Bear Stearns exposed as a bank saddled with toxic sub-prime debt
By Ambrose Evans-Pritchard
Big American finance houses have collapsed before. Continental Illinois required a $4.5bn (£2.25bn) bail-out in 1984 after coming to grief in Texas as the oil boom deflated.
The giant hedge fund Long Term Capital Management was saved by a club of banks in 1998 under the guidance New York Federal Reserve. The fund blew up after Russia's default, which ravaged its portfolio of Danish, Italian and Spanish bonds.
On both occasions the US economy was in rude good health. The damage was quickly contained.
The implosion of Bear Stearns is more dangerous.
A host of other banks, broker dealers, and hedge funds have played the same game, deploying massive leverage at the top of the credit bubble to eke out extra yield. Dozens of them are saddled with the same toxic debt - sub-prime property, credit cards, auto loans, and mountains of unsold paper from the merger boom.
This time the market for default insurance is flashing bright red warning signals across the entire spectrum of US finance.
The swap spreads on Lehman Brothers rocketed to 465 yesterday, mirroring the moves in Bear Stearns debt days before. Fannie Mae and Freddie Mac - the venerable agencies created by Roosevelt that underpin 60pc of the $11 trillion mortgage market - had a heart attack on Monday. Their bonds were in free-fall, threatening to set off another cascade of bank writedowns.
These are not sub-prime outfits. They sit at the apex of the US mortgage credit industry. Hence the dramatic move by the Fed this week to offer a $200bn lifeline, agreeing to accept Fannie Mae and Freddie Mac issues as collateral.
Had the Fed delayed, many traders believe Wall Street would have plunged through resistance levels risking a full-fledged crash.
The 'monoline' bond insurers - MBIA, Ambac, and others - that guarantee most of the $2,600bn market for US municipal bonds have seen their shares collapse by 90pc since the Autumn.
They are still battling to raise enough to capital to save their 'AAA' ratings. Should they fail, the insured bonds will be downgraded in lockstep. Pension funds would be forced to liquidate huge holdings. As New York Governor Eliot Spitzer said before his own liquidation, such an outcome is too dreadful to contemplate.
You have to go back to the banking crisis of the Great Depression to find a moment when the financial system as a whole seemed so close to the precipice.
Although 4,000 US banks failed in the early 1930s (mostly small ones), it was a long-drawn out affair. The bank runs began in the Prairies as falling food prices caused farmers to default in 1930. It seemed to be a local problem.
The crisis reached New York in December 1930 when the Bank of the United States succumbed to panic withdrawals. Legend has it that the 'WASP' clearing banks refused to back a rescue because of the bank's Jewish links.
In those days the contagion spread slowly to the rest of the world. It is much swifter now. The Swiss bank UBS has suffered US sub-prime losses on a scale to match Merrill Lynch and Citigroup, thanks to the curse of mortgage securities.
"We are now experiencing the first truly major crisis of financial globalisation," said the Swiss central bank governor Philipp Hildebrand this week.
"Never before have banks seen such destruction of their balance sheets in such a short time. Moreover, there are signs that the problems are spreading. The risk premiums on commercial property, consumer credit and corporate loans have risen sharply," he said.
Debt levels have been much higher than in the Roaring Twenties; the new-fangled tools of structured credit are more opaque: the $415 trillion nexus of derivative contracts is untested. Nobody knows for sure if the counter-parties are able to deliver on vast IOUs, or whether the construct is built on sand.
What keeps Federal Reserve officials turning at night is fear that the "financial accelerator" will now set off a vicious downward spiral. There is a risk of "very adverse economic outcomes," said Fed vice-chair Don Kohn.
Albert Edwards, global strategist at Societe Generale, said the toppling banks are merely a symptom of a deeper rot. "The banks are not the problem. Nor even the grotesquely leveraged funds. The problem is that an economic bubble financed by ridiculously loose monetary policy is unravelling," he said.
"US house prices have a lot further to fall, which will simply crush the global economy. The lesson from Japan in the early 1990s is that the death dance goes on and on and on," he said.
The Fed blundered badly in the Slump, delaying rate cuts for too long. It allowed the money supply to implode.
It is acting with breath-taking speed this time. Rates have already been cut from 5.25pc to 3pc, and will be slashed again this week. New means of showering liquidity on the banking system are being devised each week.
As luck would have it, the world's greatest expert on the financial causes of depressions - Ben Bernanke - happens to be chairman of the Federal Reserve.