The NYT describes the domino theory of Wall Street:

The Federal Reserve’s unusual decision to provide emergency assistance to Bear Stearns underscores a long-building concern that one failure could spread across the financial system…The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual. Hedge funds that rely on Bear to finance their trading and hold their securities would be stranded; investors who wrote financial contracts with Bear would be at risk; markets that depended on Bear to buy and sell securities would screech to a halt…

The volume of financial contracts that are not traded on any major exchanges has ballooned in recent years after the bailout of a big hedge fund, Long-Term Capital Management, in 1998. Now, much of the trading in derivative contracts tied to stocks and bonds takes place in unregulated transactions between financial institutions.Policy makers have been wrestling with questions about when and how they should provide assistance since the last major bailout of a tottering bank, Continental Illinois, in 1984. At the time, Continental was considered too big to fail without sending waves of losses through the financial system.

Regulators are facing an unprecedented and widespread deterioration in many markets. Last summer, the value of risky and exotic securities plummeted in value. Now, even top-rated securities once deemed as safe as Treasuries have hit the skids. Financial firms have written down more than $150 billion of their assets. Some analysts are predicting that losses in various credit markets will reach $600 billion…the bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps in which one party agrees to guarantee interest and principal payments in case an issuer defaults on its bonds.

When Continental Illinois was deemed too big to fail (TBTF), it had reported its 1983 assets at about $40 billion and equity of $1.8 billion. That’s a pretty small bank by today’s standards, and its leverage was a little over 20 to 1, too high for safety for a bank in a unit banking state, with faltering LDC and oil and gas loans.

By contrast, Bear Stearns reported its November balance sheet as about $395 billion in assets, with equity of $11.8 billion, or leverage of 33 to 1. In other words, Bear Stearns is about ten times the size of Continental Illinois, possessed of a riskier portfolio in our opinion, and far more thinly capitalized. 33 to 1 seems to be absurdly high leverage for this company (with long term debt of $131 billion on top of that). Where did all the bankers and regulators disappear to over the last few years?

This entry was posted on Saturday, March 15th, 2008 at 6:09 pm and is filed under Democrats, Republicans, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.