Jeremy Warner's Outlook: Bear fire sale marks start of capitulation

On the Richter scale of financial crises, the present implosion now registers as a full force nine – 10 being of the never-before-recorded variety. I'm not sure we can yet call it a 10, for this would imply a dislocation and resulting economic contraction worse than that of the South Sea Bubble or the Great Crash of 1929. Calamity on such a scale still seems improbable.

None the less, it is quite bad enough. Before attempting to analyse just how bad, it is worth reflecting on how much more decisively – I won't yet say "effectively", for only time will tell the effectiveness of these actions – the US Federal Reserve has dealt with the Bear Stearns crisis than our own authorities handled the Northern Rock debacle.

Through its various actions, the Fed has made it plain beyond all doubt that it will do everything possible to stop the crisis turning into a rout. It may yet fail, and certainly it is hard to see why further cuts in interest rates would ease a situation that has nothing to do with the high cost of money, but at least it is acting with resolve. Such steely determination has been sadly lacking on this side of the pond. The contrast with the tripartite authority of the Bank of England, the Financial Services Authority and the Treasury here in the UK could hardly be greater.

With no one apparently in charge, the British approach has been characterised by drift, inaction and quintessentially English faith in everything turning out for the best. The Bank of England has shown itself willing to change, by providing the liquidity that was lacking at the start of the crisis, but it has hardly been a Damoclean conversion and it still worries about the moral hazard created by supporting distressed capital markets.

With Northern Rock, the possibility of a rescue by Lloyds TSB was rejected before it was allowed to evolve into a serious proposal, this on the grounds that the Treasury couldn't be seen to be subsidising a private-sector takeover.

Lloyds was demanding that £30bn of the Rock's liabilities be refinanced by the Bank of England. With the benefit of hindsight, this looks a fantastic deal compared with the place the Treasury eventually found itself. In the end, it was forced to nationalise, so intractable had the situation become.

The Fed has shown itself to have no such scruples in subsidising a private sector bailout. By late Friday afternoon, it was already brutally obvious that the offer of emergency funds from the Fed through the good offices of JP Morgan Chase wouldn't be enough to do the trick.

The run on the bank was accelerating, rather than dissipating. Alan Schwartz, the Bear Stearns chief executive, was given an ultimatum. Either sell the bank to Jamie Dimon of JP Morgan, or the Fed might withdraw its support come Monday morning. It was gun-to-the-head stuff, and it's what should have happened with Northern Rock, but there was no one there with the authority to command such an outcome.

The Fed has supplemented its action in forcing the JP Morgan takeover with a whole raft of other, previously unthinkable, measures. Some $30bn of Bear Stearns' assets are to be directly underwritten by the Fed, and, perhaps even more significantly, the Fed's discount window is to be made available for the first time to the entire broker-dealer network. What's more, the length of time bankers can borrow has been substantially increased and the quality of security accepted has been widened. Had all this been available a week ago, it might have saved Bear Stearns.

As it is, Mr Dimon ends up with what may come to be seen as the bargain of the decade, assuming furious shareholders aren't able to scupper the deal. For just $236m, he gets Wall Street's fifth largest investment bank. Bear Stearns' New York head office alone is worth more than $1bn. Bucking the trend among banking stocks, JP Morgan bounded nearly 10 per cent, helping to push the Dow Jones Industrial Average higher on another turbulent day for the index.

For banking stocks as a whole, there was no respite as investors absorbed the full enormity of what's just happened. Yet looking through the smoke and dust, there are a few positives to be drawn from the demise of Bear Stearns. We are beginning to enter that phase of a financial crisis which is known as "capitulation".

Up until now, bankers, hedge funds and other investors have tried to hang on to their mortgage-backed securities and other forms of distress debt in the belief that eventually the market will recover and they'll be able to sell at a more reasonable price. That's changed in the last couple of weeks. As credit becomes ever scarcer, many no longer have any choice but to sell. They don't have the liquidity to ride it out.

Bear Stearns can be seen as a symbol of that process. To sell such a proud name for such a pittance is a point of surrender that would not have been even remotely conceivable six months ago. Yet it is events like this which provide markets with their eventual catharsis by creating bargains that bring back the buyers.

Regrettably, Bear Stearns is unlikely to be the end of the workout but only one of a number of similar acts of capitulation, possibly lasting many months. In the UK, bank share prices have reached levels which discount a series of hefty rights issues or alternative capital-raising exercises. The Governor of the Bank of England has already called on UK banks to recapitalise themselves, in much the same manner as Hank Paulson, the US Treasury Secretary, has of American banks.

In the UK, the response has been the reverse of what the authorities want, with banks raising dividends in an effort to demonstrate to the markets that, in the view of directors, they don't need more capital.

Paradoxically, we may have reached a stage of such complete risk-aversion among investors that the share price might even rebound for the first bank brave enough to admit there is a potential solvency problem and raise more capital. Barclays could probably do it without too much loss of face. Royal Bank of Scotland might struggle credibly to pull it off as long as Sir Fred Goodwin, who expensively bought assets only last summer, remains chief executive.

As things stand, all banks face varying degrees of liquidity shortage. Because banks no longer trust the quality of each other's balance sheets, they have become reluctant to lend to one another, which creates an absence of funding and a consequent inability to pay liabilities on demand or as debts fall due.

Banks with big capital cushions can sell assets to raise liquidity, even in a falling market. With declining asset values, capital-constrained banks struggle to raise funds in the same way as the effect of selling assets at a loss is further to impair the capital cushion. In the view of some City analysts, British banks as a breed are critically undercapitalised in view of what is likely to be a period of rising impairment charges.

One of the reasons regulators and politicians want to see banks recapitalise themselves is that banks with poor balance sheets will struggle to support economic growth with greater lending. To the contrary, they may even contract their lending, causing a worse-than-otherwise economic contraction.

Many of the more exotically designed instruments and conduits through which the credit boom of the last 10 years were funded have now in all probability gone for good. Even if markets felt inclined to revive them, the more straitened regulatory climate we are now inevitably heading into wouldn't allow it, with the political backlash against the investment bankers now growing in strength.

Other forms of credit may take months, possibly years, to start functioning normally again. Whole swathes of the capital markets as they came to exist are being extinguished by the current tidal-wave of risk aversion. The effect on the wider economy cannot be anything other than negative. The only question is of degree.

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