15 March 2008
Bear Market
It almost started yesterday. We have all been waiting for it, watching the 401k retirement plans lose ten percent of their value since the first of the year. Waiting for the run on the bank, just like the people who besieged Jimmy Stuart in ”It’s a Wonderful Life.
It wasn’t a savings and loan, of course, it was Bear Stearns, one of the major investment houses. They don’t deal with chumps like us. They cater to the high rollers, big portfolio managers. They have a strong back office unit, and some other industry leading enterprises, but they are bogged down with a mess of bad paper.
A lot of institutions are. Bear was just more vulnerable than most, and the earnest financiers have been scrambling to keep confidence in their solvency for weeks.
Time ran out yesterday for the Bear. Smart managers had been quietly shifting assets away from the banks for weeks; this week the word was that they could not meet their obligations.
If the Bear failed, it would freeze hundreds of accounts until the Feds could appoint special masters. It was start a sequential series of events that would bring the market to a standstill.
The Bear is just the tip of the iceberg. I got a fabulous PowerPoint presentation a month or so ago. You may have seen it- http://www.scribd.com/doc/2190705/CDO-Powerpoint-SubPrime-Primer - if not, it is worth a look to see how this happened.
It is only a primer, though, and it does not go far enough. The complete briefing would have to go on and show stick-figures of the Federal Reserve and JPMorgan-Chase trying to bail out the Bear, and other stick-figures of the other big hedge funds nervously looking on to see whether they can fool us all again.
The tidings have been there, for all to see, including the legendary Alan Greenspan. In 1998, the Federal had to organize a rescue for a hedge fund called Long-Term Capital Management after the highly leveraged experts got caught holding $1.2 trillion in derivative positions when bond markets moved against its bets.
The event went by with little impact to the public. I bought a house that year and do not even recall the events.
The last time something approaching the magnitude of what is happening today occurred was the Savings and Loan fiasco of the early 1980s. The sad story contains some remarkable parallels to what is happening today. The disquieting thing is that the potential losses are much bigger, and the experts knew it all along.
I cannot do constant dollars for you this morning- my head is not up to it. The estimated cost of the bailout of the Federal Savings and Loan Insurance Corporation (FSLIC) was $175 billion or more. In constant dollars, you take the then-dollar total, allow for subsequent inflation factors, and transform that into present value. Double or triple the FSLIC amount and you would start to approach the numbers we are talking about today for vulnerability of the hedge funds to the sub-prime disaster.
The Times says there might be $600 billion in bad loans that have to be cleared. By any accounting, this means some real pain is coming for you and for me.
The bankruptcy of FSLIC did not occur overnight. The signs were there for years. When disaster finally hit, the federal government bungled it. Paul Volcker was chairman of the Federal Reserve when he decided in October 1979 to restrict the growth of the money supply- the experts have a term for that, but the experts are the ones who get us all into this mess.
That restriction caused interest rates to skyrocket. In the nine months after June 1979, short-term interest rates soared from around nine percent to over fifteen.
The crisis passed in only about four years, but there were lingering consequences that were real and personal. The market dislocation is one of the things that transformed the Buckingham neighborhood where I live. It stopped the Hyde Park development at the mid-point of construction, and the neighborhood did not really recover for two decades.
Of course, it could be worse. FDR had to close the banks altogether to allow people to regroup. But the failure of another Bear Sterns would have the same sort of impact, by stopping the financial markets in their tracks. It is the electronic equivalent to pad-locking the S&L.
It will be interesting to see how it plays out. It’s a comfort that the experts will be there to help.
Copyright 2008 Vic Socotra
www.vicsocotra.com