It has been four years since the takeover of Bear Stearns and the collapse of Lehman Brothers, which precipitated the greatest financial crisis of our time. Now three years since the market hit its low, let’s look back at the crisis as it happened, and take a fresh look at what really caused it.


I’d like to start with my March 2008 article which will put us right back in the throes of the crisis and then make some comments with the benefit of hindsight.



March 22, 2008


The Fed engineered a "rescue" of the investment bank Bear Stearns last week. The firm was bought by JP Morgan for a song. It was the first serious move by the fed to address the inability of the marketplace to price bad loans. Until now simply lowering the fed funds rate was the tool of choice by Ben Bernanke. Eight months ago, two days after the crisis broke, I wrote that the cause of the crisis was the following:


Recently, the packaging of loans has become popular and some sub-prime loans have been sold together with prime loans. Normally the market would re-price suspect loans. They would be discounted by the market to a price that the market could clear. But because they are in a package, they are not visible to the market.

And there's the rub. There is no market yet. There is no way that the market can identify and price these suspect loans. There is no way for the market to know how many bad loans there are, or to what degree they should be discounted. The market hates uncertainty and we have plenty of it today. The problem in a nutshell is that there is no market for these securities. What you can't see or define cannot be dealt with—hence panic selling. The solution is to break these suspect loans out of their packages and then let the market price them. If that happened I believe the panic would be over and done with immediately.

It could be argued that the inability of the market to perform this function amounts to structural damage. I am open to that argument. It is possible that the market will not be able to resolve this problem.


This was written August 9th, 2007. It took until now for the Fed to come to the same conclusion. The amount of damage done along the way has been considerable. I give the Fed a failing grade for tardiness in actions that should have been taken at first--not at last. And I also give the Fed a failing grade for not lowering interest rates quickly, to the market rate of interest. By delaying drastic cuts until only the last month or two, the Fed has been promoting a tight money policy in the face of a credit crunch and economic slowdown.


However--better late than never. The Fed has been moving on several fronts to encourage these bad loans to come out of invisible packages and into the light of day. The credit crisis is simply a matter of lack of transparency and lack of pricing ability by the market resulting in a lack of confidence and lack of liquidity. These moves are attempts to allow the market to function. It has been frozen for eight months. And the frantic lowering of the fed funds rate, to at least a little closer to the 90 day Treasury bill, is a step in the right direction.


Many have called the deal between the Fed and one of the biggest investment banks in the nation a government bailout. They claim that Bear Stearns was saved because it's "too big to fail.” Tell that to Bear Stearns investors who have seen their stock fall from $160 a share to $2; tell that to the top executives who are now unemployed; tell that to the 7,000 employees who have lost their jobs, and the 14,000 who have lost their pensions, stock options, 401k’s, and watched as their kid’s college funds melted away. This was an institution in business since 1850 which had survived every hard economic period in past years, including the great depression, and is now gone forever.


No, this was not a bailout. Chrysler, where the government bought the company and saved all and everything involved, was a bailout. What bothers me is not the central banks actions to facilitate Bear Stearns sale to JP Morgan, but that had the Fed acted one week earlier and opened up the discount window as it eventually did to all other investment banks, Bear Stearns would exist today. Congress gave the fed the authority to do this in 1999. They altered the Glass-Steagall act, which separated commercial banks from investment banks. Under the new law the Fed was given the power to allow investment banks to come to the discount window in times of trouble just the same as commercial banks. Why they did not open the discount window last August is a mystery to me. Why they allowed Bear Stearns to be taken over and then open the discount window to all its competitors is also a mystery to me.


But, they finally have and I believe this together with several other actions the Fed and the Treasury is embarking on will end the financial crisis soon. So are we out of the woods? Not a chance. The problems we face are the following:


  1. The lingering inability to price bad loans
  2. Falling home prices and defaults
  3. The real estate recession
  4. Possible national recession/depression
  5. Mounting inflationary fears
  6. A falling dollar


The solution to the first problem is what the Fed and the Treasury are now in the process of doing. It is the least of the bad solutions in that the actions are to assist the market, in an orderly way, to function where it could not function on its own. This is the task of a central bank--to be the lender of last resort. I just hope the Fed has thought through the fact that since these are temporary loans they've made, there will come a time when they will have to liquidate this paper. How and when they do this becomes crucial. So let's say #1 is “in the process of being solved," with much work yet to be done.


The solutions to numbers two and three, falling home prices and defaults, and a real estate recession, is to do nothing, absolutely nothing. Let the market do exactly what it has been. The market provides a clearing and pricing process. It quickly and efficiently finds the price where buyers and sellers can meet and exchange. It is in the process of doing this daily and any interference from government will only serve to impede that process.


Number four, fears of a recession or depression, calls for the same--do nothing. Of course congress has already passed an economic "stimulation" program that is both expensive and probably unnecessary. Although Congress, the Administration and two thirds of the American people say we are in a recession and one-third believe we are going into a 30’s style depression.


Numbers five and six, mounting inflation fears and a falling dollar, have already somewhat been addressed by the Fed. The money supply has been slowed substantially over the last year--too substantially for my money. This indicates to me that we are in for a bout of disinflation soon. Interest rates are still high in real terms. Monetary policy has been very tight since the beginning of 2007.


This together with the latest Fed policy statement which accentuated the need to focus on inflation may have been the first Fed move to publicly shore up the dollar and begin fighting inflation. The Fed statement included a new full paragraph underscoring their concern about inflation


If foreign central banks lower interest rates soon, the differential between the dollar price of money and the price of money in other currencies should curtail the money flows out of dollars and into foreign currencies, at least to some extent. The Fed is headed toward ending the credit crunch and starting to turn its attention toward the inflation/dollar concerns.




March 8, 2012


Now back to today. It's been four years since I wrote the above commentary. I was admittedly pretty hard on the Fed. But that’s because I’ve always felt that the monetary operations of the Fed were the most dangerous part of having a Federal Reserve, and that they need to be watched closely. But I’ve also always been in support of the Fed functioning as a “bank of last resort.” The one thing that the Fed can do constructively is to protect the system at large against systemic damage.


A year before TARP was born I’d been urging that the Fed enter the banking system and buy the toxic assets that were causing the fear and contagion plaguing the financial system. I estimated that it would cost about a trillion dollars to neutralize those assets at the time--which ironically was considered a huge amount of money. I stated then, and again in the above article, that if they did so the contagion and the crisis would end immediately.


Since then the Fed and the Treasury--with congress--approved TARP, or the Troubled Asset Relief Program. The contagion ended immediately. The same is happening now in Europe as the European Central Bank has finally, after two years, decided to follow in the footsteps of the US model. I might add that the US Treasury reaped huge profits for the taxpayer on the “bailout” loans they made to banks, most of which have been paid back in full.


As I mentioned in the above article, the move by the Fed to shore up the dollar and address inflation concerns resulted in the stabilization of the dollar, which is today about the same value internationally as it was four years ago. In addition inflation has declined to average about 2% since then, and the CRB is actually lower than the highs it posted earlier.


The nature of the financial crisis here and abroad was one of fraudulent debt issuance, lack of transparency in such debt instruments, excessive leverage in such instruments, and the subsequent freezing up of credit markets, the drying up of liquidity, panic, and contagion. The only solution ever possible was to neutralize the contaminated debt instruments that caused investors to pull back and hide.


The central banks, although late in doing so, have finally done their job. But what should have cost the US about a trillion dollars has cost this country a deep recession resulting in trillions in losses, plus the piling up of trillions more in barrowed debt, plus trillions lost in asset values; all unnecessary in my opinion. What’s being dubbed “The Great Recession” was actually mild by historical standards. What we experienced was a “Great Financial Crisis.” One that I believe is for the most part, behind us.


Before us is the continuing fiscal crisis which the Fed and the Treasury can do nothing about.  This one is up to the President and congress to tackle. It’s not a liquidity crisis but a solvency crisis, and unless we get our fiscal house in order, we may find ourselves facing a new crisis, that while different in nature, would be just as costly, probably more.


But this future crisis is not an economic problem. It can be fixed and there’s really no mystery as to how to fix it. It simply amounts to living within our means as a nation. It’s a matter of math. And the equation is political. Like Greece, we will either bite the bullet and pay our bills, or kick and scream as we circle the drain. Either we institute fiscal reforms to resolve our problems, or meet in the streets to fight it out as we see other nations doing today.


The choice is ours.


-Paul Nathan

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