Financial markets across the world plummeted early this week as traders reacted with panic to the news of the collapse of Bear Stearns, one of the US’s oldest and most prestigious investment banks.
Bear Stearns fell victim to the same “credit crunch” dynamic that brought down Northern Rock in Britain last year.
Fears that it was exposed to the crisis in US mortgage debt meant that nobody was willing to lend Bear Stearns money. It rapidly found it could not raise the cash to pay off its debts – and tumbled to the ground.
Even an emergency lending facility for Bear Stearns was not enough to calm the markets. Over the weekend the bank was sold to JP Morgan for a mere $236 million. Before the credit crisis, it had been worth over $140 billion.
In a desperate bid to stop the crisis spreading, the Federal Reserve – the US’s main financial regulator – made an emergency cut in the interest it charges to other banks.
It also announced plans for a new credit facility for investment banks. The last time the Fed did something like that was during the Great Depression of the 1930s.
But it is by no means clear that these panic measures will be enough to contain the crisis.
The problem that brought down Bear Stearns is not unique to that institution.
Most banks are “highly leveraged” – they lend out far more than the amount of capital invested in them. Now this debt bubble has burst, with disastrous consequences for the banks.
We’ve already seen Northern Rock go under, as well as a variety of less well known names such as hedge funds Peloton Capital and the Carlyle Capital Corporation.
Each casualty makes lenders even more cautious, forcing “leveraged” investors to stump up more cash up front. This in turn makes them sell their investments, fuelling the downwards cycle in prices.
Britain is by no means immune from this dynamic – and the government and regulators here could well have less room for manoeuvre than those of the US.
On Monday the Bank of England announced it was offering an emergency £5 billion in three-day loans to lubricate the system. That offer was rapidly five times oversubscribed as banks scrambled desperately for funds.
Under New Labour the City has grown into one of the most significant sectors of the British economy. A crisis in the financial sector will thus wound British capitalism far more seriously than in other countries.
Already the house price boom in Britain is in trouble. Now nationalised, Northern Rock plans to cut up to 2,500 jobs and halve the value of the mortgages it has lent out.
Over 300,000 homeowners who took out fixed rate mortgages five years ago are now in danger of defaulting because their new interest rates will be much higher.
Britain’s consumer spending is built on debt secured to a large extent on home ownership.
So a slump in the housing market here could threaten to spill over into a general recession affecting all areas of the economy.