The Federal Reserve had a busy weekend. Bear Stearns was mercilessly killed off, while the Fed introduced a new lending facility, effectively reducing its collateral standards. It also cut its lending rate and increased the maturity of its liquidity support.
Bear Stearns is dead
The speed with which the Fed dealt with Bear Stearns was impressive. The Bank asked for liquidity on Friday morning and it was dead by Sunday evening; sold to JP Morgan for the shockingly low price of $2 a share, picking it up for just $236 million - 1.2 percent of Bear's market value a little more than a year ago. The Bear's shareholders were wiped out, sending out a healthy signal to other bankers. If you take large risks, there will be retribution.
This stands in stark contrast to the foolishness surrounding Northern Rock. The Fed had no time for any "market based solutions". The Fed just asked JP Morgan to name its price and they came back with $2. "Fine", said the Fed and that was the end of it.
The incredibly low price can only mean one thing - Bear Stearns was not just short of cash, it was almost insolvent and had broken through the risk-weighted capital adequacy ratios. JP Morgan now has to absorb a pile of poisonous debt, but in return gets hold of the fifth largest investment bank.
The lesson is harsh - any US bank looking like it might be in trouble had better get a fresh injection of capital. Otherwise, the Fed will kill it off.
Yet another Fed Lending facility
The Fed have introduced a new temporary lending facility. Under this new arrangement "credit...may be collateralized by a broad range of investment-grade debt securities." Basically, the Fed have further loosened their collateral standards in order to get liquidity.
The inference here is bleak - US banks are short of high quality collateral, and the Fed needs to loosen its lending criteria in order to pump more liquidity into the banking system. There is no getting away from it, the US banking system is in a deep hole right now.
The Fed cuts rates again
The Fed cut its lending rates to banks. With immediate effect, the primary credit rate was cut from 3.5 percent to 3.25 percent. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 0.25 percentage point.
The Fed also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days. The increase in maturities indicates that the crisis could be around for quite a while.
Any lessons here for the UK?
The Bank of England should be making copious notes from this weekend's action in New York. First, if any bank does start to slip, do not mess around. Quasi-solvent banks should not be tolerated. If you can not sell it within two days, liquidate it. There should be no mercy given to failing banks.
The BoE, along with their sleepy colleagues over at the FSA, should also recognize that this crisis will be long and protracted. The balance sheets UK banks should be thoroughly reviewed. If any bank looks even a little shaky, deal with it now. Sell it off or close it down before there is even a hint of any solvency problems.
Rapid upfront action will calm the situation down and reassure everyone that the remaining banks are solid. Killing off a few weak banks would be a downpayment on re-establishing the crediblity of both institutions. It is a win-win no brainer.
The alternative, delay and compromise - will mean disaster.