Northern Rock. Bear borrowed huge sums on the short-term money markets to trade and invest in long-term, illiquid assets (in the Rock’s case mortgage loans, in Bear’s case mortgage-backed securities and other fancy bits of paper). So when other banks grew queasy about its creditworthiness and started to demand much higher prices for their money, its losses began to mount, even as the value of its long-term assets was plunging.
Reality, however, is wider than just one firm. It should be welcome that the shake-out has got going, but there are likely to be other casualties soon. The biggest and most important casualty, though, is going to be the culture of easy lending to companies and to households that has lain behind the US’s economic growth in the past six or seven years.
As a result, even if the Fed cuts US short-term interest rates again by three-quarters of a percentage point or even a drastic one percentage point, credit conditions in the US will still tighten.
What that means is that the US — the world’s biggest economy, accounting for more than a quarter of world output — should be bracing itself for a pretty nasty recession. Worries about inflation, through high food, oil and commodity prices, are keeping long-term interest rates high in any case. Now lending practices are going to add to the squeeze.
Unemployment has begun to rise, though it remains low at 4,8% of the workforce, which is probably why economic troubles are still not yet the dominant issue in the presidential election. By mid-year, when the election proper begins and the candidates have (at last) been chosen, the economic pain could well be severe.
European banks are also announcing big losses from their businesses in fancy securities and they too will be worried that one of them might share the fate of Bear Stearns. That is fairly unlikely, however, as the big European investment-banking operations are all part of giant commercial banks such as UBS or Deutsche, which can absorb their losses and remain creditworthy enough to reassure the markets.
The most intriguing question, though, is what the effect will be in the fast-growing economies of China and India — economies that optimists are relying on to keep the world economy spinning. Their high savings rates mean that they will not face the same credit crunch as in the US. But China in particular is facing a worryingly high inflation rate — 8,7% in the year to February — for which its only real solution can be a risky and potentially painful revaluation of its currency against the dollar.
When that happens, some will wail about the dollar’s final collapse. But actually, as with the fall of Bear Stearns, this will be a welcome acceptance of reality. Faced by huge capital imbalances, reckless lending and vast trade deficits, the world has long needed a shake-out on Wall Street as well as a rebalancing between the dollar and the Asian currencies. The first of those has now begun. The second still lies ahead. — Â