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The ongoing credit crisis in U.S. financial markets has claimed a huge and high-profile victim: Bear Stearns, the Wall Street investment bank and securities brokerage firm. After being slammed by what amounted to a run on the bank during the week of March 10, Bear Stearns was pushed to the brink of bankruptcy and then agreed to be acquired — for $2 a share — by JP Morgan Chase over the weekend. Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson played an active role in the transaction, largely because of the potential impact that a major bankruptcy might have on confidence in the financial markets. That same day, the Federal Reserve lowered interest rates — as it did again on March 18, by three-quarters of a percentage point.
As the credit crisis shows no signs of easing, are other Wall Street firms likely to follow Bear Stearns into oblivion? Will the Federal Reserve’s efforts help to boost confidence in the financial system among U.S. and international investors? Finance professor Jeremy Siegel, author of The Future for Investors, discussed these questions and more with Knowledge@Wharton.
Below is a transcript of the conversation.
Knowledge@Wharton: The Fed just lowered the interest rate by three quarters of a point. What effect do you think that will have?
Siegel: That was right in the middle of expectations and what I thought they would do. There were two dissents this time, which is quite a lot: Charlie Plosser joined Richard Fisher from the Dallas Fed. Charlie Plosser is from the Philadelphia Fed. I know him very well. He was actually a student of mine when I taught at the University of Chicago. On the whole, I think that what Bernanke is doing is very good — he’s being aggressive where he has to be. But, as I mentioned in our last podcast, I’m concerned that the Fed is not acting as concerned about inflation as it should.
The Fed did, in its statement, acknowledge that there were inflationary pressures, but it did not elevate inflation as a problem equal to the problem of growth, and I think that both are problems at the present time. So, we’re going to have to see how that plays out and whether commodities are going to continue their ride upward. It was broken yesterday, but without [the Fed's] coming out strong against inflation, we’re going to be watching those commodity prices, and that’s going to be important. If they go back down, it’s going to be all right, but if they continue going up, it’s a threat.
Knowledge@Wharton: Let’s turn to the other big story that’s been playing out this week. Why did Bear Stearns implode so quickly?
Siegel: It was similar to a “run on the bank.” We don’t have runs on banks anymore, because we have deposit insurance — we have the Fed explicitly standing behind all of the deposits. Basically, what happens is that rumors start that your money isn’t good; then, you know you won’t lose anything by getting it out, so you run to the bank and get it out.
Now, in this case, it’s not a bank in a formal sense; it’s lenders that have been lending Bear Stearns money against their portfolio, against their purchases. And then, all of a sudden, they were worried about whether they would be repaid, because this is very short-term lending. They all yanked their lending — and this caused a tremendous cash squeeze, because they didn’t have enough cash. And that’s when the real problem started.
Knowledge@Wharton: Was the weekend sale at $2 a share to J.P. Morgan Chase the right move for the markets?
Siegel: That surprised me a lot. When they announced last Friday that the Fed was giving a $30 billion credit or guarantee to J.P. Morgan Chase, I thought that was a good move. They said that it was going to be for 28 days. I thought that they would take four weeks and auction off Bear Stearns, or tell them to find other financing — that they didn’t have to sell themselves. I was very surprised that it was done so quickly and quite puzzled by it. I don’t know whether $2 is a good price. I think that there’s going to be a lot of controversy about this issue going forward.
Knowledge@Wharton: Controversy in terms of what?
Siegel: In terms of the shareholders at Bear Stearns. This was a stock that was selling at $160 less than a year ago. Even after all of the problems were announced last Friday, it closed at $30 a share. No one dreamed that it should be $2. And to sell it out at $2, unless we don’t know all the facts, seems to me to be too extreme — and I don’t understand why it had to be done so quickly. Maybe there will be information forthcoming about that. Maybe the management did think that they were bankrupt and wanted to sell it out at $2, rather than go through bankruptcy. We’ll have to see what the results are, but it was a pretty shocking price.
Knowledge@Wharton: What impact would a Bear Stearns bankruptcy have had on other financial institutions?
Siegel: Well, one would ask the question: Is there much difference between $2 and a bankruptcy? That’s one reason why I think the 28-day loan that the Fed made last Friday was very appropriate. In other words, “Let’s give us time to sort this out and make a reasonable attempt at getting other financing and find out what the assets are.” And, that’s why it surprised me that a sale was pushed through so very, very quickly here. So, I liked what the Fed did on Friday. I’m not quite certain about why it then had pushed through, as word has it, a sort of “emergency” sale at a fire sale price.
Knowledge@Wharton: The timing was supposed to happen prior to the opening of the Asian markets on Monday, correct?
Siegel: Right. The interesting thing is that the markets were actually going to be opening better — but when they learned of the $2 price, that panicked the market. That was a very bad piece of news. Actually, when they announced that they were cutting the discount rate, as they did before the markets opened, this was a good move; when they heard the word sale — good move; but when they announced the price at $2 — bang, everything fell apart. So, it was the price more than anything else that shocked the market. I certainly support the move of lowering the discount rate as they did a quarter of a point.
Knowledge@Wharton: Is Lehman Brothers vulnerable?
Siegel: Certainly when you looked at the market yesterday, they were — it sold as low as $20. Today [March 18], a lot of confidence is coming back and it is selling at $40. I think that they are vulnerable. Everyone is “vulnerable” to a certain extent of a run. However, their financial status, from everything that we know about Lehman, is far better than Bear Stearns’.
Bear Stearns, first of all, was far more involved in the mortgage-backed market, far more levered. They thought that this stuff was great. They were buying it all the way down and with leverage. Although many Wall Street banks ended up owning some of it, they didn’t keep on piling it up. It looked like kind of a double-down strategy on the part of Bear Stearns. I mean, this stuff is worth little.
The truth is, had they had the liquidity to hold on, the Bear Stearns positions might have turned out to be very profitable. [It's] just like Long-Term Capital Management ten years ago — had they been able to hold on, those positions became profitable. But they weren’t in both of these institutions, and as a result, without liquidity, this is a major risk.
Knowledge@Wharton: You mentioned your surprise at the Fed’s move in all of this. What is your take on the Fed’s role?
Siegel: The Fed is playing a proper role. One has to realize that when the Fed was founded nearly 100 years ago, there was just the banking system. There really weren’t as many investment banks and all of the markets that we have today and everything else. So, all of the lending functions were defined in terms of the banking system. Our financial system is so much bigger today. It covers I-Banks as well as commercial banks and all sorts of markets that did not really exist before.
So, I think it is very proper for Bernanke to now say, “Let me extend credit to primary dealers. They don’t have to be dealing just with the commercial banks.” In other words, we have to recognize the extensions of the credit markets and the financial markets, and I think that he is doing so. As I say, at this point, the only quibble I have with his policy is that I’m worried he’s not coming out a little stronger about inflation because I think this is what is driving commodity prices and the dollar.
All of his other moves, I think, have been very well thought out. And certainly even the declines in interest rates — if he had put a sufficient caveat on that, I think I would approve of that also. On the whole, though, the Fed is doing really just about everything in its power now to keep the situation from developing into something worse. And people ask, “Can it get any worse?” When we look at the effects on the real economy so far — yes, home prices are falling. Yes, the home building industry has turned negative, as it has for the last year.
The amazing thing is that the best estimate of The Economist is that GDP growth in this first quarter, just like the fourth quarter of last year, will again be positive. As we know, the unemployment rate has just ticked up a few tenths of one percent. There have been tremendous disturbances and turmoil in the financial and credit markets. But, in the real economy at this particular point, we would have to say that the effects are relatively mild.
Knowledge@Wharton: What about the issue of moral hazard? Some critics have said that the Fed’s inserting itself in this situation….
Siegel: I think that we all heard that when we were listening to the news reports. This was not a bailout by the Fed. I mean, when the price of the stock goes down 99%, virtually wiping out every share owner — and in fact, I’m shocked that they set the price so low; I really think the intrinsic work was probably a bit higher. One-third of these were Bear Stearns employees that held the stock, in one form or another. The firm’s equity was virtually wiped out.
So, people say, “Oh, this is encouraging this type of behavior.” If you wipe out 99% of the value of a stock, that’s not going to encourage that sort of behavior. Also, one has to realize that this was actually a loan to J.P. Morgan Chase and they are intending to unwind that loan. My prediction is, by the way, that the Fed will not take any loss on those guarantees. This is because I think when everything is sorted out there will be enough to cover that and there won’t be any loss. And so I don’t believe that this will encourage similar behavior. If they had said, “We’re buying out Bear Stearns at $100 a share,” that would be entirely different. But not at $2 a share.
Knowledge@Wharton: So, they’re not laying out a safety net?
Siegel: There is really no safety net. Basically, Bear Stearns went all the way down; it just didn’t technically go into the bankruptcy.
Knowledge@Wharton: Are the recent interest rate cuts likely to restore confidence in the financial markets?
Siegel: It’s more than just the interest rate cuts; it’s all of these actions to extend credit beyond the traditional commercial banking areas, into other financial areas, and the process of lowering it. My feeling is that we’re going to get through this. And I think that the Fed, by late summer, will emerge as “Wow, we went through a really difficult time and we saved the economy, maybe not from a recession — but from something much worse.”
We know what it could have been because the 1930′s were a similar sort of situation, but the Fed did not stand behind the financial institutions — and then they were banks. They let them all fail and then we had the worst economy in history. I think that when we look back, we will say [Bernanke] did everything he reasonably could. We’re going to have maybe a mild recession, but we’re going to avoid anything worse. Bernanke may very well easily turn out to be a hero here, when everything is said and done and the recovery comes.
Knowledge@Wharton: If not a recession, are we likely to have a longer and deeper slowdown that we’ve had, at least in recent times?
Siegel: Actually, the interesting thing is that the slowdowns have been a little longer, but much shallower. The deep downward spikes that we used to get, particularly in manufacturing — those suddenly down-and-then-up spikes of unemployment — have given way in a more service oriented economy, in a slower, much more muted behavior of unemployment and employment and for a little longer.
In other words, remember the sluggishness coming out of the 2001 recession prompted Greenspan to keep rates down for a long period of time. So, my feeling is that we may not pick up until 2009, although I think that 2008 might surprise us in the second half. But I certainly think that it’s going to be a very mild recession, if we do have one.
Knowledge@Wharton: What are the implications for international markets?
Siegel: Well, the falling dollar is a concern. I voiced that at our last podcast. I worry that the international community has not lost faith in the Federal Reserve or in Bernanke in terms of fighting the downturn, but in terms of fighting inflation and giving up on the international value of the dollar, and I think that that is driving them. Since we’ve talked a couple of weeks ago, the dollar has gone down even further, commodity prices have risen, and oil is now at $110 and going higher. That is my primary concern. I think that is a bigger concern than Bear Stearns and the others. Those have hit the headlines.
But what is happening to the dollar and what’s happening to commodity prices has a deeper meaning. I’m afraid that it’s just going to give an upward pop of inflation, which means that Bernanke will then have to turn back from these cuts and in fact raise rates later on. So, if he came out against inflation now, I don’t think that he would have to raise rates as much later on. If he voices his concern, he can break the commodity bubble and save higher rates later on.
At this particular juncture, I am waiting for the market. We just got these cuts today. We’ll see what happens on the commodity markets. But if they continue to rise and the dollar continues to fall, Bernanke is going to have to say, “We now don’t believe any more cuts are needed, or are desirable for our economy.”
Knowledge@Wharton: What should investors be thinking about doing now?
Siegel: Well, it’s interesting in terms of [the question] when should you sell? The market has gone down a little bit since then. We’ve had a very good day today, so far. One thing that I look at is market sentiment — and I won’t go into the details, but we’ve had some indicators that were very, very negative on the part of individual investors….
That is a contrary indicator in the sense that when everyone gets bearish and everyone throws in the towel and says, “It’s just horrible,” that is usually where the market turns around. And I’m beginning to see a lot of that negative sentiment move into the market. I’m seeing spikes of volatility. I’m seeing all sorts of indices flashing high anxiety. Those indices are pretty reliable at bottoms, in terms of [indicating them]. I won’t say that we’re at the bottom right now, but I think we’re very close to the bottom.
Don’t get scared and sell anything out. This is not going to be a Great Depression. I know that some people are talking about it, but if you see the way the Fed is moving and making sure that liquidity is in the system, and if you look at what is happening in the real economy — and believe it or not, it’s still moving along with, very few people, net, having lost their jobs — I think that you will see that there are a lot reasons for being confident about the future.