In spite of all the talk about Obama’s pastor, the most important thing that happened this weekend was the shotgun purchase of Bear Stearns on Sunday. The firm – once the biggest underwriter of US mortgage bonds – lost about 99% of its value over the previous 16 days as a result of a run on the bank in which clients, alarmed by rumors of a cash shortage, withdrew $17 billion. The purchase price is less than the estimated value of the office buildings and real estate owned by the firm; it is the Wall Street equivalent of buying it for $1. There is obviously a huge risk premium built into this price, and I doubt that either Bear or JP Morgan executives really know the value of Bear’s portfolio.
Bear is the counterparty to many credit contracts (hence its problems). The risk of letting such an institution fail is that otherwise healthy institutions go down with it. Because of the central role of leverage in the financial sector, and the central role of the financial sector in funding every other sector of the economy, this would be a disaster. Of course, it creates a moral hazard, but on balance is almost certainly worth doing. That said, my guess is that we’re likely to see some other household name that is not too big to fail go down before this is all over – the government will need to demonstrate that it is willing to do this. Not for nothing, but I wouldn’t be investing a lot of my retirement account with Lehman right now.
Strangely, this is the kind of situation where investors can make huge amounts of money. The market almost always seems to over-correct when some crisis like this hits. So why isn’t there a sure-fire investment strategy of always buying into such a crisis? (As the old saw goes, “Buy on the sound of gunfire, sell at the sound of trumpets”). The problem is that these “over-corrections” are usually the market pricing in the probability of a massive crisis. The clear risk here is that there are more Soc Gen and Bear Stearns problems hiding undiscovered on balance sheets. It will only be clear in retrospect whether these are tremors at the start of financial contagion, or whether they are just adjustments to the popping of the housing bubble. You can see this fear and greed battling it out in the market today: the Dow opened about 200 points down this morning, briefly reached positive territory and is now back down 116 as I write this.
( cross-posted at The Corner )