Bear Stearns Meltdown, the Fed, and Inflation

This week saw an acceleration in the collapse of the financial edifice created on top of the mortgage bubble.  As the mortgage bubble deflates, the casualties continue to mount.  The Carlyle Group, Bear Stearns, and others are being pulled down under the weight of bad mortgage debt.

First, the The Carlyle Group's $16 billion dollar mortgage backed fund collapsed.  Then, the Fed stepped in and declared it was going to become a lender of last resort by agreeing to allow banks to swap worthless mortgage backed assets with treasuries for 28 days.  Many sighed and thought the worst had passed.

Then today, we learn that Bear Stearns, one of the big Wall Street investment houses was choking on its mortgage-backed assets and trading.  Its lenders were withdrawing funds, lacking confidence in Bear's business.  This classic run on the bank forced the Fed to step in and use its loan provision to provide Bear with fund for 28 days (done through JP Morgan Chase). 

There are a couple of thoughts to ponder:

  1. Are there are other investment banks and banks that are going to fail or all into dire straits?  The answer is yes.   I pointed out before that there is potentially $1.2 trillion in bad money held by banks and they have written down a fraction of that amount.  Many are mentioning Lehman Brothers and Citi as the next shoe to drop. 
  2. What going to happen to the economy?  The Fed is in essence printing money by exchanging treasuries for worthless mortgage backed securities.  Will this cause inflation?  Peter Schiff from Euro Pacific Captial argues yes in his article Vival La France, the Road to Hyperinflation.  Of course if we are having runs on the banks a la the Great Depression this would seem to be a deflationary problem so maybe trying to reinflate thing is the way to go?

Either way, the grim news keeps getting grimmer.  

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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