A week ago, Sunday March 16, 2008, the structure of American finance shifted. This was lost to public view behind billows of smoke. The acrid smell of burnt out jobs, dreams, pensions and investments wafted down Park Avenue. The financial press reported the dramatic imagery and the fire. Precious few asked what caused the fire and what the destruction left in the way of new realities, lessons and cautions. Let's pretend that substance matters. It will not be easy and it may not yield comforting well worn platitudes about "Wall Street Culture" or "bad apples." We need to ask, what decisions were made? What impacts are these decision having? What is at stake? How can we do things differently in the future?
The embers still smolder and visibility remains clouded. We do know that the Federal Reserve, JP Morgan take-out of Bear Stearns involved sacrificing a smaller, weaker firm and offering enhanced assistance to remaining investment banks. Whenever new rules and new rulers emerge in crisis it takes time to assess the full measure of change. The Federal Reserve (FED) has stepped out in front of the Securities and Exchange Commission (SEC). The Fed has acted dramatically and transformationally in the vacuum created by inaction from Congress, The Whitehouse and the SEC. Response to worsening economic and financial conditions has been led by the Fed. Waves of massive interest rate cuts have flooded regulated banks and now investment banks with tens upon tens of billions in cash. The cash infusions have bought time for financial institutions -- now including investment banks. Relief has come as expanded and extended opportunity to temporarily drop off distressed, unknown value assets at the local Fed bank and get known value in exchange. This allows cash to be gotten in exchange for unsalable and heavily devalued structured financial products. Parking one's mystery financial meat, comprised of bundled consumer and business loans, delays reckoning and allows banks to continue operating and work-out out losses and risks. All the while, dropping interest rates allow financial firms to borrow more cheaply and rebuild balance sheets and capital. Interest rate cuts and loans raise future earnings and reassures investors. Symbolically, the Fed has shown that its stands with dominant financial institutions. We have learned that much helped is required by our leading financial institutions and that the Fed is struggling to provide that help.
None of this works to fundamentally remove risks and losses. Firms are still losing money. Houses are still losing value. Late payments and foreclosures continue. Employment is weakening, US and global economic growth forecasts are being lowered. The Fed is buying time, working to soothe investor fears and symbolically standing behind the firms its policy largess embraces. Those cold shouldered -- or worse -- are fed upon by remaining firms, public opinion and angry investors. Postponement and public relations responses to crises have given way under the growing weight of fear and loss. Ever greater policy action and market intervention have been and will continue to be in the offing. Speculators and owners of structured product have become rate easing and assistance junkies. Ever greater fixes of Fed liquidity candy are required to get markets high(er). Ultimately, we will likely see coordinated renegotiation of mortgage principle and or, greater government led bail/out and buy-out. We will see pressure on banks to reduce the mortgage debt owed or even greater outright purchase of bundled home mortgages. The problem lies in the size of possible losses and the vital role played by leading US financial institutions. The leading banks are too big to fail and too big to bail. The problems are too big and politically sensitive to leave to market solutions. At the same time, overt interventions create policy based winners and losers. The worst case scenarios are too much to bare and the interventions needed are large enough to change the landscape of American and global financial markets. The architecture and performance of global economic growth hang in the balance. We are past the point of working to prevent pain. It is now a matter of figuring who to help and how much. The stakes are always high in such debates.
Our financial system and overall economy prospered on massive innovation, leverage and deregulation. All three are either stalled or running in reverse. When everything aligned just right, this allowed expansion of credit to American consumers and expansion of profit to financial firms. The buying of American and European consumers fueled economic development and rising incomes throughout the world. Cheap credit and debt fuled consumption pumped wealth into corporate coffers around a globalized world. Endless cheap and easy credit allowed economic development and consumption fulfillment. The costs and benefits of this system were very unevenly distributed. There is every reason to believe the pain will be too. Our recent boom was produced by cheap leverage, tolerant regulators and faith in markets. Faith is in very low supply. Fear drives violent reallocations and flights to safety. Awareness of risk has violently re-emerged and innovation has stalled. Our engine of growth and credit allocation has run out of inexpensive and plentiful gas. The problems are too big to leave alone and too large to fix without careful, concerted, international policy responses. Absent such an approach, massive swings in policy will produce violent swings in global fortunes and angry response. We now face the prospect that waves of losses, law suits and public anger will blame innovation and international exchange for downturn. If this occurs, we will actually run innovation and integration in reverse. Financial neo-Luddites will emerge to smash the credit innovation machine in hope of preventing the pain that has already arrived. Debt will be scarce, more expensive and more suspiciously viewed. If un smoothed, this could cause rapid swings in purchasing power and prices. As basic assets, food prices, energy prices and national currencies swing in price, wealth and power are violently moved out of some hands and into others. Prices, including currency prices, distribute and direct losses, gains and decisions. This is what we are already seeing in housing markets. Easy mortgage access and belief in ever rising home prices created a boom. Changes in credit access and faith in real estate inflation are producing the worst housing slump in modern history. This is rapidly slashing the wealth of middle class Americans. House prices, mortgage bonds and Dollars are falling. This creates financial stresses alongside food and energy prices increases. Billions are being redistributed from homeowners, Dollar holders, food and energy importers.
Our economy has lived off debt and speculation. They created positive feedback loops and pumped air into our economy. We evolved to benefit from and rely on this as an engine of growth. It is running in reverse now. Households and firms are in the early stages of adjustment. The process is violent and unequal in its impact. Some will get help. Others will be cold shouldered into extremis. Thus, Bear found itself crippled by a Fed cornered by the size of the task before it. JPMorgan was assisted in helping itself to Bear's still warm remains. The surviving leaders in the investment banking space were told to help themselves to overnight cash at 2.5% interest. Life and death were determined by Fed granted access to the deleveraging medicine, cash. What was decided in those meetings seems like a new financial regulatory regime for leading Wall Street firms. The regulatory structure has been changed. Access to the discount window, greater Federal Reserve oversight, new risk modeling and lower balance sheet leverage must be in the offing for Wall Street titans? This means a different structure of financial operation is taking hold in the heart that pumps credit through the global veins of commerce. New risks and new opportunities will take shape. New shoots will be sent out through the charred crust of the burnt out old house. In short, the financial rules, regulations and conditions at the center of our economy are changing. Sunday March 16, 2008 was a day of rapid, chaotic change.
Stuck between firms too large to let fail and balance sheets too large to bail, the Fed struck a balance. The new Primary Dealer Credit Facility (PDCF) allows investment backs to borrow overnight at 2.5% and against various illiquid (hard to value and sell) securities. As soon as credit became available, primary dealers began to borrow rapidly, or at a rate of $13.4billion per day. The new cash access system for primary dealers is similar to the formally regulated banks' arrangement at the Discount Window but, is 1/90 the loan duration. This move into new territory suggests the Fed has changed its role in the economy. This will quickly translate into economic change at home and abroad. Treasury officials and our President signed off on this. This is a big move. Rumors abound that formal legislation to shift capital market supervision toward the Federal Reserve and away from the SEC awaits introduction. It looks like our financial regulatory system substantively altered in the Bear Stearns, JPMorgan meetings. There seem to be new guarantees and restrictions on our leading Investment banks? I do not wish to blame the Fed, it has been charged with an impossible task and is not getting the support and assistance its efforts deserve.
As time passes and new structures take shape, we expect there to be further bouts of rapid price oscillation, readjustment and deleveraging. It would be wise to note, the actual recession remains to fully arrive. Housing and finance were first into the fray and have fallen furthest and fastest. Financial markets and the Dollar are fast on their heels. There is every reason to expect retail, employment and economic growth to follow. It remains too early to gauge the depth and duration of a downturn that is a moving target. It is time to demand clear and transparent discussion of options and exposition of decision. We will all live with the choices made, we should all be invited to the table and briefed on the options.