When bankers made forecasts for 2008 in late 2007 the most common one was: the present crisis will calm in the 2nd half of 2008, after all audits see daylight and there are no more nasty surprises. But it will get worse, possibly much worse before it gets better.
This forecast is materializing, see today’s article in FT describing the situation at Bear Stearns, US investment bank, which arranged emergency lending from JP Morgan (which may be preparing to buy bits of Bear Stearns) and got first time in forty years “direct” support from the Fed. The core of the problem is nicely explained by the Bear’s chief executive quote:
“Alan Schwartz, Bear’s chief executive, said the investment bank had fallen victim of a crisis of confidence in which counterparties in its core fixed-income markets were no longer willing to provide financing given widespread rumours that Bear could fail. On Wednesday, Mr Schwartz had told CNBC that the bank’s balance sheet had “not weakened at all”. On Friday he said that demands for cash had accelerated on Thursday”.
The Bearn Stearn’s intervention statements are here , in practice Fed is doing repo transaction with JP Morgan to fund back-to-back JP Morgan lending to Bear Stearns. Key part is repeated below:
“In a statement, JP Morgan Chase said that “in conjunction with the Federal Reserve Bank of New York, it has agreed to provide secured funding to Bear Stearns, as necessary, for an initial period of up to 28 days.
Through its discount window, the Fed will provide non-recourse, back-to-back financing to JPMorgan Chase. Accordingly, JPMorgan Chase does not believe this transaction exposes its shareholders to any material risk. JPMorgan Chase is working closely with Bear Stearns on securing permanent financing or other alternatives for the company.”
Willem Buiter wrote an excellent comment about Fed/JP Morgan joint action and raised a number of important questions.
To cut the long story short, the Fed is trapped between the short-term need to support proper functioning of money and capital markets, and on the other hand it is aware of the potential moral hazard problem in the long run. I am finishing a book with my former NBP colleagues called “Gordian knots of the 21st century”. Among many conclusions in the book we offer this one:
US has committed a crime of short-termism. It will pay the price: US will lose global leadership, and the dollar will lose the global reserve currency status. Panic and ad hoc moves to weather the present storm make me more and more confident that the above scenario will happen faster than most people expect.
Earlier this week I wrote a short piece for centralbanknews.com (subscription required) arguing the the Bank for International Settlements must become the global central bank. Events such as Bearn Stearns saga reinforce my view. An efficient global financial markets governance structure would prove much more efficient in dealing with such situations. A short paragraph from my centralbanknews article follows:
” Global problems cannot be solved by piecemeal domestic approaches. Effectively dealing with global inflation requires global coordination
of decisions and consistent communication between the largest central banks. Indeed, recent literature shows «http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906863» that if one big central bank misbehaves then other central banks’ pursuit of good
monetary policy may in fact lead to increased output volatility across the board.
What is more, research suggests «http://eprints.lse.ac.uk/525/1/ecbwp514.pdf» that gains from such coordination are larger when countries differ in terms of economic structure. So cooperation between emerging markets and the developed economies would have a lot more impact than the G8′s recent inconclusive mumblings. “