Another Blow Up for Uncle Ben and His Hammer

A few weeks back I mentioned that I had felt bad for Ben Bernanke because he inherited a situation he could do nothing about. And now today, the game continues. This is the game where Ben is holding the hammer, and he is trying to hit the economic monkeys as they pop out of the various holes – you know this game right? It’s a game to test your reactions. However, Ben is holding a foam hammer and instead of 9 holes for monkeys to pop out of, there are 2,000.

This morning, the latest “monkey,” the esteemed brokerage/investment house Bear Stearns, will be bought by JP Morgan for $2/share. This was a $159 stock within the last 12 months! Basically, they own a lot of bad mortgage paper and would have effectively gone bankrupt if not bailed out. The Federal Reserve guaranteed some debt on the books of Bear Stearns also to help make this happen.

See Article Here

The lesson here is that the lending/credit bubble created far too much excess in an industry that tends toward excess anyway. The reason for regulation in the banking/credit industry (reserve requirements for example) is to prevent “excess” in the system. Instead, the Fed encouraged excess in the form of super low rates, low reserve requirements, and lack of banking oversight in order to spur the economy. They went too far, and now I expect much more pain – eventual higher interest rates despite the Fed, much higher inflation caused by the falling dollar, and credit contraction (i.e. stricter lending standards) which will crush many people. Remember, often people and organizations overreact right? I expect lending institutions to overreact and further restrict lending and when that happens, along with rising rates, asset prices will FALL.

Point: the Fed did lower the Discount Rate this morning, a step I thought they would have started doing initially when trouble started last year. This is the rate that the Fed lends money directly to banks. Often, the Fed targets the Fed Funds Rate, which is the rate that banks charge each other to borrow money. Interestingly, I got into a mini-argument with a grad school professor about this with him insisting that the Fed doesn’t touch the discount rate – I countered that I learned in Econ 101 that the Fed could cut this rate. I never understood where a well-versed and well regarded professor got that idea, but I just stopped arguing before it got serious.

Part of the problem with the whole lending idea is that most institutions borrow money short (they borrow variable rate money, such as your passbook savings account, or from the Fed at the discount rate) and lend it long (such as 30 year mortgages). If you were a bank, and you offered folks a 5% CD, and only earned 6% on mortgages you originated, you wouldn’t make much money after expenses. Banks need 2.5-3% “spread” to be profitable. We had long rates below short rates and companies were blowing up. The discount rate cut could help, but it may be too late because we don’t even know where these problems (monkeys) might pop up next.

Urgent Note:

This may be irrelevant, but you might want to call your mortgage broker this morning. The last time the Fed cut rates, 30 year mortgage loans dropped to 5.11% for about 2 hours. They then proceeded to jump up to above 5.4% and then proceeded higher (part of the inflation problem I will try to explain in another post soon). If we get any kind of drop (we might not), then it won’t last long in my opinion.

 Chris Grande