The epicenter of the financial crises

Robert Samuelson:

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At the epicenter of the crisis are the now-notorious "subprime" mortgages made to weaker borrowers and subsequently "securitized." On paper, the financial system seems to have ample resources to absorb losses. Commercial banks have $1.3 trillion in capital; U.S. investment banks in 2006 had an estimated $280 billion in capital -- and other investors, including foreigners, may hold half or more of subprime loans. But no one knows who or how much. Recent estimates of subprime losses range from $285 billion to $400 billion. They might go higher. Ignorance breeds caution and fear.

The stunning fall of Bear Stearns reflects these realities. It was not a traditional commercial bank that took deposits from the public but America's fifth-largest investment bank that funded most of its operations with borrowed money ("leverage"). On average, the ratio of borrowed money to underlying capital for investment banks and hedge funds is about 32-1, according to a recent study. Many of these loans -- commercial paper, "repurchase agreements," bank credits -- are backed by the securities owned by the borrowing financial institutions.

What this means is that if lenders became worried about the worth of these securities, they might ask for more collateral or pull their loans. In effect, that's what happened to Bear Stearns. Deprived of its credit lifeblood, Bear Stearns either had to collapse or be purchased by someone with credit. J.P. Morgan Chase bought Bear for almost nothing: $236 million for a firm valued at $20 billion in January of 2007.

Whether Bear Stearns was the victim of unfounded rumor or of genuine rot in its securities portfolio is unclear. But the very uncertainty defines the nature of the modern financial crisis -- and the difficulties facing the Fed in trying to contain it. Financial institutions (banks, investment banks, hedge funds, and others) are interconnected through networks of buying, selling, borrowing and lending. These require confidence that commitments made will be commitments honored. If the confidence collapses, the processes of extending credit for the economy and of trading -- for stocks, bonds, foreign exchange -- may also collapse.

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To restore confidence tot he marketplace will take more than Fed guarantees. Much of the problem is driven by the uncertainty of the value of securities whose value is set by an imperfect market. To get a handle on the value of these mortgage backed securities we need to do a risk analysis of each portfolio and set out the risk factors so that the risk can be managed in a rational unemotional manner. Right now it is being managed on the basis of unknown risks which drives the valuation down in an attempt to compensate for that unknown risk.