If you have ever taken the time to watch water swirl
around a pier, you have seen turbulence. The fixed object creates eddies that
are at first large and then, as the turbulence seems to move around and away,
they diminish. The late Robert Kraichman, a physicist saw this type of
turbulence and wondered if it happened on a larger scale, would the same
large to small changes take place.
Because the oceans and upper atmosphere consist of a
layered structure, the rules of observable turbulence did not respond the
same way. Turbulence he discovered increases when the number of layers that
are in play are increased. Our economy is also a multi-layered entity. That
said, it would be safe to suggest, since the science of economics has failed
to predict the current market situation, to keep in mind that the turbulence
we are currently experiencing is bound to continue to grow in size.
We don’t
need to go back too far in time to examine the possibility. Let’s start
with Friday. The sudden market shock that Bear Stearns provided was for all
intents and purposes unexpected. Who could have guessed that when the
investment bank announced that they were about to go bankrupt, losing half
their share value in a day, that it would be the New York Fed and JP Morgan
sent to the rescue? But then again, why did we not expect it?
We have
entertained the idea of late that there is a real disconnect between what is
on the “books” is worth the actual stated value at far too many
financial firms. One analyst suggested in the ensuing frenzy that morning
that the only entity that was not aware of how poorly booked the
world’s fifth largest broker was, turned out to be the bank of last
resort. Once the Fed opened its balance sheet to Bear Stearns, providing a
short-term liquidity boost through JP Morgan, those that shorted the broker
rejoiced.
And Monday, JP
Morgan picked up the beleaguered firm for two dollars a share. But the
question remains: should the Fed get involved at all and should they have, as
they announced Monday morning, open their discount window to brokerages? The
answer to both those questions is no.
First the
Federal Reserve, if they were doing their job, would have been ahead of this
crisis months ago. But they seem to be trailing the news, reacting in kind
with investors who seem to be better informed. Banks are highly regulated
entities with transparent balance sheets and bookings that can be easily
assessed. Yes, they have faced some difficulties in the current credit crisis
and have taken steps to accurately price thinly traded securities. But
investment banks or brokers are another story altogether.
When Bear
Stearns announced the collapse of two hedge funds last fall, the stock
continued to fall from its precipitous high of $171. Investors – not
depositors, were reassured even as early as Wednesday of last week that the
company was doing just fine. And then the bankruptcy announcement, the Fed
bailout and the fire sale that allowed JP Morgan to pick apart the firm for
its brokerage business and clearinghouse operations at a price that has made
most folks speechless.
Opening the
discount window to the possibility that there are other brokers out there
with similar problems has the short sharks positively salivating. It may have
been that Bear made the biggest bets in these opaque investments and the
worst has passed with not much more than a several percentage point drop in
the overall stock market value. But this kind of turbulence is multilayered
and, if Dr. Kraichman’s theories apply, it is far from over.
Now it should
be noted that what the Fed did, loaning money to Bear not JP Morgan and
assuming the losses or, in the best possible scenario, the profits may create
a greater vacuum than would have happened had they let the broker fail. The
Wall Street Journal made an excellent comparison when it looked at repo
securities as compared to federally insured deposits. They wrote: “In
1990, securities repo credit, at $372 billion was about 13% the size of
federally insured bank deposits, at $2.8 trillion. By last year, securities
repo credit had ballooned to $2.6 trillion, 60% of the value of federally
insured deposits at $4.3 trillion.”
The mistakes
the Fed made were many and financial historians will have a field day
speculating how things should have unfolded. But one thing can be said with
certainty. The Fed’s actions will not shorten the current recession.
Main Street is well entrenched in it already and saving a couple of poorly
managed investment firms will not ease any of that pain. There are fewer
arrows left in the Fed’s quiver after this dramatic move.
What happens on
Wall Street, more specifically to the financials, is not what the Fed should
be focused on. I know that market purists have stepped up and suggested that
the Fed should take a hands-off approach to the situation and until this past
weekend, I was not so sure that would have been the best reaction. Now, I
tend to agree.
Paul Petillo
www.BlueCollarDollar.com
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