Multi Trillion dollar near miss: Bear Stearns could have caused real crisis

It doesn’t get a lot scarier than this. Apparently Bear Stearns, at the time of its sudden insolvency, was carrying trading contracts worth $2.5 trillion, globally. This has led to some introspection on the subject of Wall Street’s insularity.

The New York Times sets the scene, very graphically, using a conference call as its opening stanza: “JUST after JPMorgan Chase announced its initial $2-a-share deal to buy Bear Stearns, government officials held an extraordinary impromptu conference call. The participants on the Sunday night call, who got a preview of the deal, were Wall Street’s biggest power brokers: Lloyd Blankfein of Goldman Sachs dialed in from home. John Mack of Morgan Stanley rushed to the office to listen on speakerphone. Richard Fuld of Lehman Brothers, who had been directed to return home from a business trip in New Delhi by none other than Henry Paulson, the Treasury secretary, was patched in, too, among others.

The half-hour call, led by Mr. Paulson and Timothy F. Geithner, the president of the New York Federal Reserve Bank, was a rallying cry for support of Bear Stearns — and more broadly, the financial markets, which, as it was described on the call, were on the verge of a major meltdown if not for the pre-emptive steps that the Fed and JPMorgan took. “It was much worse than anyone realized; the markets were on the precipice of a real crisis,” said one participant. Given that Bear held trading contracts with an outstanding value of $2.5 trillion with firms around the world, “we were talking about the possibility of a global run on the bank.”” This wasn’t poker night at Henry Paulson’s place. This was a meeting of the minds on an immediate situation whereby Bear Stearns, the financial markets, and that $2.5 trillion, comprised of real, payable, contracts, were effectively in free fall, which would hit the global economy like an asteroid saying hi to the dinosaurs. The problem is debt, and a lot of it. The global financial market, like the US, runs on credit, sometimes complex credit. When that fails, it hits everyone, in some form or other. Imagine you’re one of many people building a house of cards without a building code. You do what’s necessary to make your cards stand up, but there’s not a lot of coordination with anyone else. Banks and financial institutions borrow money, but they have their own methods. Say you’re a bank. You have a certain amount of assets, and you borrow against those assets from another bank of financial institution, to invest in other financial products and make more money. Naturally, you also want to be able to borrow big money, to maximize your returns. To do that, you have to find more assets to use as collateral for your borrowings. It’s a rational process, at this point, but it gets a quite bit less rational when the assets become things like selling interests in your own lendings, like mortgages, which you package up and sell as securities to investors. You get their money, and they get the returns, or a good rate of return, from the securities. So, on the basis of these securities, you borrow more money. It’s a routine process, but it's also a very fluid process, because some people will sell their securities at a premium to others, and the scene about who's holding what, and who's exposed to what, becomes very complex. One of the very few valid statements made about the difficulty in finding out who was exposed to what in the subprime situation was that it really would have taken some time to physically go and find out. Then you discover that those securities are worthless, and you’re up to your ears in debts secured by nothing. So, you either pay what's owing, or you produce some assets as collateral. And if you can't do that, you're dead. You've also contributed to the deaths of others. Because everybody else in the sector is playing the same game, if you default, you trash your creditors, which trashes someone else who lent to them, etc. The financial house of cards is not a very good load-bearing structure under these conditions. Just to make things peachy keen, a lot of quite worthless “assets” were all anyone has to show for this bit of chaos. Investors all over the world were hit, bank stocks got hammered mercilessly, and global equity markets lost $5.2 trillion in value in January, 2008. Nobody blinked much about that $5.2 trillion, which was a lot of money, and represents a lot of lost investment and business, but the markets and institutions had other things to worry about, like their own survival. The difference with this $2.5 trillion is that it was and still is, a load bearing $2.5 trillion. That money was payable. The rules are that "Thou shalt pay up when due", because that's how the machine works. Non-payment means the machine is not at all well. Bear Stearns is/was a very big noise in global finance, and the financial sector needed that $2.5 trillion to do business. A series of defaults across the sector on that scale would make the house of cards look like Dresden after the fire bombing. So the Fed did glue the scrambled egg back together, and prevented what would have been a very ugly situation. Paulson, who is apparently working 48 hour days, deserves special credit for his tireless efforts. The New York Times article comments aptly enough that while the rest of the world was generously let in on the secret eventually, it’s still Wall Street The Mighty calling the shots. “…The Four Seasons crowd may talk a big game about being global — sending lieutenants to start offices halfway around the world — but when it comes to opening up its secret society to foreigners, oddly, doing so is still an afterthought.

It is not just a problem in business. While the Fed and the Treasury Department often check in with their foreign counterparts, they still sometimes take a view that is more local than global. Mr. Paulson, formerly of Goldman Sachs, can propose a radical plan to regulate the financial industry in the United States, as he did this week, but it doesn’t address the larger problem: we’re now so interconnected with the markets abroad, whether it be Japan or even Brazil, that whatever we do on our own is almost beside the point.” Big Debt is also not likely to be contained by local measures. The Global Village, or in terms of the financial sector, the Global Pillage, is a circular process. The hits on the market may be spread a bit wider, but that, if anything, makes it worse, because exposure can affect banks and financial institutions around the world in 24 hours. The movements of capital can be convulsive, as we’ve seen with recent events. Those guys on the phone weren’t kidding about a global run on the bank. A very real possibility, and a very nasty one. Now a global meltdown scenario is being envisaged. It’s hypothetical at this point, but it’s not impossible, and it would work very much like the Bear Stearns scenario, but with no way of bailing out the guy holding the big money contracts. Consider what happened when thousands of mortgagees started defaulting in the US, and now consider what thousands of banks and financial institutions defaulting on their contracts would look like, while probably experiencing runs on their own money. What happens is that if one borrower can’t pay another, the process continues indefinitely. The market has shown a total inability to cover its tail in terms of the present situation. It doesn’t even have the methods in place. The Fed has had to do most of the work, and nearly all of the anteing up, to pay for this fiasco. The US can consider itself lucky it still has a financial sector. Internationally, there’s a further problem coming. Whatever anyone thinks of the US’ very insular approach to international matters, the Asian and Europeans are now generating huge amounts of capital. There are real questions about their fiscal motor skills and eye/hand coordination, should their big financial heavyweights encounter a similar situation. European finance took a massive pounding, even on the periphery of the US credit crunch, with relatively limited exposure. In Asia, the money moves in and out of markets like schools of barracuda. The last big financial crisis in Asia trashed the entire economies of several ASEAN nations, flattened their currencies, and the pieces are still being picked up, a decade later. There’d be a run on the entire Asian capital market, in a crisis. Like to guess where that would eventually wind up? Yep, right on the American lenders. The US is a major global investor, and is positioned right where the tsunami is likely to hit, if the global markets can’t handle it. If this mess has proved one thing, it’s that the bigger the target, the more hits it takes. At the rate they’re growing, the European and Asian markets will have enough capital inertia to do real damage, in the next 20 years. A global approach to the securities industry, with some good interactions with central banks, is probably the only way to handle the next big crunch. That couldn’t possibly be a simple process, but at least you’d have a theoretical ambulance for the casualties, and a theoretical hospital to send them to, as distinct from nothing, which is the situation at the moment.