Bear facts worth remembering

CROESUS/AN INSIDER'S VIEW:THE NEAR COLLAPSE and subsequent bailout of Wall Street's fifth-largest investment bank, Bear Stearns, rocked world financial markets on St Patrick's Day. The events leading up to this latest crisis echoed those of the Northern Rock crisis in the UK.

Rumours had been circulating that Bear Stearns (BS) was having liquidity problems and they ultimately proved to be self-fulfilling as Bear simply could not raise sufficient cash to meet its immediate liquidity requirements. The bank is a large player in the derivatives markets where institutions can take very large market exposures without having to put up much cash. However, in volatile markets such positions can rapidly generate large losses which require cash to be immediately paid over to counterparties.

The near-collapse of BS was the latest extreme example of the current unwillingness of banks to lend to each other.

Just as in the Northern Rock case, the crisis at BS was one of liquidity and not solvency. Indeed, the shares continue to trade on the stock market and are trading at a price that is higher than JP Morgan's knock-down $2 per share offer for the company.

It does seem that, in moving rapidly to organise a rescue, the Federal Reserve learned some lessons from the Northern Rock situation. Just prior to the Northern Rock rescue it had been rumoured that Lloyds TSB had been prepared to mount a bid but the Bank of England would not countenance providing sufficiently large guarantees. Subsequently it took six months to reach the final resolution which was the temporary nationalisation of Northern Rock.

Banking stocks throughout the world were badly hit in the aftermath of the BS rescue. However, US financial stocks rallied strongly as the Fed cut its discount rate, which is the rate at which it lends to the banking system, by a percentage point, and cut the Fed Funds rate by three quarters of a point, to 2.25 per cent. More importantly the Fed sharply extended its support to the financial system in order to dispel lingering fears that other institutions could suffer the same fate as BS. The strength of the bounce back of US equities surprised some analysts given that the Fed reduced the Fed funds rate by just 0.75 per cent when many had been expecting a full percentage point reduction.

In the statement accompanying the interest rate announcement, the Fed acknowledged that policy remained focused on fostering economic growth. However, the need to control inflation was also highlighted.

Many economists are predicting that the Fed funds rate will eventually be cut to 1 per cent, the level it hit in the 2001/2002 slowdown. What is being overlooked is that inflation was much lower in those years, with consumer prices rising by only 1.6 per cent in 2002. Indeed one of the big worries at the time was the perception that deflation was a significant risk, which could have negated the impact of low nominal rates.

In an environment of declining prices, real rates of interest would remain positive even if nominal rates were cut to zero. Depending on which measure is used, inflation in the US is now about 3 per cent, which implies that real interest rates are now negative.

Croesus takes the view that 2 per cent may well be the low point for US short-term interest rates, but this should still deliver a powerful stimulus to the economy given that it implies negative real interest rates.

Irish banking stocks were also hit hard on St Patrick's Day and did join in the subsequent global recovery. However, the recovery in Ireland was somewhat anaemic, reflecting deepening concerns regarding the large property related exposures of the Irish banks. Fast-moving global financial market developments have been unequivocally bad news for the Irish economy.

On the currency front, the strength of the euro against the dollar will result in a serious loss of competitiveness over the next 12 months. Of even greater concern is the strength of the euro against sterling where the rate is now 0.78, which would represent parity for the old Irish pound.

Over the short term, at least, these exchange rate moves are not going to reverse and therefore the strong euro will act to depress Irish economic activity over the next year.