The Subprime Beast Escapes Its Cage

In today’s interconnected global marketplace, where billions of dollars can change hands with a few keystrokes, you only need one or two events to set off a catastrophic chain-reaction that spawns panic and fear, destroys trust, and eviscerates capital markets.

Fearing such an event in response to the subprime mortgage fiasco, the Federal Reserve, in a move unprecedented in banking history, lent a whopping $30 billion to JP MorganChase so it could purchase Bear Stearns – the formerly high-flying, fifth largest investment house on Wall Steet whose stock lost 97% of its value in about 100 hours. Then, truly taking the term “bailout” to the next level, the Fed put $400 billion – more than half the cash it keeps on reserve in the Treasury and at various banking institutions – into an open-ended lending program that major Wall Street banks could borrow from, in the the hope that the credit markets won’t dry up and send us all into unheated caves for the next few years.

The Fed is trying to prevent a worst-case scenario that would involve Bear Stearns going belly-up and dumping its entire portfolio of assets onto a market where lenders are terrified and buyers are in hiding. If this happened, every other institution that held the same kind of assets would have to lower their prices, which would force lenders to call in their debts, and cause more failures. Gretchen Morgenson (who won the Pulitzer for 2002 in Beat Reporting "for her trenchant and incisive Wall Street coverage") lays out the behind the scenes action.

It’s a classic run on the bank, powered by panic and fear. Bear Stearns and many other Wall Street banks are highly leveraged, often borrowing 25-30 dollars for every dollar they hold in assets. Which , if they have $1 billion in assets, means they’re in debt for $25-30 billion. Everything is fine as long as the lenders still trust the banks to repay the money. But once the whispers start that a bank is in trouble (perhaps because it financed a gigantic pile of subprime mortgages that are heading toward default) then lenders get nervous and start demanding repayment. Once panic sets in, and everyone calls in their debts at the same time, highly leveraged banks will never be able to make the payments and, well, it only took 100 hours for Bear Stearns to meet its end.

As the villain in my political thriller, Moment of Hercules, so ably put it:

"Globalization has created a gigantic interconnected marketplace, where everything depends on something else happening. It does not take much to let loose the deadly beast of uncertainty in this marketplace, and that starts a chain reaction by creating fear. Fear that promises won’t be kept, that goods won’t arrive, that debts won’t be repaid. If you create enough fear, trust starts to break down and the psychology of panic takes over. Overreaction becomes the norm. Financial institutions stop lending, investment houses stop buying, and everyone in the markets races towards the exits. You have a global sell-off."

What’s really scary is that no central bank has ever been exposed to this kind of market risk before. In taking its actions the Fed is, in the words of one Wall Street analyst, “driving with its tank half full.” Plus, there are land mines lurking in Bear Stearns’ portfolio – assets whose value cannot be determined because, in a market with no buyers, it’s awfully hard to determine what price you can get.

Lehman Brothers looks like it could be next to go. And yes, there most definitely will be a next.