SERIOUS MONEY:FINANCIAL MARKETS were plunged into chaos last week as the US's worst credit crisis in modern history rolled on and deteriorated as the possibility of a financial meltdown edged ever closer following a classic liquidity run on the unregulated non-bank system.
The latest trouble first surfaced at Carlyle Group, the bastion of private equity capitalism, as one of its sponsored hedge funds collapsed after increasingly cautious and capital-constrained institutions refused to provide refinancing. Unfortunately, the turmoil did not end there and quickly spread to the heart of the financial system as Bear Stearns, the so-called "Sparta of Wall Street" and its 85-year history proved to be a soft belly in the face of recent travails.
The notion that the current difficulties are comparable to the demise of long-term capital management (LTCM) a decade ago is beyond naivety and deserves no attention at all as the liquidity crisis has morphed into a more serious solvency problem.
The demise of Bear Stearns represented a classic liquidity run as the counterparties - the financial parties with which it dealt refused to trade with the ailing institution and fled just as depositors did from the UK's Northern Rock last September.
It should come as no surprise to astute investors that the number of defunct institutions continues to grow - the casualty list continues to rise and the number of insolvent providers of finance edge ever higher. Indeed, roughly 240 mortgage lenders have closed their doors forever over the past 15 months and almost 70 hedge funds have met their death since last summer, but the credit crisis reached alarming proportions at Bear Stearns, whose chief executive Alan Schwartz declared just days previously that conditions were improving. How wrong can a man be!
The chaos and the subsequent liquidity run on the non-bank system left the Federal Reserve with no option but to act immediately in to relieve liquidity pressures in the capital markets and forestall a systemic failure. The Bernanke Fed is no longer in denial and its latest actions demonstrate that it is well aware that its traditional policy tools via aggressive monetary easing will not resolve the serious issues facing the financial system.
Helicopter Ben, as Bernanke is known on Wall Street, was making every effort to stabilise the credit crisis and has introduced a series of new facilities to restore calm to capital markets. Under his direction, the Federal Reserve has created a number of liquidity facilities to keep financial institutions encountering short-term problems alive. The measures introduced include the term auction facility (TAF) for depository institutions, the term securities lending facility (TSLF) for primary government securities dealers and the primary dealers credit facility (PDCF). Opening the discount window to non-banks seemed unlikely just days ago, according to Donald Kohn, vice-chairman of the Federal Reserve.
The radical extension of lender of last resort support to non-bank institutions is not without risk. In this regard, investors need to distinguish between liquidity and solvency.
Investors should be under no illusion in the current environment - the crisis is serious. A serious downturn is at hand.
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