Fear stalks bear market

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The Independent Online

The FTSE 100 is at a two-year low; the US Federal Reserve has announced an emergency cut in interest rates and taken over $30bn of Bear Stearns' assets; the dollar has flopped to an all-time low against the euro, and hit a 12-year low against the yen; the Bank of England saw fit to lend a further £5bn to the banks; the Mumbai stock market was down 6 per cent yesterday, Hong Kong fell 5 per cent and Frankfurt 4 per cent. Even President George Bush admitted: "We are in challenging times".

Is this the moment? The moment, that is, when the world economy slides into slump? The collapse of Bear Stearns is a signal of much worse to come. Perhaps the most significant barometer of the economic health of the world today isn't the FTSE 100, the Dow or the Nikkei, dreadful though they were at times, nor the free-falling dollar or the soaring value, yet again, of gold. Rather it is the suddenness with which the situation is being compared with the 1930s, the most miserable decade in a century of economic history.

That may be an apocalyptic view, a typical product of the mood swings of markets suffering from bipolar syndrome; but the world economy is sick. It is suffering from illnesses that are beginning to feed on each other, creating a vortex of downward spirals. Grim forces have gripped the world economy, a combination not seen since the Great Depression.

No wonder, then, that the mood was panicky in the markets yesterday, the threat of a full-blown banking crisis causing a new round of convulsions that wiped billions of dollars off the value of stocks and sent many popular bank shares plunging in value.

Investors were shocked by the revelation that Bear Stearns, the fifth largest investment bank in the US, had become virtually worthless in a matter of days, after a crisis of confidence led its customers and trading partners to abandon it. It was being run, in effect, yesterday by its rival JPMorgan Chase, which bought the business at a fraction of its previous value in a rescue deal orchestrated by the Federal Reserve late on Sunday night. The US Federal Reserve itself guaranteed $30bn (£15bn) of Bear Stearns' assets, the biggest central bank bail-out ever.

That deal averted immediate disaster, preventing a bankruptcy that would have triggered chaos among Bear Stearns' large network of interconnected trading partners, including its fellow investment banks and players in the $3 trillion hedge fund industry.

But economists and bankers furiously debated whether the actions would be enough to restore confidence and prevent a run on another bank, and traders' actions spoke even louder than their words.

Across financial markets, investors who have used borrowed money to place their bets were pulling back, sending many asset prices lower. Commodities such as sugar and oil fell back sharply from the record levels of recent weeks, and only gold, a traditional safe haven investment in times of financial crisis, was holding its value.

The nervousness wiped £51bn off the FTSE 100 of leading British shares, which closed down 3.9 per cent at 5,414.4, its lowest level for two years. That will cut pension fund values for millions of Britons, and investors who have hung on to shares in the demutualised building societies since their windfalls in the Eighties and Nineties saw further declines in those values. HBOS, owner of Halifax, lost 13 per cent of its value yesterday, and Alliance & Leicester was down 7 per cent.

In the US, the Dow Jones Industrial Average also plunged more than 200 points in early trading, shrugging off President Bush's upbeat take on the collapse of Bear Stearns. "One thing is for certain, we're in challenging times. But another thing is for certain: We've taken strong, decisive action," he said. His administration had "shown the country and the world that the United States is on top of the situation".

The lessons from the run on Northern Rock in the UK and now Bear Stearns in the US is that banks can collapse with breathtaking speed. With confidence still very shaky, traders were casting round for future casualties. Lehman Brothers, another of the biggest investment banks in the US, was reassuring investors yesterday that its solvency position was much stronger than that at Bear Stearns.

But the Federal Reserve has stepped in to prevent a domino effect, ripping up decades of policy to promise it would lend money directly to prop up any investment bank in trouble. It was a sign of the times that the five members of the Fed's board of governors had to dust off a Depression-era law to justify their actions.

Meanwhile, the Bank of England pumped an extra £5bn into the financial system in an attempt to encourage banks to keep lending to each other. What politicians and regulators have most feared since the credit crisis first emerged last summer now appears to be coming true. The size and scale of the global banking system is contracting sharply, and efforts to prime the pumps with hundreds of billions of pounds of additional liquidity have so far only mitigated the problem.

The Fed will make its next move today, probably cutting US interest rates again. It has already reduced its target rate from 5.25 per cent to 3 per cent in the past six months, in the hope that lower borrowing costs will stimulate economic activity and stabilise the US housing market, which is at the root of the global financial crisis. Today there is every chance that the Fed will chop rates by a full 1 percentage point, probably now the minimum that will be needed to calm markets. Even so, it will hasten the rout of the dollar. There is talk that the governments of the G7 group of leading economies may intervene to prop up the currency. It all adds up to one of the more painful moments in world economic history.

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