This short piece from Edward Hadas about the implications of the Bear Stearns collapse is worth re-printing in full:
Bear Stearns may be the big name in financial distress right now, but it could soon have company – thanks in part to the after-shocks of its own problems.
To start with, Bear or any new owner will be under pressure to shrink its $395bn balance sheet. That would mean pretty immediate trouble for some of the hedge funds that use Bear’s prime broking services. What’s more, with liquidity tight all around, a hasty selling programme at Bear could hit prices in many asset markets, perhaps leading to more painful margin calls. There could also be further knock-on effects in the already strained $45 trillion credit default swap market where Bear is a player. It could be hard for firms that have effectively engaged in bets with Bear to unwind them.
Then there are the more indirect effects. Like the prospect of a hanging, the near-failure of a competitor concentrates the mind. Brokers and banks will be more intent on deleveraging, even at the expense of accepting some losses. Cash raised on unattractive terms is better than a Bear-style liquidity crunch.
The sudden collapse of Bear will also add to the already great reluctance to lend to financial institutions. The credit default swaps at some other brokers widened sharply on Friday and the share prices of some banks took a hammering.
Scarce and expensive credit will amplify the general financial miasma. US banks will take another $50bn or so of write-downs in the first quarter, according to Bears’ own analyst. The reporting season resumes in earnest in the coming week. There could be more bad quarters to come, with US house prices still falling and defaults on other types of consumer debt starting to rise.
The authorities will clearly do what they can to prevent a vicious cycle of debt deflation. On top of their increasingly desperate measures to pump liquidity into the system, the market is already expecting a 100 basis points cut in the US overnight rate next week. But in a liquidity crisis, rates are almost irrelevant. The Federal Reserve’s ready rescue of Bear increases the odds of a generalised, taxpayer-funded financial bail-out.
The combination of super-low rates and a possible nationalisation of loan losses will add to the pressure on the already beleaguered dollar. Indeed, while Bear is biggest firm to hit the wall so far in this credit crunch, the biggest name in financial distress could eventually be the United States.
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