Topic: Economics
Why It Had to Be Bear Stearns They overreacted to good times and must suffer the consequences.by Jeff Peters
(conservative)
Tuesday, March 18, 2008
Everyone reacted to the Bear Sterns market incident with dismay. Confidence in the American economy is plummeting. Inflation targeting or price stability, the Fed's finest form of supply-side economics, seems to have no place in monetary policy these days.
At first I believed that no such recession was in the making but with the media distorting confidence, sky rocketing energy costs from exchange rates and the war, and possible unnecessary inflation and further inefficiencies in market pricing, lead me to believe that we are in a negative trajectory.
Or am I playing the role of overreacting to our current economic situation. Output hasn't fallen just yet as revised GDP numbers went up from 0.6% to 1.6%. Costs certainly are rising but parallel to rising GDP - which is not quite stagflation, but we may be headed in that direction if output becomes negative.
To add to the chaotic preaching of the mainstream media, we have at hand the fall of one of the world's largest private banks whose stock plummeted from around $70 to $2 per share in one day. Some financial experts are hinting that this is a ripple from the sub-prime mortgage crisis.
But let's face it: the federal funds rate was very low. In response to that the offering rate in the market for loans was low, and everyone - including those with no credit history went credit-happy. That in and of itself is risky business, no question! Lending to the poor who don't understand adjustable rate mortgages shows that some companies can be pretty damn close to being risk loving.
Can I blame businesses and people trying to get a bang for their buck? No, because that is how free-markets work.
However, free-markets themselves can disguise real information or at least cause seemingly rational people to overlook their situation. While everyone on Wall Street breaks their record in annual bonuses because of a booming market people tend to overestimate their current situation and engage in more risk.
So then you have the Fed who decided to increase the federal funds rate to prevent overheating in the economy. Guess what else went up: the offering rate in the market for loanable funds - including those sub-prime mortgages of which the poor invested their horrible credit.
A bubble widens and then bursts, leaving hundreds of thousands of poor families with homes they can't afford. Then Ben Bernanke and President Bush feel bad and try to reverse that trend by lowering interesting rates and voting on a fiscal stimulus plan - both which probably won't work.
The monetarist consumption function tells us that people will realize that they will eventually have to repay these government checks through federal and inflationary taxes. So much for pushing out aggregate demand.
Now we have Bear Sterns who unfortunately fell to the sub-prime beast. How so?
Debts (or assets to a bank) can be used to back securities. Investments banks and other financial institutions engaged in this risky trading. Once sub-primers defaulted on their loans, so did the securities traded by these banks. Bear Stearns, being one of the largest underwriters for mortgages was just the first of possibly several financial institutions to go!
When people overreact to "good times" it can lead to a crisis especially when unexpected events create shocks in the economy. Managing risk is no easy job but deciding what is too risky, like underwriting risky mortgages and using it to back securities, is essential to a good business.
Thus, it was an unfortunate decline for Bear Stearns but the market had to weed out those institutions that irresponsibly managed their assets. Recessions or worrying economic times tend to scrape off the table all of the firms that have no cushion under their bosoms.
I sort of like to think of this event as an example of Warren Buffet's market wisdom: companies can tinker with the value of their shares by altering the numbers in their balance sheets but at some point in the future it must return to its real intrinsic value. Responsible companies will prevail while over-valued firms plummet to the floor when real challenges take hold.
RIP Bear Stearns.
Update:
Economists, including the notorious Alan Meltzer of Carnegie Mellon University, called the Fed's move to assist J.P. Morgan Chase's acquisition of Bear Stearns, not a bail out, but simply a move to shift the 5th largest investment bank to a more responsible manager. I'm too ignorant and juvenile in the field of economics to know if this is a fine characterization.
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