Fed's Magic Mirror

Carl Mortished
From The Times
March 26, 2008

Seen in the Fed's magic mirror, Bear Stearns appears to be worth it.
“Yo! Ben Bernanke! Give us a million dollars. I promise to pay it back as soon as I cut a deal. You want collateral? I'll give you collateral.

“I got a house — the realtor says he can sell it tomorrow for half a million. A condo in Florida, two cars, a boat and a stock portfolio — that must be worth a hundred grand.

“Whaddya mean, what's it all worth? Don't worry, Mr Bernanke, I'm not going bust. I just need some cash to tide me over until these deals come good. It's a little cashflow problem. What do you call it? Liquid-something. No, not liquidation. I mean liquidity. Like that friend of yours on Wall Street... what's his name? Barry Stearns?”

It is indeed astonishing what the support of the Federal Reserve Bank can do for your business if your name is Bear Stearns. Only a week ago the once-proud and stern Bear was whimpering like a teddy, sold for $2 per share to JPMorgan, a $300 million fire sale hailed as a lifeline. Threadbare, its stuffing of mortgage-backed securities spilling on the street, Bear Stearns was said to be as good as bust, fit only for dismemberment by the brigade of gleeful boys in buttoned-down shirts at JPMorgan.

Except this week it is worth $1.4 billion or $10 per share and it's all because of Mr Bernanke and his magic money guarantee.

The Federal Reserve did an extraordinary thing — it guaranteed the value of $30 billion of assets held by Bear Stearns. All over America, people are losing their businesses and their homes because lenders no longer believe that their assets are worth what they say they are worth.

But last week the Government of the United States of America said, if Bear Stearns believed its assets were worth $30 billion, that was good enough and the Federal Reserve would stand by it. The Fed had underpinned the house of Bear, it would no longer sink and that made possible JPMorgan's initial $2-per-share grab.

Unsurprisingly, Bear Stearn's shareholders suddenly gained confidence. They could smell the money. The difference between bankruptcy and solvency is nothing more than confidence in value and the allowance of time for that value to crystallise into cash. Confidence that bricks and mortar or stocks and bonds or even a contract can become cash is what some people call liquidity and it is what underpins solvency.

The Fed's action gave Bear Stearns what every cashflow-challenged businessman wants — a guarantee of value and a week's grace. Of course, the guarantee was not really a lifeline because Mr Morgan doesn't care two figs for Mr Bear or Mr Stearns. Mr Morgan wants to expand his house into his neighbour's plot.

More importantly, he wants to make sure that there is no embarrassment at the Bear Stearns home that might bring down property values in the Wall Street neighbourhood. No bailiffs please, no car repossessions at 2am, no foreclosures and tacky garage sales.

Central bankers have a fancy name for embarrassment. They call it systemic risk — a sudden, panicky fear that everyone's home is worth as little as the Bear Stearns home. But Mr Bernanke's wand has worked its magic. Suddenly, the house of Bear and Stearns is on solid ground. There is no systemic risk. Stock prices are rising and the stampede of frightened investors towards the safety of gold and oil appears to have slowed.

This is illusion. Nothing has really changed except that, like every good magician, the Chairman of the Federal Reserve held up a mirror that showed an alternative reality. Bear Stearns and every other Wall Street bank are still holding the rubbish assets they owned a week ago and American families are still swimming hard in the deep end, trying to keep their heads above the water line of illiquidity.

Let us be real about liquidity. It is not some technical term — it is the essence of a business, it is the ability to generate cash from what you do. If your business depends on a million-dollar contract with a customer who is deemed unreliable, is your turnover really a million dollars? If a bank refuses you an overdraft to fund that business, are you just illiquid? At what point do you become insolvent?

What lies beneath the Wall Street towers rarely bothers bankers as long as the surface glitz is untarnished. A clutch of Bear Stearns investors will continue to scream injustice — if $2 can become $10 in the space of a week, surely by the end of three months the bank that was bust will be worth billions more.

Outside, in the not very real world of American consumer finance, perceptions of reality may also change. There has been a slight pick-up in home sales in America — normal as a real estate downturn shifts from deadlock to sell-off mode.

Dubious lenders that had shut up shop will see the distorting mirror, not the reality, and will begin to scout for new victims in the belief that any transaction can be turned into a commission and a cash margin. Some talk of moral hazard in the Fed's underwriting of the Bear Stearns takeover, but we should not imagine that the Ivy League team at Bear will carry on with their country club memberships intact. Many will lose their jobs, punishment for the financial crime of pretending that risk was a statistic that could be manipulated. There was talk of 20,000 job losses on Wall Street even before the Bear stumbled.

The bigger question is whether this loss of liquidity, the massive sucking of cash out of the wallets of Americans is part of something bigger — a loss of confidence in the ability of Americans to maintain the lifestyle to which they have become accustomed.

The liquidity has been flying east and south for many years, chasing profits in huge industrial and energy projects in emerging markets. It will continue to do so, seeking better returns, more promising prospects than funding the lifestyle of the underskilled, the tired and the underperforming.