Fire sale at Bear Stearns and panic at the Fed

    Sunday evening, J.P. Morgan announced its purchase of Bear Stearns at $2 per share after it had closed at $30 on Friday, and the Federal Reserve announced yet another emergency credit facility.

    The shareholders at Bear Stearns were lucky to get anything for the firm, and J.P. Morgan CEO James Dimon, eager to get his hands on Bear Stearns’ brokerage business, may ultimately have built the scaffolding for his own hanging.

    The hidden liabilities and potential for law suits at Bear Stearns are huge. Look at the unanticipated trouble Bank of America is having with Countrywide. Sometimes CEOs simply do reckless things. Dimon is gambling not investing. When the other shoe falls, shareholders will know who to blame.

    Bear Stearns is not the only big financial house in trouble. The potential for contagion is real and menacing. The real questions are: Which of the big banks will be next to fail? How many more banks will fail? Will the whole system turn to panic if Citigroup unwinds?

    The quality of leadership provided by Citigroup CEO Vikram Pandit, and Robert Rubin, the man who chose him, is a major concern now that Citigroup has been forced to pour $1 billion into the hedge fund Pandit sold his employer. The Board at Citigroup seems hypnotized to be putting up with that maneuver.

    We don’t want to return to Glass-Stegall but some of the large bank groups may have to be broken up. Citigroup tops the list. These firms are just not managed well and are too large and diverse to be managed effectively. The economy has been put at grave peril by the unwillingness of Pandit and other leaders of the Wall Street banks to reform what are clearly broken banking practices and a failing business model.

    The Federal Reserve, to bolster liquidity, cut the primary credit rate charged primary dealers who borrow against securities at the Fed from 3.5 percent to 3.25 percent. Also, it increased maximum maturity for loans from 30 to 90 days. This should increase liquidity in the securities market a bit but will not address the primary systemic problems that make bank credit so difficult to obtain.

    The Federal Reserve continues to bail out major financial institutions without imposing meaningful conditions to improve their conduct and performance. It is failing to require the reforms that have closed the bond market to banks, make the securitization of bank loans virtually impossible, and have greatly curtailed responsible lending to businesses by banks. In turn, the banks continue to impose onerous conditions on their customers. Many are sound businesses not responsible for the crisis the banks have created yet bear the primary burden.

    Hence, the Federal Reserve continues to give aid to the irresponsible, while letting these same banks punish their customers.

    Through Sunday’s move, the Fed is trying to reassure financial markets that it stands ready to back up the banks but this is not likely to work. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have reacted to events and consistently been behind the curve. Their leadership has been wholly lacking.

    Sunday’s moves by the Federal Reserve are the desperate acts of failing men.

    The threat of contagion and wholesale breakdown is on a scale of 1929 is real.

    Yet, President George W. Bush adopts the posture of Herbert Hoover, telling us everything will work out soon. He looks more like a man whistling through the graveyard. Bernanke and Paulson look worse than that.

     

    Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

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