A rescue for Bear Stearns, but the Fed is destroying the dollar

Markets have tumbled on news that US investment bank Bear Stearns had to be bailed out by the Federal Reserve. From rate cuts to bailouts, the central bank's attempts to cushion the falling financial sector are actually making things worse.

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America's Northern Rock crisis appears to have been wrapped up rather more quickly than our own.

Stricken investment bank Bear Stearns has been sold to JP Morgan Chase for the princely sum of $2 a share. The bank's share price at the close on Friday was $30. In September, when British-born billionaire Joe Lewis took a 7% stake in the bank, the share price was more like $100. That's a hefty discount for JPM and a hefty loss for Mr Lewis.

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But at least the Federal Reserve has found a private sector solution to this nasty little episode of the credit crisis. Can we all rest easy now?

Not by a long chalk

JP Morgan Chase's purchase of Bear Stearns isn't exactly the private sector solution it might be cracked up to be. Chief executive Jamie Dimon has "secured special financing from" the Fed to secure the deal, reports The Times. In effect, the US central bank has underwritten $30bn of Bear Stearns' "toxic investments".

That's not all the Fed is doing. It has also lowered its emergency lending rate to 3.25% from 3.5%, meaning that the premium over the US base rate has shrunk to a distinctly non-penal 0.25%. On top of that, the Fed extended its lending facilities for allowing investment banks to secure short-term lending against a variety of securities, which the wider market simply won't swallow at the moment.

Then there's the big interest rate cut expected tomorrow when the Fed comes together for its regular rate-setting meeting. Markets are pricing in a cut of at least three-quarters of a percentage point, which would take the key rate down to 2.25%, but many are now predicting a cut of one full percentage point or more.

How the Fed is destroying the dollar

The Fed is certainly throwing all it has at the problem. The big question is will it be enough? Maybe that's not the right question. The real worry is, it may well be too much. Let me explain.

The Fed has been focusing on making more cheap money available to cushion the fall of the financial sector, but it's not working. Banks need all the money they can get to shore up their balance sheets. They are no longer interested in lending it out, cheaply or otherwise.

As the saying goes, you can take a horse to water, but you can't make him drink. The floods of money coming out of the Fed aren't tempting anyone. What they are doing, unfortunately, is absolutely destroying the dollar.

For a brief moment, a few months back, the dollar looked like it would rebound. The assumption was that with the Fed cutting interest rates rapidly and sharply, the US economy would recover. At the same time, Europe and the UK would slow down as their stubborn central banks held interest rates at comparatively high levels.

That theory has been proved wrong. Now it seems, the only way is down for the dollar, and with every interest rate cut, the downward slide gets steeper.

The clamour from the Gulf states to cut the link between their currencies and the dollar is growing louder. Because their currencies are linked to the greenback, so is their monetary policy. And while the US economy is probably in recession, the Gulf states are booming. In general, low interest rates plus a booming economy adds up to inflation, and that's exactly what's happened in the Gulf. Qatar had inflation of 12% for 2007, while the UAE's came in at 8%.

The countries are now resorting to price controls, but with Kuwait already dropping the dollar in favour of a basket of currencies last May, it may only be a matter of time before its peers follow.

The Gulf states aren't the only ones to worry about far from it. The foreign investors who have been buying US foreign debt may go on strike, or offload their holdings, as they see no end to the slump in the US currency. This would scupper the Fed's rate cuts, by "driving long-term market interest rates through the ceiling," says Gary Duncan in The Times. "A severe world recession would be unavoidable."

Duncan suggests that it's time for the Fed and the US Treasury to start talking about intervention from Europe and Japan to prop up the dollar. That's all very well and I'm sure that manufacturers in both Europe and Japan would welcome such a move but perhaps a more straightforward answer would be for the Fed to stop cutting interest rates.

After all, it isn't working. So why not arrest the dollar slide without having to ask for the intervention of Europe and Japan?

The trouble is, in Ben Bernanke, we have a Fed chairman who is convinced that the reason the US fell prey to the Great Depression in the 1930s is because the Federal Reserve didn't cut interest rates fast enough. So far, none of the evidence to the contrary is convincing him it won't work. I suspect Mr Bernanke is assuming that if rate cuts aren't working yet, it's because he hasn't cut far enough or hard enough.

The trouble is, when you're focused on avoiding one crisis from the past, another tends to rear up and bite you on the backside. Mr Bernanke may be about to find that the credit crisis is about to turn into a currency crisis.

Turning to the wider markets

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Financials tumble on Bear Stearns news

In London, the FTSE 100 tumbled 150 points from a high of 5,782 to end the day at 5,631 - an overall fall of 60 points - as the news from Bear Stearns hammered the banking sector. Banks including HBOS, Barclays and Alliance & Leiceter dominated the FTSE losers. For a full market report, see: London market close

Elsewhere in Europe, Paris's CAC-40 closed down 36 points, at 4,592, as the likes of BNP Paribas and Credit Agricole slumped. In Frankfurt, the DAX-30 was 48 points lower, at 6,451.

On Wall Street, the Bear Stearns bailout prompted heavy selling on Friday. The Dow Jones slumped by as much as 300 points at one point and eventually closed 194 points lower, at 11,951. The S&P 500 was 27 points lower, at 1,288. And the tech-rich Nasdaq closed 51 points lower, at 2,212.

In Asia, the Japanese Nikkei fell 454 points to 11,787 today, its lowest in two and a half years, thanks to the stronger yen and Friday's events on Wall Street. In Hong Kong, the Hang Seng was 1,152 points lower, at 21,084, with HSBC amongst the top fallers.

Gold jumps 3% to new record

Crude oil had risen over $1 to $111.32 this morning, and Brent spot was at $108.60 in London.

Spot gold had jumped by over 3% to a fresh record high of $1,030.80 this morning, up from Friday's high of $1,007, as investors stepped up buying in response to market turmoil and the tumbling dollar. Silver had climbed to $12.14.

In the currency markets, the pound fell to a record low of 1.2761 against the euro and a three-year low of 195.21 against the Japanese yen this morning on concerns over the vulnerable state of UK banks. Meanwhile, the pound had fallen back from Friday's three-month high against the dollar and was last trading at 2.0138. And the dollar was at 0.6329 against the euro and hit a thirteen-year low against the Japanese yen, last trading at 96.91.

And in London this morning, the FTSE 100 index was down over 100 points in early trade as all but three of its components fell, led by Royal Bank of Scotland.

If you're worried about the banking crisis and would like to read more - and find out the latest developments as they happen - see www.moneyweek.com

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.