Brokerage firms, money center banks, and hedge funds have been slowly circling each other for months trying to assess each other's credit worthiness. The fear that one or more of them would fail in their commitments to the others (a risk known as counterparty risk) has been simmering below the surface for months. With the Bear Stearns action yesterday and the implosion of Carlyle Capital earlier in the week, this fear erupted into a full boil.
In this morning's Wall Street Journal, a bond-fund manager explained the essence of the problem: "The nature of financial companies is that they are pretty much a black box. If people start to worry about what's in the box, there's not much firms can do to demonstrate that they are not as weak as they appear to be. (WSJ, 1/15/08) In other words, confidence is king on Wall Street. Without confidence, the entire system grinds to a halt.
One of the Federal Reserve's most vital functions is to help maintain confidence in the financial markets. If a major financial firm gets in trouble, they sometimes step in to help organize an orderly transition. This is exactly what happened yesterday with Bear Stearns. Working in concert with JPMorgan Chase, the Fed extended loans to the erstwhile Wall Street titan to help make sure it could meet its obligations to other financial firms. This financial lifeline buys time for the markets to figure out a longer-term solution, which will likely entail the sale of the firm to a stronger entity. This is probably the first of other Wall Street restructurings. I would not be surprised to see other firms follow in Bear Stearns' footsteps.
What does this mean for the rest of us? In the near term, I expect further pressure on stocks and the dollar. The pressure on stocks will come from the continuing uncertainty about how far this credit crisis will go before it bottoms out. The pressure on the dollar will come from lower interest rates on government debt. But don't expect the lower interest rates on government debt to lead to lower rates for you and me. The same crisis of confidence that made financial institutions shy away from Bear Stearns as a counterparty will also make them nervous about the rest of us, at least until a sense of normalcy returns to the markets.
I don't know how long it will take for the markets to get back to normal. These things take time. The emerging market crunch of 1998 lasted 12 months; the dot-com debacle of 2000 lasted three years. But no matter how long this crunch takes, it is important to stay focused on relative value in the market. Right now, relative value is in U.S. stocks. We urge you to hold steady and stay the course.