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Bear Stearns bail-out
A new stage of the crisis
The failure of the investment bank Bear Stearns
marks a new stage of the banking crisis, as the liquidity-solvency
spiral continues its downward course. At the same time, the Fed-financed
bailout, together with calls for a wider state rescue of failing banks,
is opening up an ideological crisis for ultra-free-market capitalism.
LYNN WALSH reports.
THE SALVAGE OF the major investment bank, Bear
Stearns, by the US Federal Reserve marks a new stage in the development
of the US and global financial crisis. The fifth biggest investment
bank, the weakest link in the chain, was brought down by a bank run, not
of depositors, but of creditors – other investment banks - that are
themselves facing runs, as their creditors in turn demand additional
security or repayment of loans. Bear Stearns was ‘too big to fail’, so
the Fed has pumped in $30 billion to prevent a complete shipwreck, a
state-financed rescue under cover of JP Morgan Chase, which is buying
Bear Stearns at a fire-sale price.
Financial Times columnist, Martin Wolf, designated
14 March "the day the dream of global free-market capitalism died… By
its decision to rescue Bear Stearns, the Federal Reserve, the
institution responsible for monetary policy in the US, chief protagonist
of free-market capitalism, declared this era over". (The Rescue of Bear
Stearns Marks Liberalisation’s Limit, 25 March). At the same time, a
state bank in Germany was forced to undertake a second rescue operation
to prevent the collapse of IKB Deutsche Industriebank. This prompted the
chief executive of Deutsche Bank to proclaim: "I no longer believe in
the market’s self-healing power".
Whether the Fed’s action is enough to halt the
downward liquidity-solvency spiral now gripping the financial sector
remains to be seen. The US recession is deepening, especially the
housing sector, and this will further undermine the financial sector and
work through the global economy. Those representatives of the capitalist
class who have any insight at all are now bracing themselves for a major
economic crisis, more serious than 1973-74 and most likely the worst
since the great depression of the 1930s.
A rapacious Bear
BEAR STEARNS HAS always had a reputation as one of
the most rapacious investment banks, taking big risks in pursuit of big
profits. The firm profited during the depression of the 1930s, and
profited from trading in New York City bonds after the city went
bankrupt in the 1970s. Bear’s chief executive, James Cayne, was seen as
an arrogant maverick: Bear refused to contribute to the Fed-led rescue
of the hedge fund, Long Term Capital Management, in 1998.
Recently, Bear’s main activity has been trading
bonds, especially the complex, mortgaged-linked bonds that have poisoned
the finance system. Like other investment banks, Bear’s activity was
highly leveraged, that is, financed by huge amounts of credit. On the
strength of $11.8 billion of shareholders’ capital, the bank ran a
balance sheet of $395 billion.
Last July, two of the hedge funds run by Bear
Stearns went bankrupt, with losses of $2.6 billion. Throughout the
crisis, Cayne continued to play golf and participate in bridge
tournaments. He also negotiated a $1 billion investment from the
state-owned Chinese bank, Citic Securities – which failed to stop Bear
Stearns slide (Citic is now pulling out of the deal).
Bear Stearns’ activities are not at all untypical of
Wall Street investment banks: Bear just happened to be the weakest link.
As the bank teetered on the brink of collapse, the Financial Times
clearly described the vicious cycle that was pulling it down: "To
finance that balance sheet [$395bn] Bear relies on short-term loans
secured against its portfolio of bonds. This week those loans dried up;
Bear hardly had a chance. A poisonous cycle has taken hold. As
mortgage-backed bonds fall in value – even those backed by
quasi-government entities, Fannie Mae and Freddie Mac – banks demand
more security to lend against them. That pushes leveraged investors to
sell bonds, depressing prices still further, prompting more margin calls
[demands from creditors for more security] and the collapse of some
funds, such as Peloton and Carlyle Corporation. Bear Stearns is not just
heavily leveraged, it was a lender to CCC [Carlyle]". (Editorial: Exit
Bear, 15 March)
As the FT’s editorial remarked, "there is a whiff of
1929 about all this". At that time, banks were forced to sell off assets
to provide more collateral to their creditors, triggering one spasm of
liquidation after another. The Fed, at that time, failed to intervene,
standing back while a string of banks collapsed.
This time, the Fed has energetically intervened,
making liquidity available to the markets (starting with $38bn last
August, after the collapse of the Bear Stearns hedge funds). However,
the additional $100 billion and $200 billion tranches of credit made
available by the Federal Reserve on 7 and 11 March came too late to save
Bear Stearns. By the weekend of 15-16 March, the bank was clearly on the
verge of collapse, and the Federal Reserve and the US Treasury
department urgently convened a meeting of bankers to discuss a rescue
package. Ben Bernanke and Hank Paulson (US Treasury secretary) were
desperate to rescue Bear Stearns before Asian financial markets opened
on Monday morning. Clearly, news of the failure of a major New York
investment bank could have triggered a massive collapse on the stock
exchanges of Japan, China, and elsewhere, detonating a worldwide
financial collapse.
JP Morgan Chase, one of the US’s biggest (regulated)
commercial banks, emerged as the only likely purchaser. On the basis of
a $30 billion guarantee from the Federal Reserve to cover Bear’s
‘less-liquid assets’ (that is, insuring JP Morgan against Bear’s most
toxic bonds), JP Morgan agreed to buy out Bear Stearns for $270 million
– that is, $2 a share, compared with a share value of $170 a year ago.
Later, JP Morgan was forced to raise its bid to $10 per share. Many of
Bear’s 14,000 workers will lose their jobs. Cayne has now sold his $6
million shares – walking away with ‘only’ $61 million (the same shares
would have been worth about $1.2bn in January 2007).
Role of the Federal Reserve
IN RECENT WEEKS, the Federal Reserve, with the
support of the US Treasury department, has intervened decisively in an
attempt to halt the wave in subprime writedowns and defaults on margin
calls (demands for additional collateral for outstanding loans). The
actions of the Federal Reserve have been described as ‘dramatic’,
‘unprecedented’. A Morgan Stanley economist refers to the
‘hyper-proactive’ role of the Fed. Since last August, the Fed has
injected three major liquidity packages into the banking system.
Moreover, also last August, the Fed effectively bailed out Citigroup,
the US’s biggest commercial bank, a regulated bank entitled to borrow
from the Fed, by allowing it to borrow $25 million and pass it on to two
of its insolvent brokerage affiliates, unregulated investment firms that
were not entitled to borrow directly from the Fed.
The Fed’s liquidity injections reached a new scale
in the week before the collapse of Bear Stearns. On 7 March the Fed made
a further $100 billion available to commercial banks (deposit
institutions) that have had access to the Federal Reserve as a lender of
last resort. However, the Fed was now prepared to accept "a wider range
of collateral", that is, some of the potentially dubious (if not
worthless) securities at the heart of the credit crisis. The Fed also
extended the period for money loans. A few days later, in an even more
dramatic move, the Fed (11 March) made $200 billion available to
investment banks (that deal in bonds, shares, and other securities on
their own account and on behalf of hedge funds and other clients).
Previously, these banks had no access to the Fed’s reserves. Once again,
they would be allowed to borrow on the basis of potentially dodgy
collateral.
Alongside the provision of massive extra liquidity,
the Federal Reserve drastically cut its base lending rate. In five moves
after September, it cut the overnight lending rate from 5.25% to 3%.
There was another 0.75% cut on 17 March, following the Bear Stearns
rescue, bringing the nominal rate to 2.25%. Given the current levels of
inflation (officially 4% ‘headline’ inflation, 2.3% ‘core’ inflation
excluding food and fuel), this is a negative real rate of interest.
This course of action represented a dramatic u-turn
in Fed policy. In his first period of office after February 2006,
Bernanke advocated ‘orthodox banking principles’. Highlighting the
dangers of inflation, Bernanke said there would be no cutting of
interest rates to pre-empt a slowdown (the US housing market was already
slowing down at the beginning of 2007), there would be no ad hoc bending
of the rules to help financial institutions facing problems as a result
of their reckless activities. There would be no bail-outs because
bail-outs give rise to ‘moral hazard’, that is they allow irresponsible
banks to escape the consequences of their actions. This approach was
based on Bernanke’s complacent view of the US economy. In February 2007,
Bernanke portrayed (in the words of the New York Times) "a Goldilocks
economy that is neither too hot, with inflation, nor too cold, with
rising unemployment". Even after the collapse of two Bear Stearns hedge
funds in August 2007, Bernanke played down the effects this would have
on the wider economy.
But as the subprime crisis unfolded in August,
Bernanke, like many others, was forced to abandon his rosy view and face
the growing likelihood of a financial collapse. Having in early August
rejected the idea of an interest rate cut, the Fed held an emergency
meeting and implemented a 0.5% cut in the discount rate (to 5.75%) on 18
August. At the same time, Bush presented a $168 billion (approximately
1% of GDP) stimulus package to Congress. And, as we have seen, the Fed
was forced to make bigger and bigger injections of liquidity into the
banking system in a desperate effort to relieve the tightening of the
credit crunch.
Even the measures announced in the first week of
March, however, were not enough. On 13 March it was announced that the
Carlyle Group had defaulted on $16.6 billion of loans (unable to meet a
‘margin call’, for additional collateral of only $400m). At the same
time, a mortgage lender, Thornburg, also failed to meet margin calls.
Then the Bear Stearns crisis, which had been
simmering since the previous August, came to a head. This was when the
Fed became ‘hyper-proactive’. Bernanke, Tim Geithner (president of the
New York Federal Reserve), and Paulson (Treasury secretary) recognised
that they were on the brink of a catastrophe. Bear Stearns is only the
fifth-largest investment bank, but it is highly ‘interconnected’, with
tentacles stretching into a wide range of banks and financial
institutions. For instance, Bear Stearns has been one of the biggest
traders in credit default swaps (a type of derivative used to insure
other securities), a sector of the derivatives market that has ballooned
to a colossal total nominal value of $45 trillion! A complete collapse
of Bear Stearns would have triggered a financial meltdown, potentially
far more serious than the collapse of the hedge fund, Long Term Capital
Management, in 1998. The Fed’s action was ‘dramatic’, ‘sweeping’. The
Economist recognised that the Fed undertook "extraordinary manoeuvres"
to meet the "threat of catastrophe". (The $2 Trillion Bail-Out, 19
March) Without the Fed’s action, commented the New York Times, the Bear
Stearns crisis "could have triggered potentially a collapse of the
financial system".
There was no attempt to organise a consortium of
banks to bail out Bear Stearns. Instead, the Fed in effect mounted a
direct bail-out through the major commercial bank, JP Morgan Chase. The
Fed is acting as a ‘puppet master’ for JP Morgan, which will effectively
buy Bear Stearns at a fire-sale price. At the same time, the Fed is
establishing a new ‘shadow bank’ that will acquire the most risky,
illiquid securities (mostly subprime securities) using $30 billion of
Fed funds. If these dodgy assets turn out to be worthless, JP Morgan
will lose $1 billion while the Fed will lose $29 billion. If, however,
the new entity (to be managed by BlackRock, an investment management
firm) turns a profit, JP Morgan could in the future make a profit once
the $30 billion is repaid to the Fed. However, the main motive of JP
Morgan appears to be its desire to acquire a primary bond dealer that
can trade securities directly on behalf of JP Morgan and its clients. JP
Morgan is in a relatively strong position compared to many other banks
(with much lower write-offs of subprime mortgage loans).
It has become clear that the Fed, backed by Paulson,
initially dictated that JP Morgan would pay only $2 per share to buy out
Bear Stearns. Bernanke and the government were desperate to avoid
accusations that they had created ‘moral hazard’ by bailing out reckless
speculators. However, after the initial deal was agreed, there was a
rebellion of Bear Stearns executives and employees (who between then own
30% of Bear Stearns shares). JP Morgan faced the prospect of taking over
an empty shell – Bear Stearns executives were scrambling to find other
jobs, with the possibility of a mass exodus of key personnel. Moreover,
Bear Stearns shareholders, including the staff and the hedge fund
financier, Joe Lewis (who owns a big slice of Bear Stearns shares),
threatened to block the Fed-sponsored deal with legal action. Delay in
resolving the Bear Stearns crisis could have undermined the whole point
of the rescue mission. The Fed was therefore forced to renegotiate the
deal, offering $10 for Bear Stearns shares. This time, the Fed ensured
that the revised deal would go through by bending stock exchange rules
to allow JP Morgan to instantly purchase nearly 40% of Bear Stearns
shares – giving JP Morgan a decisive vote. (A Change of Heart at JP
Morgan, International Herald Tribune, 26 March)
Inflation or deflation?
WILL THE Fed-JP Morgan bail-out do the trick? The
leaders of US capitalism are desperately hoping that it will. So far,
the banking sector has written off about $150-200 billion of distressed,
subprime assets, and the credit rating firm, Standard & Poors, estimates
that the total writedowns will amount to about $285 billion. But this is
optimistic. The continued decline of the housing market is likely to
bring an avalanche of new defaults in both the subprime and prime
mortgage markets. These could further undermine the value of
mortgage-backed securities. There is also the possibility of huge losses
occurring as a result of trading in derivatives, credit default swaps,
and so on. Some commentators estimate that the total losses to the
financial sector could be in the region of $1 trillion – but there are
others who put the worst-case scenario at as much as $3 trillion – an
absolute catastrophe.
Representatives of big business are now debating
what course of action should be taken by the government and the Federal
Reserve. More voices are now advocating a major bail-out of bankrupt
banks and finance houses, with the wholesale taking over of risky,
illiquid financial assets.
For instance, Paul De Grauwe (economics professor at
Leuven University) argues that injections of capital by the Federal
Reserve (or other central banks) will not halt the downward spiral of
liquidity and solvency problems for banks and financial institutions. De
Grauwe explains that when an investment bank or hedge fund is "hit by a
withdrawal (a liquidity problem) and is forced to sell assets, the price
of its assets declines and a solvency problem is created". (Act Now to
Stop the Markets’ Vicious Circle, Financial Times, 19 March) Injections
of liquidity will, in themselves, not halt the downward spiral: there
has to be a liquidation of worthless or unsellable assets. "The US
Federal Reserve…" writes De Grauwe, "has no option but to buy distressed
assets in an attempt to put a floor on the downward asset valuations
spiral, which risks getting out of control".
Also writing in the Financial Times, Mohammad El-Erian,
a prominent US fund manager (Pimco), argues that "incremental steps
using traditional policy instruments [ie interest rate cuts, injections
of liquidity] are ineffective". (Why the Fed must Act in Unfamiliar
Ways, 17 March) Governments, he warns, must be prepared to break the
rules. El-Erian argues that governments must contemplate "altering
contracts so that stressed mortgage holders can avoid default and
foreclosure; and/or explicitly using the government’s balance sheet to
support the housing market". This would involve using government funds
to pay off unrepayable mortgages and buy unsellable assets from a
variety of lenders. El-Erian accepts that such measures would undermine
the "sanctity of contracts" and "erode the integrity of the market
system". However, these risks are "inevitable at this advanced stage of
the crisis. Indeed, the question is not just what happens to
irresponsible lenders and imprudent borrowers. It is also about the
damage that is being inflicted on others as the finance system freezes".
In other words, faced with the survival of their system, the
representatives of capitalism are prepared to discard their principles
of moral hazard and sanctity of contracts, and draw on public funds
(taxpayers’ money) to bail out the system.
At the same time, however, other commentators have
pointed to the problems such action could create for capitalism. The
obvious question is: where would the money come from for a massive
bail-out? One financial analyst, Steve Randy Waldman (James Saft, Fed
Move Won’t Halt the Slide, International Herald Tribune, 14 March),
calculates that, after the $200 billion made available to banks on 11
March, the Federal Reserve has another $300-400 billion left. Therefore,
to buy out even $1,000 billion of unsellable securities the Fed – or the
US government – would obviously require additional funds. These could be
raised either by (1) additional capital from the government (that would
have to be paid for either through additional government borrowing or
increased taxation), or (2) printing money (which would raise the very
real spectre of inflation).
"If it’s too big there will have to be an element of
monetisation, with the Fed financing it", says Tim Drayson, economist in
London with ABN AMRO. "Monetisation is rising from what was a small
likelihood to what is now an increasing risk". (Quoted in Saft, A Wider
US Financial Bail-out Could Fuel Inflation, International Herald
Tribune, 20 March) Monetisation is a polite way of saying printing money
to pay off debts.
Saft writes: "Calls are increasing for the Federal
government, either directly or through the Federal Reserve, to cut the
knot of the credit crisis at a stroke by buying up mortgages that banks
and investment banks are finding difficult to finance. If the government
bought mortgage debt at or near 100 cents on the dollar, even though
much of it is trading well below that amount, it would allow banks to
pay back loans used to finance these holdings. If done in sufficient
size, say $800 billion or $1 trillion, it would relieve the terrible
pressure on bank balance sheets and allow other credit markets, like
those for corporate loans, to return to something approaching
equilibrium".
One of the voices warning against prolonged,
negative real rates of interest is Paul Volcker, the former Fed
chairman, who ruthlessly squeezed out inflation from the US and world
economies after 1979 through ‘monetarist’ policies – high interest rates
and a restricted money supply. Volcker warns against lowering interest
rates too far. The threat of resurgent inflation is "lurking not very
far in the background", he warns. That would be "the ultimate
destructive result of this". (Krishna Guha, Administration Urged to
Share Credit Burden, Financial Times, 19 March)
This poses a dilemma for US capitalism. Faced with a
catastrophic collapse, they will, at a certain stage, undoubtedly be
prepared to print money in order to wipe out an unsustainable level of
bad debt. In that case, however, they would certainly face the threat of
inflation. On the other hand, the tightening of the credit crunch, with
mountains of bad debt weighing down widening sectors of the US economy,
could push the US into a deflationary spiral, similar perhaps to the
situation in Japan in the 1990s. This would mean massive overcapacity,
falling prices, an investment slump and escalating unemployment – with
the prospect, as in Japan, of a prolonged period of stagnation. There is
no easy way out for capitalism: both inflation and deflation, in their
different ways, pose economic and political dangers for the system.
Historically, the US ruling class has feared
depression more than inflation, having experienced capitalism’s biggest
ever slump in the 1930s. This is in contrast to the European
bourgeoisie, who have not forgotten the period of hyper-inflation during
the inter-war period (reflected in the European Central Bank’s current
resistance to lowering eurozone interest rates). In the past, US leaders
have always tended to resort to printing dollars to inflate their way
out of crisis. This was facilitated in the post-war period by the role
of the US dollar as a reserve currency. Today, however, the situation
has changed: a collapse of the dollar (combined with negative real
interest rates) could provoke a flight of capital from the US (to euro
assets and other stronger currencies, such as the Swiss franc) and make
it even harder for the US to finance its federal budget deficit and
current account deficit (which are overwhelmingly financed by the inflow
of capital from abroad).
Political reaction against ‘crony’ capitalism
ONE THING IS conspicuous when representatives of
capitalism are calling for ‘unconventional tools’ for fixing the credit
crunch. The various measures they are demanding, in one form or another
state-finance bail-outs of the financial sector, are overwhelmingly
aimed at rescuing the banks and other financial institutions. In other
words, it would mean the state-backed rescue of the super-rich
financiers and speculators responsible for the crisis. On the other
side, the assistance so far proposed for millions of struggling home
owners who were drawn into the financial mess by profit-hungry
moneylenders are minimal, even token measures. This glaring disparity
will inevitably have political repercussions in the next period.
Significantly, this issue has been raised by
Financial Times columnist, Martin Wolf, who notes that there appears to
be a financial system "where in good times the profits are privatised
and in bad times the losses are socialised". The rescue of Bear Stearns
is a backdoor state-funded bail-out through the agency of a massive
private bank, JP Morgan Chase. However, a large-scale bail-out on a
scale required to rescue the banking sector in general would require
either direct nationalisation or, more likely, indirect nationalisation
through an arms-length body such as the Resolution Trust Corporation
that was set up in the early 1990s to rescue the bankrupt Savings and
Loans institutions. The Savings and Loans crisis ended up costing US
taxpayers the equivalent of $450 billion at today’s values, or 3.2% of
GDP. In contrast, the bill for the current financial crisis is estimated
at 7% of GDP by Wolf, who takes a relatively conservative view. On the
other hand, Nouriel Roubini of RGE Monitor estimates that the bill for
bailing out the banking and financial system in the event of a systemic
crisis would be at least 12% of GDP and could be as high as 19% (which
would add another $2.7 trillion to the public debt). As Roubini says,
this would mean "saddling every US household with an additional $30,000
of debt in perpetuity…" In addition, there could be, he estimates, a
further $10 trillion losses in the US private sector as a result of
falling values in domestic housing and commercial real estate, together
with stock exchange losses.
Warning of the political repercussions of the
crisis, Wolf writes: "This is not a crisis of ‘crony capitalism’ in
emerging economies, but of sophisticated, rules-governed capitalisms in
the world’s most advanced economy. The instinct of those responsible
will be to mount a rescue and pretend nothing has happened… worse, the
institutions that prospered on the upside expect rescue on the downside.
They are right to expect this. But this can hardly be a tolerable
bargain between financial insiders and wider society. Is such mayhem the
best we can expect? If so, how does one sustain broad support for what
appears so one-sided a game?" (Financial Times, Economists’ Forum, 27
February)
Responding to this, Roubini writes: "This is indeed
a one-sided game where financial insiders privatise profits while the
massive losses of their reckless behaviour – searching dangerously for
yield, gambling for redemption, being subject to distorted incentives
not to monitor their lending and risky investments – are systematically
socialised during a crisis. This is actually ‘crony capitalism’ of the
worst kind, as bad as the one that plagued emerging economies and led to
their severe financial crises in the last decade".
The financial-sector crisis has already had a
devastating effect on millions of heavily-indebted home-buyers, but its
full impact on the wider economy in the US and internationally has yet
to be felt. The severe economic downturn that is now very likely will
throw many millions of workers into unemployment and poverty. There will
be a massive, world-wide political reaction against ‘free-market’
capitalism and the parasitic ruling class that reaps its profits at the
expense of society. The economic crisis will inevitably bring with it an
ideological and political crisis – and a search for an alterative system
that can meets the needs of the majority who work to produce the wealth.
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