In Big Finance, Interconnections Are Double-Edged

By Katherine Reynolds Lewis
c.2008 Newhouse News Service

WASHINGTON — This is Ben Bernanke's reality: The Federal Reserve Board couldn't allow Bear Stearns & Co. to go bankrupt.

The collapse of the fifth-largest securities firm would have hurt its trading partners, customers and investors. Worse, it would have sent shock waves of fear through the financial markets as everyone asked: If Bear can fail, is anyone immune?

"At the end of the day the financial system hangs together because of confidence," said Mark Zandi, chief economist at Moody's in West Chester, Pa.

Once that confidence is shaken, investors and customers of other financial institutions might demand their money or ask for new collateral, even as creditors refuse new loans — a classic run on the bank.

As one bank after another falls short of cash, credit freezes up. The banks have to sell assets to survive, depressing prices and hurting the already-struggling economy.

The entire financial system could crash if people stop believing that banks will honor obligations.

"These things really do feed on themselves," said H.W. Brands, a history professor at the University of Texas at Austin who has written about capitalism. "There is an aspect of, if you believe it hard enough, it will happen, and if you start to have doubts, the doubts themselves will cause it to happen. It's not that far from belief in miracles."

Hence Fed Chairman Bernanke's historic decision to guarantee up to $30 billion worth of mortgage-related investments held by Bear, after worry over the assets left the firm with no willing creditors. The unprecedented pledge cleared the way for JPMorgan Chase & Co. to buy Bear Stearns at the bargain price of $2 per share — for a stock that was trading at over $100 last year.

Two or three decades ago, the government could let a major securities firm go bankrupt without repercussions. (One did, in fact: Drexel Burnham Lambert.) That's no longer an option, given the interconnectedness of big financial institutions.

The Fed's challenge now is to take steps to restore the free flow of capital without raising concern that its very intervention means the situation is catastrophic, said Charles Calomiris, a finance professor at Columbia University.

Pump too much money into the banking system and the Fed depresses the value of the dollar, makes Treasury securities less attractive to foreigners, hurts the economy and raises the likelihood of inflation.

It's not that our financial system is fragile. Indeed, once confidence is restored, recovery can be swift. When people believe the market will rise, they rush to buy low, which drives prices up.

It's that our modern system rests on an international network of banks, brokerages and hedge funds among which a complex web of transactions makes it difficult to see exactly where the fabric will unravel when a thread is pulled.

At the same time, with the pain spread out, there's less damage to any one institution or country.

"This problem would be much worse if it were all localized in the United States," said Allan Meltzer, economics professor at Carnegie Mellon University.

Moreover, it's thanks to financial innovation and the global network of banks and brokerages that we can get a less expensive mortgage from any number of outfits, not just the local savings and loan, said Stephen Cecchetti, finance professor at Brandeis University and former research director of the New York Federal Reserve Bank.

"Having consumers have access to financing for purchasing their houses and smoothing income fluctuations, I think that's a really great thing," Cecchetti said. "Much of the reduced volatility in the economy, the fact that we've had only two extremely minor recessions since the 1980s, that's a consequence of financial innovation."

Many new financial products are successful and never make headlines, Calomiris said. But there will be bumps in the road.

"Financial intermediaries are not God. They try to figure out the risk based on the past," he said. "There's a learning curve. About half of the time they substantially underestimate the risk."

In the current mess, the difficulties with new mortgage products were masked by the booming real estate market and the explosion of the subprime market, which grew sixfold from 2000 to 2006, Calomiris said.

Rating agencies and lenders started to discount the risk of default because house prices seemed to move in only one direction — up. Wall Street traders chased short-term results that would boost their bonuses and career prospects, gobbling up risk like candy.

Housing is especially volatile because recent lending practices allowed people to leverage so much of the purchase. If you put 5 percent down to buy a $400,000 home, for instance, a 10 percent drop in housing values wipes out your equity and then some.

"We need to reassess government policy," including minimum capital requirements for all financial institutions, Calomiris said. "The government has been like a drug pusher of leverage in the housing industry."

Still, the allure of get-rich-quick opportunities will probably keep us chasing the latest hot investment, leading to future bubbles that will eventually pop.

"We're not going to solve the problems of mankind, and that's one of them: the short-term focus," Zandi said.

Richard Sylla, professor of financial history at New York University, concurred.

"These crises have been going on for 400 years; it's amazing we keep having them," he said. "Progress in finance is not linear. It's always two steps forward and one step back."

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1893-1907 — A series of Wall Street panics culminates with J. Pierpont Morgan calming the "Panic of 1907" by marshaling a group of bankers to inject their own money into the markets. The Federal Reserve system was created in 1914 in response.

1930-33 — Thousands of banks fail in the Great Depression, in part because the Fed doesn't act quickly enough.

1973-74 — The stock market loses 40 percent to 50 percent of its value while inflation runs rampant.

1987 — Black Monday, Oct. 19, sees a 22 percent stock market crash.

Late 1980s — The U.S. government bails out depositors in hundreds of failed savings and loan associations, costing taxpayers over $120 billion.

1998 — The Fed puts together a $3.6 billion bailout of hedge fund Long-Term Capital Management after complex investments go sour.

2000-02 — The combined effects of the dot-com bubble and 9/11 cause stocks to lose 40 percent of their value.

Source: Richard Sylla, New York University

This article was originally published on Tuesday, March 18, 2008, by Newhouse News Service.